The Oxford Handbook of Banking [3 ed.] 9780198824633

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Preface

Preface   Edited by Allen N. Berger, Philip Molyneux, and John O.S. Wilson The Oxford Handbook of Banking (3rd edn) Edited by Allen N. Berger, Philip Molyneux, and John O. S. Wilson Print Publication Date: Oct 2019 Subject: Economics and Finance Online Publication Date: Nov 2019

(p. vi)

(p. vii)

Preface

Ten years on from the Global Financial Crisis, banks are still adapting to new, more con­ strained operating and regulatory environments. Banks now hold more capital and liquidi­ ty than they did prior to the crisis, and have had regulatory limits placed upon riskier ac­ tivities. Large banks have reduced their international activities in order to focus on do­ mestic and select overseas markets. In the US, Europe, and elsewhere banks are now subject to: new capital, liquidity, and tax regulations; resolution regimes; stress tests; bail-in mechanisms; corporate governance; executive compensation and disclosure rules; along with enhanced supervisory oversight, particularly for the thirty globally systemically important banks, the G-SIBs. FinTech de­ velopments are creating opportunities for both incumbent banks and new competitors in a diverse array of areas ranging from online banking, robo advisory services and distrib­ uted ledger technology (Blockchain) to marketplace or peer-to-peer lending platforms, as well as InsureTech and RegTech. There are now over 2,000 cryptocurrencies in existence, the most well known being Bitcoin with a 54 percent share of the total cryptocurrency market capitalization. These developments present banks with competitive challenges from the entry of technology firms and opportunities to redesign business models, offer new services, and improve efficiency. For example, legacy systems are likely to be gradu­ ally replaced with more technology-based systems using distributed-ledger technology and Blockchain. The more competitive environment and stricter regulation have affected bank profits. Banks have to spend more on regulatory compliance and organizational restructuring. As of this writing, many large European banks are generating single digit returns that often do not cover their cost of capital, leading to a destruction of shareholder value. The slug­ gish performance of the European economy following the European Sovereign Debt Crisis presents further challenges. The Eurozone set its plans out to create a European Banking Union in 2012 in order to establish a more robust framework for dealing with troubled Page 1 of 2

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Preface banks, although parts of the new regime (including a Euro-wide deposit insurance scheme) are yet to be fully implemented. Many of the aforementioned pressures continue to have similar influences on banking business globally. The slowdown in economic growth, the low (and in some cases nega­ tive) interest rate environment, coupled with regulatory measures designed to improve safety and soundness have generally acted as a drag on bank performance. Markets re­ main volatile and both banks and regulators continue to grapple with the complexities of measuring and managing a host of systemic as well as bank-level risks. Of particular re­ cent interest has been the accounting treatment of credit risk indicators (p. viii) such as loan loss provisions and reserves and the fair valuation of financial instruments, as well as issues related to the transparency of off-balance-sheet activities. Uncertainty continues to heighten. Trade wars, Brexit, Euro area challenges (such as Italian indebtedness), the possible end of the bull run in equity markets, the slowdown in emerging markets (China in particular), political polarization (both domestic and international), Middle East ten­ sions, and other factors all add to uncertainty and a less favorable global operating envi­ ronment for banks. This Third Edition seeks to evaluate many of the aforementioned areas and is a substan­ tial update on the Second Edition. There are new chapters on community and mutual banking; Islamic banking; microfinance; modern central banking; bank bail-ins and bailouts; deposit insurance; bank capital; financial literacy and consumer protection; and banking in China, and Australia and New Zealand. Developments in FinTech are dis­ cussed in the chapters on small business lending, payments, and financial innovation. General themes relating to the impact of the new regulatory environment and the impact of banks on the real economy are also substantially covered in specific chapters, as well as significant updates to the other topics covered in the Second Edition. Allen N. Berger Philip Molyneux and John O.S. Wilson

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List of Figures

List of Figures   Edited by Allen N. Berger, Philip Molyneux, and John O.S. Wilson The Oxford Handbook of Banking (3rd edn) Edited by Allen N. Berger, Philip Molyneux, and John O. S. Wilson Print Publication Date: Oct 2019 Subject: Economics and Finance Online Publication Date: Nov 2019

(p. xv)

List of Figures

2.1 Size of the Financial Markets by Country/Region 2001 and 2016, Percentage of GDP 40 2.2 Portfolio Allocation of Households and Non-financial Corporations (Average 1997–2016), Percentage of GDP 41 5.1 Firm Leverage [Liabilities/(Liabilities+Equity)], 2007 135 5.2 A Typical Cash Bonus Function 137 7.1 Total Reserves, Required Reserves, and Vault Cash Over Time 192 7.2 Capital Ratios Over Time (1934–2017) 194 7.3 Traditional Banking vs. Securitization in the Shadow Banking System 199 7.4 Comparison of Basel II and Basel III Capital Requirements 203 8.1 Scale-Related Diversification and Risk-Return Frontiers 232 11.1 Number of US Banks by Institution Type 342 11.2 Mergers & Acquisitions by Institution Type 345 11.3 Bank Entry and Exit Rates by Institution Type 347 12.1 Shares of Global Islamic Banking Assets (1H2017) 362 12.2 Number of Islamic Banks Reporting to Bankscope 363 12.3 Islamic Banks’ Total Assets (million $) 363 12.4 Share of Islamic Banks’ Assets in Total Banking Sector Assets (%) 364 12.5 Share of Islamic Banks’ Assets in Total Banking Sector by Country (1H2016) 364 12.6 World Islamic Population 1990, 2010, and 2030 (millions) 365 13.1 Microfinance Services Classified by Objective and Delivery Mode 422 15.1 Credit Scores at Mortgage Origination 473 15.2 Total US Mortgage Foreclosure Starts 474 15.3 US House Price and Mortgage Debt Growth 478 15.4 US Mortgage Rates 479 15.5 Refinancing Incentive and Refinancing Volume 485 15.6 Issuance of US Mortgage-Backed Securities 486 Page 1 of 3

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List of Figures 15.7 Holders of US Residential Mortgage Debt 487 (p. xvi) 15.8 Primary-Secondary Mortgage Market Spread 488 15.9 US Subprime Mortgage Delinquency Rates 489 15.10 US Household Assets 492 15.11 European House Price Indices 493 16.1 US Securitization Outstanding 506 16.2 European Securitization Outstanding 510 16.3 European Securitization Issuance by Country (2017) 510 16.4 Securitization Transaction (Simplified) 512 16.5 Credit Enhancements 517 17.1 Share of Assets of Non-bank Financial Intermediaries 533 17.2 Average Annual Growth Rate of OFI Sector 2011–15 and 2016 534 17.3 The Credit Intermediation Chain 536 17.4 Composition of Liabilities of Financial Business 538 17.5 US Money Market Fund Assets 551 17.6 “Riskier” US Residential Mortgage-Backed Securities 553 17.7 US Mortgage-Backed Securities: Agency vs. Non-Agency 555 17.8 Non-bank Credit Intermediation in China 556 17.9 Depository Institution Claims on Other Financial Institutions in China 557 17.10 US Leveraged Loans: Outstanding Volume and Spreads 559 17.11 US Leveraged Loans: Issuance of Lowly Rated Debt (B-Rated or Lower) 560 17.12 US Leveraged Loans: Average Debt Multiples 560 19.1 Central Banks’ Total Assets 618 19.2 Central Banks’ Key Intervention Rates 619 20.1 TARP Capital Injections to Banks 636 21.1 Number of Countries with Explicit Deposit Insurance 689 21.2 Percentage of Countries with Explicit Deposit Insurance 690 21.3 Percentage of Bank Liabilities Covered by Deposit Insurance 691 21.4 Percentage of Countries that have Increased Coverage as a Result of the Finan­ cial Crisis 692 21.5 Percentage of Countries that Charge Risk-adjusted Premiums 700 22.1 US Bank Capital Ratio, 1834–2014 713 22.2 Increase in the Quantity of Capital (Tier 1 Ratio of G-SIBs) 730 22.3 Increase in the Quantity of Capital (Leverage Ratio of G-SIBs) 730 22.4 Increase in the Quality of Capital (Time Series) 731 (p. xvii) 22.5 Increase in the Quality of Capital (Cross Sections) 731 22.6 Changes in the Distribution of Capital 732 29.1 Bank Acquisitions (by Year) 1985–2017 930 29.2 Percentage of Bank Acquisitions that Are Cross-Border (by Year) 1985–2017 931 29.3 Bank Acquisitions (by Region and Year) 1985–2017 933 29.4 Percentage of Cross-Border Bank Acquisitions (by Region and Year) 1985–2017 934

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List of Figures 31.1 Number of Commercial Banks and Commercial Bank Branch Offices in the US between 1940 and 2017 982 31.2 Aggregate Return-on-Equity and Equity-to-Assets Ratios for the US Commercial Banking Industry, 1934 to 2017 984 31.3 Merged Banks, Newly Chartered Banks, and Failed Banks, Expressed as a Per­ centage of the US Commercial Bank Population, each Year from 1970 to 2017 985 31.4 Strategic Map of the Banking Industry 988 31.5 The Changing Distribution of US Commercial Banks by Asset Size (in 2009 dol­ lars) between 1980 and 2017 992 31.6 Commercial Banks, Savings Banks, and Credit Unions in the US in 2017 993 32.1 Price-based and Quantity-based Financial Integration Composite Indicators 1007 33.1 Composition of Financial Assets in Japan by Holder 1040 33.2 Loans Outstanding of Private Banks 1041 33.3 Profits and Losses for Ordinary Banks 1064 33.4 Diffusion Index for Lending Attitude of Financial Institutions 1065 34.1 Aggregate Financial Development in International Comparison, 2015 1080 34.2 Private Credit to GDP across Low- and Lower-middle-income African Countries, 2015 1081 34.3 Private Credit to GDP (%) 1081 34.4 Access to and use of Financial Services in International Comparison, 2010–17 1082 34.5 Short-term Loans as Percentage of Total Loans 1084 34.6 Private Credit/GDP (%) in African Countries 2011–15, Actual vs. Predicted Val­ ues 1085 34.7 Use of Formal Account and Loan Services across Firm Size Groups in Interna­ tional Comparison, 2013–17 1090 34.8 Account Penetration across Regions, 2011, 2014, and 2017 1092 (p. xviii) 34.9 Gaps in Account Penetration in Sub-Saharan Africa 1094 34.10 Gaps in Mobile Money Account Penetration in Sub-Saharan Africa 1095 35.1 Chinese Financial Sector Assets Over Time 1114 35.2 Financial Sector Size across Countries in US dollars as of 2016 1114 35.3 Credit-to-GDP Gap for China and Other Countries 1115 35.4 Evolution of Financial Institutions in Asset Share 1116 35.5 The Rise of Shadow Banking 1119 35.6 Wealth Management Products, 2007–17 1119 35.7 Barriers to Account Ownership (% of Adults with No Account) 1128 38.1 Asset Composition of Banks in Australia, NZ, and Globally 1198

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List of Tables

List of Tables   Edited by Allen N. Berger, Philip Molyneux, and John O.S. Wilson The Oxford Handbook of Banking (3rd edn) Edited by Allen N. Berger, Philip Molyneux, and John O. S. Wilson Print Publication Date: Oct 2019 Subject: Economics and Finance Online Publication Date: Nov 2019

(p. xix)

List of Tables

4.1 Size and Complexity of G-SIBs, 2018 vs. 2013 (G-SIBs Ranked by Total Assets 2017) 101 4.2 Geographical Diversification of G-SIBs and Subsidiaries in OFCs, 2018 vs. 2013 (G-SIBs Ranked by Number of Countries in 2018) 105 4.3 Breakdown by Industry of Subsidiaries of G-SIBs, October 2018 (in bold) and May 2013 107 4.4 Number of Subsidiaries of US G-SIBs According to the FED/NIC Data Set, 2002– 18 112 4.5 Public Sections of Resolution Plans of the 8 US G-SIBs (July 2017): Key Selected Information 126 6.1 List of G-SIBs, November 2017 176 7.1 Countercyclical Capital Buffers 204 7.2 G-SIB Surcharges 206 10.1 Payment Instrument Use, 2016 289 11.1 Cooperative Banks and National Associations for Cooperative Banks 330 11.2 Institution-Type Composition by Size Category 343 12.1 Differences between Islamic and Conventional Banking Systems 367 12.2 Summary of Major Sharia-Compliant Financial Contracts 368 12.3 Stylized Balance Sheet of a Conventional Bank 370 12.4 Stylized Balance Sheet of an Islamic Bank 371 12.5 Comparing Islamic and Conventional Banks 373 12.6 Comparing Islamic and Conventional Banks—Controlling for Bank Characteris­ tics 374 12.7 Comparing Islamic and Conventional Banks During Crises 378 12.8 The Effects of Islamic Banks on Bank Liquidity Creation 384 12.9 Islamic Bank and Stock Illiquidity 385 13.1 Impact of Business Training on Business Outcomes 423 16.1 US Securitization Issuance 508 Page 1 of 3

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List of Tables 17.1 A Stylized View of the Structural Characteristics of Credit Intermediation 541 (p. xx) 19.1 LOLR Actions by the FED in the 2007–9 Crisis 621 22.1 Balance Sheet 708 22.2 Minimum Requirements Under Basel II and Basel III 717 22.3 Basel I Risk Weights 718 22.4 Risk Weights Under Basel II 719 22.5 Capital Conservation Buffer (CCB) 721 22.6 Historical CCyB Add-ons 723 22.7 Summary of Capital Buffers 723 22.8 G-SIBs in 2017 724 22.9 Basel III (Method 1) G-SIB Capital Surcharges 725 22.10 Method 1 vs. Method 2 (2016) 725 22.11 Comparison of Leverage Ratios, 2017:Q4 727 23.1 Prescriptive Information Disclosure, Pillar 3 in Basel III 759 23.A1 Percentage of Actual/Fitted, “Negative”/“Positive” Observations 765 24.1 Evolution of Research on the Impact of Bank Concentration and Competition on Bank Performance 779 29.1 Cross-Border Bank Acquisitions by Geographic Region, 1985–2017 932 31.1 Distribution of Financial Assets in the US Across Private Sector Financial Inter­ mediaries in 1980 and 2017 978 31.2 Comparing the Average Values of Selected Financial Ratios between 434 Small and 56 Large US Commercial Banks in 2017 990 31.3 Largest US Banking Companies as of December 31, 2017 by Total Assets ($ bil­ lions) 994 31.4 Global Investment Banking Revenue in 2017 994 32.1 Number of Credit Institutions and Foreign Branches 1008 32.2 Total Assets of Domestic Banking Groups and Foreign-Controlled Subsidiaries and Branches 1009 32.3 Concentration in European Banking Herfindahl index for credit institutions and share of total assets of the five largest credit institutions 1010 32.4 Bank Profitability—Return on Equity (%) 1015 33.1 Financial Assets in Japan by Holder 1035 33.2 Assets and Liabilities of the Japanese Corporate, Government, and Household Sectors 1037 33.3 Descriptive Statistics for Different Bank Types in Japan 1042 33.4 Four Main Types of Bank in Japan 1049 34.1 Decomposition of Interest Rate Spreads in Uganda in 2008 1087 34.2 Explaining Overhead Costs in Africa 1088 (p. xxi) 34.3 Account Penetration over Time and across Countries 1093 34.4 Mobile Phone use in Financial Transactions in Africa by Country, 2017 1102 35.1 Bank Performance Across Countries, 2016 1117 36.1 Deposit Money Banks’ Assets to GDP (%), Average for the Region 1144 36.2 Balance-Sheet Structure of Banking Sectors at end 2016 1146 37.1 Market Concentration and Foreign Bank Penetration 1156 Page 2 of 3

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List of Tables 37.2 Financial Depth and Credit Indicators 1165 37.3 Interest Rates, % 1167 37.4 Margins, Diversification, Liquidity, and Profitability, % 1168 37.5 Bank Capital, Stability, Profitability, and Leverage 1174 37.6 Cost Structure and Efficiency 1175 37.7 Bank Solvency and Asset Quality 1181 38.1 Size and Importance of the Financial Services Industry in Australia and New Zealand 1192 38.2 Overall Industry Concentration and Sectoral Concentration 1193 38.3 Bank Funding Sources in Australia and New Zealand, and Globally 1196 38.4 Sector Concentration by Bank Type in Australia and Loan Type in all Australian and New Zealand Banks 1199 38.5 Cost-to-Income Ratios 1202 38.6 Profitability 1203 38.7 Capital Requirements 1207

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List of Abbreviations

List of Abbreviations   Edited by Allen N. Berger, Philip Molyneux, and John O.S. Wilson The Oxford Handbook of Banking (3rd edn) Edited by Allen N. Berger, Philip Molyneux, and John O. S. Wilson Print Publication Date: Oct 2019 Subject: Economics and Finance Online Publication Date: Nov 2019

(p. xxii)

(p. xxiii)

List of Abbreviations

AAOIFI Accounting and Auditing Organization for Islamic Financial Institutions ABCP asset-backed commercial paper ABL asset-based lending ABS asset-backed securities ABSPP asset-backed securities purchase program ACH Automated Clearing House ADIs Authorised Deposit-taking Institutions AIG American International Group A-IRB advanced internal ratings-based approach AMA advanced measurement approach AMC asset management company AMLF Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility APP asset purchase program APRA Australian Prudential Regulation Authority Page 1 of 15

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List of Abbreviations AQR asset quality review ARM adjustable rate mortgage ASF available stable funding ASIC Australian Securities and Investments Commission ATM automated teller machine BCBS Basel Committee on Banking Supervision BCCI Bank Credit and Commerce International BEEPS Business Environment and Enterprise Performance Survey BHC bank holding company BIS Bank for International Settlements B/M ratio book-to-market ratio BoJ Bank of Japan BOJ-NET Japan’s Real Time Gross Settlement Network BOLR buyer of last resort BOPEC Summary performance ratings assigned to US bank holding companies over the period 1987 to 2004 BRRD Bank Recovery and Resolution Directive BRSS Bank Regulation and Supervision Survey C&I commercial and industrial CAMELS Capital, Assets, Management, Earnings, Liquidity, and Sensitivity (p. xxiv) CAPM capital asset pricing model CAR cumulative abnormal return CATFIN Page 2 of 15

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List of Abbreviations early warning systemic risk indicator CB central bank CBC commercial bank clearinghouse CBOT Chicago Board of Trade CBPP covered bond purchase program CCAR Comprehensive Capital Analysis and Review CCB capital conservation buffer CCyB countercyclical capital buffer CDCI Community Development Capital Initiative CDO collateralized debt obligation CDS credit default swap CEE Central and Eastern Europe CFPB Consumer Financial Protection Bureau CET1 Common Equity Tier 1 CGFS Committee on the Global Financial System CHAPS UK’s RTGS network Check 21 Electronic processing/collection of paper checks in the US CHIPS A US bank-operated large-value payment network CISS Composite Indicator of Systemic Stress CLS Bank A Continuous Linked Settlement bank handling foreign exchange transactions CLTV combined loan-to-value ratio CMBS commercial mortgage-backed security CME Page 3 of 15

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List of Abbreviations Chicago Mercantile Exchange CMO collateralized mortgage obligation CNAV constant net asset value CoCos Contingent Convertible Bonds CoVaR Conditional Value at Risk CP commercial paper CPFF Commercial Paper Funding Facility CPP Capital Purchase Program CR3 three-bank concentration ratio CR5 five-bank concentration ratio CRA credit rating agency CRD Capital Requirements Directive CRE commercial real estate CS credit spread CSPP corporate sector purchase program CSR corporate social responsibility CVA credit valuation adjustment DEA data envelopment analysis (p. xxv) DFA Dodd–Frank Act DFAST Dodd–Frank Act Stress Test DIC Deposit Insurance Company DIDMCA Depository Institutions Deregulation and Monetary Control Act DRC Page 4 of 15

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List of Abbreviations Democratic Republic of Congo DSGE dynamic stochastic general equilibrium D-SIBs domestically systemically important banks DSTI debt-service-to-income DTI debt-to-income ratio DVP delivery versus payment DW discount window EAD exposure at default EBA European Banking Authority EBITDA earnings before interest, tax, depreciation, and amortization EBRD European Bank for Reconstruction and Development EC European Commission ECB European Central Bank ECOFIN EU Council of Finance EDIS European Deposit Insurance Scheme EEC European Economic Community EESA Emergency Economic Stabilization Act EFSF European Financial Stability Facility EFTPOS electronic funds transfer at point of sale EIB European Investment Bank EIOPA European Insurance and Occupational Pensions Authority ELA emergency liquidity assistance EM Page 5 of 15

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List of Abbreviations emerging market EMU Economic and Monetary Union ES expected shortfall eSLR enhanced supplementary leverage ratio ESRB European Systemic Risk Board ESRC European Systemic Risk Council EU European Union Euro 1 A European bank-operated large-value payment network EVT extreme-value theory FAS Financial Access Survey FASB Financial Accounting Standards Board FDI foreign direct investment FDIC Federal Deposit Insurance Corporation FED US Federal Reserve Fedwire US’s RTGS network FHA Federal Housing Administration FHFA Federal Housing Finance Agency (p. xxvi) FHLB Federal Home Loan Bank FHLMC Federal Home Loan Mortgage Corporation (also Freddie Mac) FICO Fair Isaac and Company FILP Fiscal Investment Loan Program FINDEX Global Financial Inclusion Database FinTech Page 6 of 15

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List of Abbreviations financial technologies F-IRB foundation internal ratings-based approach FNMA Federal National Mortgage Association (also Fannie Mae) FRB Federal Reserve Bank FSA Financial Services Agency FSAP Financial Sector Assessment Programs FSB Financial Stability Board FSIs financial system inquiries FSOC Financial Stability Oversight Council FSRRA Financial Services Regulatory Relief Act FSU Former Soviet Union FX foreign exchange G20 Group of 20 Heads of State GAAP Generally Accepted Accounting Principles GCC Gulf Cooperation Council GFC Global Financial Crisis or Great Financial Crisis GDP Gross Domestic Product GIIPS Greece, Italy, Ireland, Portugal and Spain Giro European credit transfer network GLB Gramm–Leach–Bliley Act GNMA Government National Mortgage Association (also Ginnie Mae) GSE government-sponsored enterprise G-SIBs Page 7 of 15

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List of Abbreviations Global Systemically Important Banks G-SIFIs Global Systemically Important Financial Institutions HAMP Home Affordable Modification Program HARP Home Affordable Refinance Program HHI Herfindahl–Hirschman Index HMDA Home Mortgage Disclosure Act HQLA high-quality liquid assets ICOs initial coin offerings IDB Islamic Development Bank IFIs international financial institutions IFRS International Financial Reporting Standards IFSB Islamic Financial Services Board IFSI Islamic Financial Services Industry IIFM International Islamic Financial Market IMF International Monetary Fund InsurTech insurance technologies IO industrial organization IRA individual retirement accounts IRB internal ratings-based ITT intention-to-treat JA Bank Japan Agriculture Bank JBIC Japan Bank for International Cooperation JFC (p. xxvii)

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List of Abbreviations Japan Finance Corporation KYC know your customer KYCC know your customer’s customer LATE local average treatment effects LGFV local government financing vehicle LCBOs large and complex banking organizations LCR liquidity coverage ratio LGD loss given default LIBOR London Interbank Offered Rate LLP loan loss provisioning LMI liquidity mismatch index LOLR lender of last resort LPFC limited-purpose finance company LSAP Large-Scale Asset Purchase LSIs Less Significant Institutions LTRO Long-Term Refinancing Operation LTV loan-to-value LVG leverage M maturity M&A mergers and acquisitions MAC material adverse change MBS mortgage-backed securities MENA Page 9 of 15

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List of Abbreviations Middle East and North Africa MERS Mortgage Electronic Registration System MES marginal expected shortfall MFIs microfinance institutions ML machine learning MMDA money market deposit account MMIFF Money Market Investment Fund Facility MMFs money market funds MMMFs money market mutual funds MoF Ministry of Finance MRO Main Refinancing Operations MTN medium-term note NBCI non-bank credit intermediation NCOF net cash outflows NEIO new empirical industrial organization NFC non-financial corporation (p. xxviii)

NFIB National Federation of Independent Businesses NIC National Information Center NIRP negative interest rate policy NOW negotiable order of withdrawal account NPF non-performing financing NPL non-performing loan NRSRO Page 10 of 15

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List of Abbreviations Nationally Recognized Statistical Rating Organization NSFR net stable funding ratio OCC Office of the Comptroller of the Currency OECD Organisation for Economic Co-operation and Development OFC off-shore financial center OLA orderly liquidation authority OLF orderly liquidation fund OMO open market operations OMT outright monetary transactions OTH originate-to-hold OTC over-the-counter OTD originate-to-distribute OTS Office of Thrift Supervision P2P Peer-to-peer PBoC People’s Bank of China PCA prompt corrective action PD probability of default PDCF primary dealer credit facility PE private equity PIN Personal Identification Number PLC public limited company PPI payment protection insurance PRA Page 11 of 15

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List of Abbreviations Prudential Regulatory Authority PSD2 Payments Systems Directive 2 PSEs public sector entities PVP payment versus payment QE quantitative easing RAROC risk-adjusted return on capital RCTs randomized controlled trials RegTech regulatory technology REITs real estate investment trusts REMICs real estate mortgage investment conduits Repos repurchase agreements RFC Reconstruction Finance Corporation RMB renminbi RMBS residential mortgage-backed securities RMP relative market power (p. xxix)

ROA return on assets ROE return on equity ROSCAS rotating savings and credit associations RSF required stable funding RTGS Real-Time Gross Settlement RWA risk-weighted assets S&Ls savings and loans SBA Page 12 of 15

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List of Abbreviations Small Business Administration (US) SBCS small business credit scoring SCB stress capital buffer SBET small business economic trends SCF Survey of Consumer Finances SBLF Small Business Lending Fund SCAP Supervisory Capital Assessment Program SCP structure–conduct–performance SCR sectoral capital requirements SDG sustainable development goals SEC Security and Exchange Commission SEE Southeastern Europe SEPA Single Euro Payments Area SES systemic expected shortfall SFT securities financing transaction SIC Standard Industrial Classification SIFI systemically important financial institution SIV structured investment vehicle SLR supplementary leverage ratio SMEs small to medium-sized enterprises SNC Shared National Credit SND subordinated notes and debentures SOCBs Page 13 of 15

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List of Abbreviations state-owned commercial banks SOEs state-owned enterprises SOP say-on-pay SPOE single point of entry SPV special purpose vehicle SRISK systemic risk SRF Single Resolution Fund SRM Single Resolution Mechanism SSB Sharia Supervisory Board SSBF Survey of Small Business Finance SSC sequential servicing constraint SSM Single Supervisory Mechanism STBL Survey of Terms of Bank Lending STC simple, transparent, and comparable (p. xxx)

SWF sovereign wealth fund SWIFT Society for Worldwide Interbank Financial Telecommunication, a message transfer net­ work TAF Term Auction Facility TAGP Transaction Account Guarantee Program TALF Term Asset-Backed Securities Loan Facility TARGET 2 Europe’s RTGS network TARP Troubled Assets Relief Program TBTF too-big-to-fail Page 14 of 15

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List of Abbreviations TFP total factor productivity TIP targeted investment program TITF too-interconnected-to-fail TLAC total loss-absorbing capacity TLGP Temporary Liquidity Guarantee Program TLTRO Targeted Longer-Term Refinancing Operations TMTF too-many-to-fail TruPS trust preferred securities TSLF Term Securities Lending Facility UCITS Undertakings for Collective Investment in Transferable Securities UMP unconventional monetary policies VaR Value at Risk VI Vienna Initiative WMP wealth management products WOCCU World Council of Credit Unions WTO World Trade Organization ZLB zero lower bound

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List of Contributors

List of Contributors   Edited by Allen N. Berger, Philip Molyneux, and John O.S. Wilson The Oxford Handbook of Banking (3rd edn) Edited by Allen N. Berger, Philip Molyneux, and John O. S. Wilson Print Publication Date: Oct 2019 Subject: Economics and Finance Online Publication Date: Nov 2019

(p. xxxi)

List of Contributors

The Editors Allen N. Berger

is the H. Montague Osteen, Jr., Professor in Banking and Finance and Ph.D coordina­ tor of the Finance Department, Darla Moore School of Business; Carolina Distin­ guished Professor, University of South Carolina; Senior Fellow, Wharton Financial In­ stitutions Center; and Fellow, European Banking Center. He also currently serves on the editorial boards of seven professional finance and economics journals. He is coauthor of Bank Liquidity Creation and Financial Crises (2016, Elsevier) and is current­ ly co-authoring TARP and other Bank Bailouts and Bail-Ins around the World: Con­ necting Wall Street, Main Street, and the Financial System (2019, Elsevier). He has published well over 100 professional articles including papers in top finance journals. His research has been cited over 70,000 times according to Google Scholar, and he has given invited keynote addresses on five continents. He was Senior Economist from 1989 to 2008 and Economist from 1982–9 at the Board of Governors of the Fed­ eral Reserve System. He received a Ph.D in Economics from the University of Califor­ nia, Berkeley in 1983, and a B.A. in Economics from Northwestern University in 1976.

Philip Molyneux

is Dean of the College of Business Administration at the University of Sharjah (in the UAE). His main area of research is on the structure and efficiency of banking markets

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List of Contributors and he has published widely in this area. Recent publications appear in the Journal of Money, Credit and Banking, Journal of Financial Intermediation, Journal of Banking & Finance and the Review of Finance. He has co-written/edited over thirty-five books and is also the series editor of the Palgrave Macmillan Studies in Banking and Finan­ cial Institutions—with over 135 books in the series to date. In the past, Philip has act­ ed as a consultant to the New York Federal Reserve Bank, World Bank, European Commission, UK Treasury, Citibank Private Bank, Barclays Wealth, McKinsey, Credit Suisse and various other international banks and consulting firms.

John O.S. Wilson

is Professor of Banking and Finance and Director of the Centre for Responsible Bank­ ing & Finance based at the University of St Andrews. He is also a Member of the Sci­ entific Advisory Board of Chartered Association of Business Schools Academic Journal Guide. Previously, he was Treasurer and General Secretary of the British Accounting and Finance Association during the period 2009–11, and the founding Chair of the British Accounting and Finance Association Financial Markets and Institutions Spe­ cial Interest Group over the period 2007–18. He has guest edited (p. xxxii) special is­ sues for Journal of Corporate Finance, Journal of Banking & Finance, Journal of Eco­ nomic Behaviour & Organization, European Journal of Finance, Public Money & Man­ agement, British Accounting Review and Managerial Finance. In the period June 2011 to April 2012, John served as a full member of a Commission on Credit Unions estab­ lished by the Irish Government. The Commission delivered interim and final reports to the Minister for Finance in September 2011 and April 2012 respectively. In 2018, John delivered evidence on the impact of Brexit on UK small and medium-sized enter­ prises to the House of Lords EU Internal Markets Committee.

Contributors Tobias Adrian

is the Financial Counsellor and Director of the Monetary and Capital Markets Depart­ ment of the International Monetary Fund (IMF). In this capacity, he leads the IMF’s work on financial sector surveillance, monetary and macroprudential policies, finan­ cial regulation, debt management, and capital markets. He also oversees capacitybuilding activities in IMF member countries, particularly with regard to the supervi­

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List of Contributors sion and regulation of financial systems, central banking, monetary and exchange rate regimes, and asset and liability management. Prior to joining the IMF, he was a Senior Vice President of the Federal Reserve Bank of New York and the Associate Di­ rector of the Research and Statistics Group. At the Federal Reserve, he contributed to monetary policy, financial stability policies, and crisis management. He taught at Princeton University and New York University and has published extensively in eco­ nomics and finance journals, including the American Economic Review, Journal of Fi­ nance, Journal of Financial Economics, and Review of Financial Studies. His research spans asset pricing, financial institutions, monetary policy, and financial stability, with a focus on aggregate consequences of capital markets developments. He holds a Ph.D from the Massachusetts Institute of Technology, an M.Sc. from the London School of Economics, a Diploma from Goethe University Frankfurt, and a Maîtrise from Dauphine University Paris. He received his Abitur in Literature and Mathematics from Humboldtschule Bad Homburg.

Franklin Allen

is Professor of Finance and Economics and Director of the Brevan Howard Centre at Imperial College London and has held these positions since July 2014. He was on the faculty of the Wharton School of the University of Pennsylvania from July 1980 to June 2016. He now has Emeritus status there. He was formerly Vice Dean and Director of Wharton Doctoral Programs, Co-Director of the Wharton Financial Institutions Cen­ ter, Executive Editor of the Review of Financial Studies and Managing Editor of the Review of Finance. He is a past President of the American Finance Association, the Western Finance Association, the Society for Financial Studies, the Financial Interme­ diation Research Society and the Financial Management Association, and a Fellow of the Econometric Society and the British Academy. He received his doctorate from Ox­ ford University. His main areas of interest are corporate (p. xxxiii) finance, asset pric­ ing, financial innovation, comparative financial systems, and financial crises. He is a co-author with Richard Brealey and Stewart Myers of the eighth through twelfth edi­ tions of the textbook Principles of Corporate Finance.

Linda Allen

holds the William F. Aldinger Chair in Banking and Finance at Baruch College, City University of New York. Her broad areas of research are risk measurement and man­ agement, focusing on systemic risk, credit risk, and operational risk; the evolution of

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List of Contributors financial markets and bank regulation; and the organization of financial institutions. Her latest book Credit Risk Measurement In and Out of Crisis: New Approaches to Value at Risk and Other Paradigms, 3rd edition (Wiley, 2010), co-authored with Antho­ ny Saunders, describes the global financial crisis that began in 2007, as well as de­ constructs credit risk measurement models commonly used by bankers and other fi­ nance professionals. She is also the author of Capital Markets and Institutions: A Global View (Wiley, 1997) and co-author of Understanding Market, Credit and Opera­ tional Risk (Blackwell, 2004). She is an associate editor of many finance journals, and has published extensively in top academic journals in finance and economics. Along with her consulting in securities litigation, she has lectured and advised all over the world on topics of risk measurement and management, banking trends, and financial market development.

Deniz Anginer

is a financial economist in the Finance and Private Sector Development Team of the World Bank’s Research Group. He conducts research in the areas of financial interme­ diation and empirical asset pricing. His research work in systemic risk and financial stability has been widely cited by academics, media, and policymakers. He has a Ph.D in Finance from the Ross School of Business at the University of Michigan.

Adam B. Ashcraft

is currently a Managing Director in the Global Risk Analytics Group at Bank of Ameri­ ca. Previously, he worked at the Federal Reserve Bank of New York for seventeen years where he held various roles including Co-Chair of the LISCC Liquidity Program, Head of Credit Risk Management, and Research Economist. He holds Bachelor’s de­ grees in Economics and Mathematics & Statistics from Miami University and a Doc­ torate in Economics from the Massachusetts Institute of Technology.

Thorsten Beck

is Professor of banking and finance at Cass Business School in London. He is also a research fellow of the Centre for Economic Policy Research (CEPR) and the CESifo. He was Professor of Economics from 2008 to 2014 at Tilburg University and the

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List of Contributors founding chair of the European Banking Center from 2008 to 2013. Previously he worked in the research department of the World Bank and has also worked as consul­ tant for, among others, the European Central Bank, the Bank of England, the BIS, the IMF, the European Commission, and the German Development Corporation. His re­ search, academic publications, and operational work have focused on two major ques­ tions: What is the relationship between finance and economic development? What policies are needed to build a sound and effective financial system? Recently, he has concentrated on access to financial services, including SME finance, as well as on the design of regulatory and bank resolution frameworks. He holds a Ph.D from the Uni­ versity of Virginia and an M.A. from the University of Tübingen in Germany.

(p. xxxiv)

Lamont K. Black

is an Assistant Professor of Finance in the Driehaus College of Business at DePaul University in Chicago. He is also the Academic Director for DePaul’s Center for Finan­ cial Services and the Chair of the Banking Advisory Group for FinTEx. Prior to joining the faculty of DePaul, he was an economist at the Federal Reserve Board of Governors in Washington, DC. His research has been published in several journals, including Journal of Financial Intermediation, Journal of Money, Credit and Banking; and Jour­ nal of Banking and Finance. He serves as a referee for the Review of Financial Stud­ ies and Management Science among other journals. In his work on banking policy, he contributed to issues including incentive compensation, bank liquidity requirements, and European financial stability. He is also a co-organizer of the annual Chicago Fi­ nancial Institutions Conference.

Michael Blank

is a Ph.D candidate in Business Economics at Harvard Business School. Previously, he served as a senior research analyst at the Federal Reserve Bank of New York.

Robert R. Bliss

is Professor Emeritus of Finance at Wake Forest University, where he taught courses in derivatives, fixed income, and capital markets. Prior to returning to academia in 2014, he served as a senior financial economist at Federal Reserve Bank of Chicago

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List of Contributors and held research positions at the Bank of England and the Federal Reserve Bank of Atlanta. Previously, he taught finance at Indiana University. His research interests in­ clude fixed income securities and derivatives, structured finance, risk management, financial regulation, and the law and economics of insolvency. He earned his doctor­ ate in finance from the University of Chicago.

Arnoud W.A. Boot

is Professor of Corporate Finance and Financial Markets at the University of Amster­ dam and member of the Royal Netherlands Academy of Arts and Sciences (KNAW). He is chairman of the Bank Council of the Dutch Central Bank (DNB), member of the Dutch Scientific Council for Government Policy (WRR) and chairman of the European Finance Association (EFA). He is also a research fellow at the Centre for Economic Policy Research (CEPR) in London. He was member of the Advisory Committee of the European Systemic Risk Board (ESRB), and a faculty member at the Kellogg Graduate School of Management at Northwestern University in Chicago. He has written exten­ sively in the areas of financial institutions and corporate finance, with publications in major academic journals, such as the Journal of Finance, American Economic Review, Review of Financial Studies, and the Journal of Financial Intermediation.

Narjess Boubakri

is the Bank of Sharjah Chair in Banking and Finance, Professor of Finance and Head of the Finance Department at the School of Business Administration of the American University of Sharjah. Her research interests include, among other things, privatiza­ tion, corporate governance, political economy of reforms, institutional economics, and the impact of institutional infrastructure on corporations. Her papers have been pub­ lished in the Journal of Finance, the Journal of Financial Economics, the Journal of In­ ternational Business Studies, the Journal of Accounting Research, and the (p. xxxv) Journal of Financial and Quantitative Analysis, among others. She acts as Associate Editor for the Journal of Corporate Finance, as Editor in Chief for Finance Research Letters, co-editor for the Quarterly Review of Economics and Finance, and is on the editorial boards of Emerging Markets Review and the Journal of International Finan­ cial Markets Institutions and Money.

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List of Contributors Christa H.S. Bouwman

is Associate Professor of Finance and Patricia & Bookman Peters Professor of Finance at Mays Business School at Texas A&M University; and Fellow of the Wharton Finan­ cial Institutions Center at the University of Pennsylvania. She was Associate Professor of Banking & Finance at Case Western Reserve University where she also held the Lewis-Progressive Chair; Visiting Assistant Professor of Finance at MIT’s Sloan School of Management; Research Associate at the Federal Reserve Bank of Cleveland; and Visiting Scholar at the Federal Reserve Bank of Boston and the Federal Reserve Board in Washington DC. Her research interests are in Financial Intermediation and Corporate Finance. She is Co-Editor-in-Chief of the Journal of Financial Intermedia­ tion. She is Associate Editor of the Journal of Banking & Finance; and former Asso­ ciate Editor of the Journal of Financial Intermediation, the Review of Finance, and Corporate Governance: An International Review. Her research papers have been pub­ lished in the American Economic Review, Journal of Financial Economics, Review of Financial Studies, Journal of Financial Intermediation, Journal of Financial Stability, Journal of Banking & Finance, and MIT/Sloan Management Review. She is a co-author of the book “Bank Liquidity Creation and Financial Crises” (Elsevier, 2015). She worked for five years at ABN AMRO Bank (in Venture Capital, Project Finance Adviso­ ry, and Capital Structure Advisory), and as a part-time litigation consultant for the US Department of Justice. She received a Ph.D in Finance from the University of Michi­ gan, an M.B.A. from Cornell University, and a B.A./M.A. in Economics and Business (cum laude) from the University of Groningen, the Netherlands.

Peter Breuer

is Deputy Chief of the Global Analysis Division at the International Monetary Fund. In this role he jointly manages a team that analyzes risks to global financial stability, monitors and assesses global market developments, and helps ensure that the Fund takes consistent and well-informed views about financial risks and policies, including in the Global Financial Stability Report. Previously, as Deputy Chief of the Debt and Capital Markets Instruments Division, he oversaw teams analyzing risks emanating from shadow banking and providing debt management advice. He also led the Finan­ cial Sector Stability Assessment for Luxembourg. He headed the IMF’s office in Ire­ land as Resident Representative during the EU–IMF program in 2011–14. In previous roles, he served as Assistant to the Director in the Monetary and Capital Markets De­ partment, and worked in the IMF’s Asia-Pacific, European, International Capital Mar­ kets, Strategy and Policy Review, and Research Departments. Policy areas he has cov­ ered include capital markets and financial stability, as well as debt sustainability and

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List of Contributors restructuring issues. Previous country responsibilities include Argentina, Bulgaria, Finland, Hong Kong, Ireland, Luxembourg, Pakistan, Paraguay, Peru, Uganda, United (p. xxxvi) Arab Emirates, and Uruguay. He holds a Ph.D and an M.A. from Brown Uni­ versity, a M.Sc. from the London School of Economics, and a B.A. from Vassar Col­ lege.

Claudia M. Buch

is the Vice-President of the Deutsche Bundesbank. She is responsible for Financial Stability, Statistics, and Internal Audit. She is the accompanying person of the Presi­ dent of the Bundesbank on the ECB Governing Council and a member of the German Financial Stability Committee (FSC). Prior to joining the Bundesbank in May 2014, she was the President of the Institute for Economic Research (IWH) in Halle (2013– 14), Professor of Economics at the Otto von Guericke University Magdeburg (2013– 14), and Professor of Economics for “International Finance and Macroeconomics” at the University of Tübingen (2004–13). From 2012 to 2014, she was a member of the German Council of Economic Experts. She was Scientific Director at the Institute for Applied Economic Research (IAW) in Tübingen (2005–13), and worked at the Institute for World Economics in Kiel (IfW) from 1992 until 2013. She habilitated at the Univer­ sity of Kiel (2002) after receiving her doctorate there in 1996. Between 1985 and 1991, she studied Economics at the University of Bonn and she graduated from the University of Wisconsin (Eau Claire) with a Master of Business Administration degree in 1988. Her fields of specialization are financial stability, international banking, inter­ national finance and macroeconomics, and financial integration.

Erwin Bulte

is Professor of Development Economics at Wageningen University, and Professor of Institutions and Development at Utrecht University. His main research interests in­ clude institutional change, health, insurance, and agricultural development in devel­ oping countries, and much of his research is based on field experiments in Africa. Er­ win has published more than 100 papers in international journals, including papers in the American Economic Review, Economic Journal, European Economic Review, and Journal of Public Economics. He is one of the leaders of the Policies, Institutions and Market program of the CGIAR.

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List of Contributors Charles W. Calomiris

is the Henry Kaufman Professor of Financial Institutions at Columbia Business School, a Professor at Columbia’s School of International and Public Affairs, and a Research Associate of the National Bureau of Economic Research. He is a member of the Shad­ ow Open Market Committee and the Financial Economists Roundtable. He is a Distin­ guished Visiting Scholar at the Hoover Institution, where he co-directs the Initiative on Regulation and the Rule of Law, and a Fellow at the Manhattan Institute. He re­ ceived a B.A. in Economics from Yale University in 1979 and a Ph.D in Economics from Stanford University in 1985.

Gerard Caprio, Jr.

is William Brough Professor of Economics at Williams College and Chair of the Center for Development Economics. Previously he was the Director for Policy in the World Bank’s Financial Sector Vice Presidency and head of the financial sector research group. His research included establishing the first databases on banking crises around the world and on bank regulation and supervision, and he worked on financial system reform and development issues around the world. He has consulted for the IMF, the World Bank, and various governments. He has authored numerous (p. xxxvii) articles, and co-authored The Guardians of Finance: Making Regulators Work for Us, with Jim Barth and Ross Levine (MIT Press, 2012), with whom he also wrote Rethink­ ing Bank Regulation: Till Angels Govern (Cambridge University Press, 2006). Earlier positions include: Vice President and Head of Global Economics at JPMorgan, and economist positions at the Federal Reserve Board and the IMF. He has taught at Trini­ ty College Dublin, where he was a Fulbright Scholar, and at George Washington Uni­ versity.

Fernando J. Cardim de Carvalho

was Emeritus Professor of Economics at the Institute of Economics, Federal Universi­ ty of Rio de Janeiro (Brazil). Former associate editor of the Journal of Post Keynesian Economics, he is author of the books Mr Keynes and the Post Keynesians (Edward El­ gar, 1992) and Liquidity Preference and Monetary Economies (Routledge, 2015). His research interests were Keynesian macroeconomics, international monetary econom­ ics, and financial systems.

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List of Contributors

Jacopo Carmassi

is a Senior Financial Stability Expert in the Financial Regulation and Policy Division, DG Macroprudential Policy and Financial Stability, at the European Central Bank. He is a Fellow of CASMEF, the Arcelli Center for Monetary and Financial Studies, Univer­ sity LUISS Guido Carli, and a Fellow of the Wharton Financial Institutions Center, University of Pennsylvania. Previously, he worked as an economist at Assonime, the Association of Joint Stock Companies incorporated in Italy, and at the Italian Banking Association. He holds a Ph.D in Law and Economics from University LUISS Guido Car­ li of Rome. He is author of several publications on banking and financial regulation topics, including the 2007–9 Global Financial Crisis, bank capital rules, bank crisis resolution, deposit insurance, banking union in Europe, and the corporate complexity of Global Systemically Important Banks.

Elena Carletti

is Professor of Finance at Bocconi University and Scientific Director of the Florence School of Banking and Finance at the European University Institute (EUI). Previously she was Professor of Economics at the EUI, holding a joint chair in the Economics De­ partment and the Robert Schuman Centre for Advanced Studies. She is a member of the Board of Directors of Unicredit SpA and of the Advisory Scientific Committee of the European Systemic Risk Board. Furthermore, she is Research Fellow at CEPR, Fellow of the Finance Theory Group, CESifo, IGIER, and the Wharton Financial Insti­ tutions Center. Among other appointments, she has worked as consultant for the OECD and the World Bank, has served in the review panel of the Irish Central Bank and of the Riskbank, and has been a board member of the Financial Intermediation Research Society and of the Fondazione della Cassa di Risparmio di La Spezia. Her main research areas are Financial Intermediation, Financial Crises and Regulation, Competition Policy, Corporate Governance, and Sovereign Debt.

Barbara Casu

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List of Contributors is the Director of the Centre for Banking Research at Cass Business School, where she is Professor of Banking and Finance. Her main research interests are in empirical banking, although several of her research projects are cross-disciplinary and include aspects of financial regulation, structured finance, accounting and (p. xxxviii) corporate governance. She has published widely, with over forty publications in peer-reviewed journals. She has also written the popular textbook Introduction to Banking (Pearson FT, 2015), which is widely adopted for banking courses across the world. She has re­ cently co-edited the Palgrave Handbook of European Banking.

Nicola Cetorelli

is a Vice President at the Federal Reserve Bank of New York and the Head of the Fi­ nancial Intermediation Function in its Research Group. His research has focused on the industrial organization and the corporate finance characteristics of the banking industry and the relationships with real economic activity. More recently he has worked on themes of international banking and on the evolution of financial interme­ diation. He represents the New York Fed on various Financial Stability Boards’ inter­ national working groups. He has published in a number of scholarly journals, among which the Journal of Finance, Journal of Economic Theory, American Economic Review, and Journal of International Economics. He has also written many articles in various policy journals and book chapters. He received his Ph.D in Economics from Brown University and a B.A. from the University of Rome, Italy.

Ruiyuan (Ryan) Chen

is an Assistant Professor of Finance at the West Virginia University. His current re­ search focuses on state ownership, corporate governance, and corporate cash hold­ ings. His research has been published in Emerging Markets Review, the Journal of Corporate Finance, and the Journal of Financial and Quantitative Analysis.

Robert Cull

is acting research manager and Lead Economist in the Finance and Private Sector De­ velopment Team of the World Bank’s Development Research Group. His most recent research is on the performance of microfinance institutions, African financial develop­

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List of Contributors ment, Chinese financial development and firm performance, and the effects of the global financial crisis on foreign banks in developing economies. He has published nu­ merous articles in peer-reviewed academic journals including the Economic Journal, Journal of Development Economics, Journal of Economic Perspectives, Journal of Fi­ nancial Economics, Journal of Law and Economics, and the Journal of Money, Credit, and Banking. The author or editor of multiple books, his most recent co-edited book, Banking the World: Empirical Foundations of Financial Inclusion was published by MIT Press in January, 2013. He is also co-editor of the Interest Bearing Notes, a bimonthly newsletter reporting on financial and private sector research.

Olivier de Bandt

is director of International Economics and Cooperation at the Banque de France. He was previously head of the Directorate of Research and Risk Analysis at the ACPR, the French Prudential Supervision and Resolution Authority. He holds a Ph.D from the Department of Economics of the University of Chicago. He contributed many articles in peer-reviewed academic journals on stress-testing methods, the analysis of sys­ temic risk, the impact of banking regulation, the economics of insurance. He is an As­ sociate Editor of the Journal of Financial Stability.

Luiz Fernando de Paula

is Professor of Economics at the State University of Rio de Janeiro (Brazil), joint ap­ pointment between the Faculty of Economics (FCE) and (p. xxxix) Institute of Social and Political Studies (IESP), and CNPq Researcher. He is currently a co-editor of the Brazilian Keynesian Review. He is author of the book Financial Liberalization and Economic Performance: Brazil at the Crossroads (Routledge, 2011) and co-editor of the book Financial Liberalization and Economic Performance in Emerging Countries (Palgrave Macmillan, 2008). A former chairman of the Brazilian Keynesian Associa­ tion, his research interests include banking, financial systems, Keynesian macroeco­ nomics, and economic policies related to emerging economies.

Hans Degryse

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List of Contributors is Professor of Finance at the Department of Accountancy, Finance and Insurance of the KU Leuven. He is a research fellow at the CEPR, CESIfo, the European Banking Center (EBC), and TILEC. He is a member of the Group of Economic Advisers of ES­ MA. Before joining Leuven in 2012, he was Professor of Finance at Tilburg University. His research focuses on financial intermediation, including theoretical and empirical banking as well as market microstructure. He has published in many journals includ­ ing the American Economic Review, Journal of Finance, Journal of Financial Econom­ ics, Review of Financial Studies, Management Science, Review of Finance, Journal of Financial Intermediation, and the Economic Journal, and has been presented in lead­ ing international conferences such as the American Finance Association, the Western Finance Association, the European Finance Association, and the Financial Intermedia­ tion Research Society. He co-authored, with Moshe Kim and Steven Ongena, the grad­ uate textbook Microeconometrics of Banking: Methods, Applications and Results (Oxford University Press, 2009).

Gayle L. DeLong

is an Associate Professor in the Economics and Finance Department of Baruch Col­ lege in the City University of New York. She earned a Ph.D in International Business and Finance from New York University and a Masters in International Business Stud­ ies from the University of South Carolina. Her research interests include banking, public–private partnerships, and the implications of regulations. In 2012, she won the Abraham J. Briloff Prize in Ethics at Baruch College, New York.

Asli Demirgüç-Kunt

is the Director of Research at the World Bank. After joining the Bank in 1989 as a Young Economist, she has held different positions, including Director of Development Policy, Chief Economist of Financial and Private Sector Development Network, and Senior Research Manager, doing research and advising on financial sector and pri­ vate sector development issues. She has published over 100 articles in the areas of banking crises, financial regulation, links between financial and economic develop­ ment, access to financial services and financial inclusion. She has been the President of International Atlantic Economic Society (2013–14) and Director of Western Eco­ nomic Association (2015–18). Prior to coming to the Bank, she was an Economist at the Federal Reserve Bank of Cleveland. She holds a Ph.D and an M.A. in economics from the Ohio State University.

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List of Contributors

Robert DeYoung

is the Koch Distinguished Professor of Business Economics and holds the Harold Otto Chair in Economics at the University of Kansas School of Business. He is also co-edi­ tor of the Journal of Money, Credit and Banking. Prior to joining the KU (p. xl) faculty, he was an Associate Director of Research at the Federal Deposit Insurance Corpora­ tion, an Economic Advisor at the Federal Reserve Bank of Chicago, a Senior Econo­ mist at the Office of the Comptroller of the Currency, and a Joyce Foundation Teach­ ing Fellow at Beloit College. He worked his way to an undergraduate degree at Rut­ gers University-Camden, and holds a Ph.D in economics from the University of Wis­ consin-Madison.

Gregory Elliehausen

is Principal Economist in the Consumer Finance Section of the Division of Research and Statistics at the Board of Governors of the Federal Reserve System. His current research focuses on consumer financial behavior, regulation of financial markets and services, and markets for high-rate credit products. His research has been published in numerous professional journals. Recent work includes Truth in Lending: Theory, History, and a Way Forward (co-authored with T.A. Durkin), which analyzes the pur­ poses, strengths, and weaknesses of disclosures as consumer protections in financial transactions, and Consumer Credit and the American Economy (co-authored with T.A. Durkin, M.S. Staten, and T.J. Zywicki), which examines the economics, psychology, law, and regulation of consumer credit in the United States. Previously, he held re­ search positions at George Washington University (2006–9), Georgetown University (1998–2005), and the Board of Governors of the Federal Reserve System (1981–98). He has a Ph.D degree in business administration from the Pennsylvania State Univer­ sity.

Mark J. Flannery

has been the BankAmerica Eminent Scholar in Finance at the University of Florida since 1989. He previously held faculty positions at the University of North Carolina (Chapel Hill) and the University of Pennsylvania. He has published extensively, partic­

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List of Contributors ularly in the areas of corporate finance and financial regulation. He holds economics degrees from Princeton (A.B.) and Yale (M.A., M.Phil, and Ph.D). He served as presi­ dent of the Financial Intermediation Research Society (FIRS), president and board chairman of the Financial Management Association, and member of the board of di­ rectors of the American Finance Association. He was an editor of the Journal of Mon­ ey, Credit and Banking from 2000–5.

W. Scott Frame

is a financial economist and senior advisor on the financial markets team in the re­ search department of the Federal Reserve Bank of Atlanta. His major fields of study are financial institutions, credit markets, real estate, and public policy. He has been with the Bank since 2001, although he spent two years as the Belk Distinguished Pro­ fessor of Finance at the University of North Carolina at Charlotte (2012–14). Before joining the Bank, he was a senior financial economist at the US Treasury Department from 1996 to 2000. He also worked at the Federal Reserve Bank of Atlanta as an eco­ nomic analyst from 1993 to 1995 and as an instructor at the University of Georgia. He was promoted to financial economist and policy advisor in 2007 and assumed his cur­ rent duties in 2012.

Xavier Freixas

is Chairman of the Department of Economics and Business and Professor at the Uni­ versitat Pompeu Fabra in Barcelona (Spain) after becoming full (p. xli) Professor at the Université de Toulouse. He is also affiliated Professor at Barcelona Graduate School of Economics as well as Research Fellow at CEPR. He has previously been president of the European Finance Association, Deutsche Bank Professor of European Financial Integration at Oxford University, Houblon Norman Senior Fellow of the Bank of Eng­ land and chairman of the Risk Based Regulation program of the Global Association of Risk Professionals (GARP). He has been a consultant for the European Investment Bank, the New York Fed, the European Central Bank, the World Bank, the Inter-Amer­ ican Development Bank and the European Investment Bank. He is Associate Editor of the Journal of Financial Intermediation and of the Journal of Financial Services Re­ search. He is well known for his MIT Press book, jointly with Jean-Charles Rochet, Mi­ croeconomics of Banking. His research focuses on banking and regulation, and has been published in top international journals.

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List of Contributors

Zuzana Fungáčová

is a Senior Advisor at the Bank of Finland Institute for Economies in Transition in Helsinki. Her research interests are in banking, emerging markets and their financial sectors as well as financial stability. She has experience from the European Central Bank and was also a Visiting Economist at the Austrian Central Bank. She obtained her Ph.D in Economics from the Center for Economic Research and Graduate Educa­ tion in Prague and served also as a research affiliate at the Institute of Economic Studies at Charles University in Prague. Her research has been published in academ­ ic journals including Journal of Banking and Finance, Journal of Financial Services Re­ search, Journal of Economic Behavior & Organization, World Development, Journal of Macroeconomics, Economics of Transition, Regional Studies and China Economic Re­ view.

John Goddard

is the Head of Aberystwyth Business School at Aberystwyth University, Wales. He is also Emeritus Professor of Financial Economics at Bangor University, and served as Deputy Head of Bangor Business School between 2007 and 2017. His previous acade­ mic appointments were at the University of Leeds, Abertay University and Swansea University. He has several years’ practitioner experience in the UK life insurance in­ dustry. His research interests are in industrial organization, financial markets and in­ stitutions, and the economics of professional sports. He is author or co-author of sixtynine refereed journal articles. His co-authored book publications include The Econom­ ics of Football (2nd edition, Cambridge University Press, 2011), Banking: A Very Short Introduction (Oxford University Press, 2016) and the textbook Industrial Organiza­ tion: Competition, Strategy, Policy (5th edition, Pearson, 2017).

Xian Gu

is an Assistant Professor of Finance at the Central University of Finance and Econom­ ics in Beijing. Previously she worked as a post-doctoral research fellow at Wharton Fi­ nancial Institutions Center and an economist at CITIC Securities in Beijing. She was also a Visiting Researcher at central banks including Bank of Finland and Hong Kong

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List of Contributors Monetary Authority. She earned her Ph.D from Beijing Normal University. Her main research interests are banking, corporate finance, and China’s economy.

Omrane Guedhami

is the C. Russell Hill Professor of Economics and Professor of International Finance at the Moore School of Business at the University of South (p. xlii) Carolina. His current research focuses on corporate governance, privatization, corporate social responsibil­ ity, and formal and informal institutions and their effects on corporate policies and firm performance. His research has been published in the Journal of Financial Eco­ nomics, the Journal of Accounting Research, the Journal of Accounting and Economics, the Journal of Financial and Quantitative Analysis, the Journal of Interna­ tional Business Studies, and Management Science, and the Review of Finance, among others. He is a member of the editorial boards of major journals, such as Contempo­ rary Accounting Research and the Journal of International Business Studies, and is currently serving as a Section Editor at the Journal of Business Ethics and Associate Editor of the Journal of Corporate Finance and the Journal of Financial Stability.

Jens Hagendorff

is Professor of Finance at the University of Edinburgh. Professor Hagendorff previ­ ously worked at Cardiff University, the Financial Stability Department of the Bank of Spain and as a lecturer at the University of Leeds. He held Visiting positions in the US, Italy, and Spain, most recently as a Visiting Fellow at The Federal Reserve Bank of Atlanta and the Bank of Spain in Madrid. He publishes and lectures on a range of topics in finance, banking, and investments, in particular the risk and return implica­ tions of corporate governance in the banking industry. His work has been published in leading international journals, including the Review of Financial Studies, Journal of Quantitative and Financial Analysis, and Review of Finance. He is one of the authors of Size, Risk and Governance in European Banking (Oxford University Press, 2013).

Philipp Hartmann

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List of Contributors is Deputy Director General of the research department at the European Central Bank, which he helped build up from its beginning. He also coordinates the ECB’s work on financial integration and is a Fellow of the Centre for Economic Policy Research. Pre­ viously, he held positions at the London School of Economics, the European Monetary Institute and Erasmus University Rotterdam. He published research on financial, monetary, and international issues in numerous journal articles and several books. He serves as an associate editor of the Journal of Financial Stability. His policy work has been published in many official reports and discussed in fora including the ECOFIN Council, the ECB Governing Council, the Basel Committee on Banking Supervision and the United Nations Economic Commission for Europe. He holds a Doctorat en Sciences Economiques (Paris) earned in the European Doctoral Program in Quantita­ tive Economics.

Iftekhar Hasan

is the E. Gerald Corrigan Chair in International Business and Finance at Gabelli School of Business, New York, USA. He serves as the scientific advisor at the Bank of Finland and is affiliated with the University of Sydney as a fractional Professor. He is the managing editor of the Journal of Financial Stability and serves as an associate ed­ itor for several other academic journals. His research interests are in the areas of fi­ nancial institutions, corporate finance, and emerging economies. Professor Hasan has numerous publications in print, including books and edited volumes, and (p. xliii) peerreviewed journal articles in finance, economics, accounting, information systems, and management journals.

Richard J. Herring

is Jacob Safra Professor of International Banking and Professor of Finance at The Wharton School, University of Pennsylvania, where he is also Director of The Wharton Financial Institutions Center. Outside the University he serves on the FDIC Systemic Risk Advisory Committee and the Systemic Risk Council. His research focuses on banking and financial market regulation and supervision.

Patrick Honohan

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List of Contributors

is Honorary Professor of Economics at Trinity College Dublin, a Non-resident Senior Fellow at the Peterson Institute for International Economics and a Research Fellow of CEPR. From 2009–15 he was Governor of the Central Bank of Ireland. Previously, he was a Senior Advisor at the World Bank and his career has also included periods on the staffs of the IMF, the Economic and Social Research Institute, Dublin, and as Eco­ nomic Advisor to the Taoiseach.

Joseph P. Hughes

is Professor of Economics at Rutgers University. He has been a Fellow of the Wharton Financial Institutions Center and a Visiting Scholar at the Federal Reserve Bank of Cleveland, the Federal Reserve Bank of Philadelphia, the Federal Reserve Bank of New York, and the Office of the Comptroller of the Currency. His research has been published in such journals as the American Economic Review, the Journal of Banking and Finance, the Journal of Economic Theory, the Journal of Financial Intermediation, the Journal of Financial Services Research, the Journal of Money, Credit, and Banking, and the Review of Economics and Statistics. He received his Ph.D from the University of North Carolina at Chapel Hill.

David Humphrey

is the F.W. Smith Eminent Scholar in Banking at Florida State University and is a Vis­ iting Scholar at the Payments Cards Center at the Federal Reserve Bank of Philadel­ phia. He has taught at three universities and previously worked at the Federal Re­ serve for sixteen years. His publications have focused on banking and payment sys­ tem issues. He received his Ph.D from the University of California (Berkeley).

Dasol Kim

is a Senior Economist at the Office of Financial Research, US Department of the Trea­ sury. He previously served as an Assistant Professor in Banking and Finance at Weath­ erhead School of Management, Case Western Reserve University. He has published papers in journals such as the Journal of Financial Economics, the Review of Financial

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List of Contributors Studies, and European Financial Management, and his research has been featured in various media outlets, including the Wall Street Journal, Barron’s, the Atlantic, and Forbes. He holds a doctorate in financial economics from the Yale School of Manage­ ment, Yale University. In addition, he holds a master’s degree in statistics from Co­ lumbia University and a bachelor’s degree in mathematics and economics from the University of California, Los Angeles.

Leora Klapper

is a Lead Economist in the Finance and Private Sector Research Team of the Develop­ ment Research Group at the World Bank. Her publications focus on corporate and household finance, banking, entrepreneurship, and risk management. (p. xliv) Her cur­ rent research studies the impact of digital financial services, especially for women. She is a founder of the Global Findex database, which measures how adults around the world save, borrow, make payments, and manage risk. Previously, she worked at the Board of Governors of the Federal Reserve System and Salomon Smith Barney. She holds a Ph.D in Financial Economics from New York University Stern School of Business.

Andreas Lehnert

is the director of the Division of Financial Stability at the Federal Reserve Board in Washington, DC. He joined the Fed after earning his Ph.D in economics from the Uni­ versity of Chicago. He started in the household finance research group where he worked on a variety of topics in consumer and mortgage credit. During the financial crisis, he contributed to several projects including various mortgage modification ini­ tiatives, the TARP, the 2009 bank stress tests, and the TALF. In November 2010, he moved to the Board’s newly created financial stability group where he participates in a variety of ongoing initiatives to promote financial stability, including regulatory re­ form, the periodic assessment of financial vulnerabilities, the development of macro­ prudential tools, and the design and oversight of the bank stress tests; in addition, he supports the Federal Reserve’s role on the Financial Stability Oversight Council and the Financial Stability Board. His research focuses on financial stability, macropru­ dential policy, banking, and finance.

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List of Contributors Robert Lensink

is a Professor of Finance at the University of Groningen, and a Professor of Finance and Development (part-time) at Wageningen University. He is a development econo­ mist with extensive experience in field studies, including impact evaluations, with a focus on microfinance in the broadest sense. He was the chair of the International Re­ view Panel of the 1st and 2nd round of the International Initiative of Impact Evalua­ tion (3ie) Open Window to select proposals for impact evaluation in developing coun­ tries. He has published more than 100 articles in international journals, among which include the American Economic Review, Economic Journal, Management Science, Public Economics, and World Development. In 2011, he won the SOM Outstanding Re­ searcher Award (Best Researcher of the Faculty of Economics and Business, Universi­ ty of Groningen). Robert Lensink has been appointed Officer of the Order of OrangeNassau.

Xinming Li

is an Associate Professor of Finance at the School of Finance at Nankai University and a consultant at the World Bank Group. He is also the holder of the Emerging Scholars Award by the Federal Reserve and the Conference of State Bank Supervi­ sors. His research areas include a variety of topics related to banking and financial in­ stitutions, corporate finance, and international finance.

Alex Martin

is a Senior Research Assistant at the Federal Reserve Board of Governors in the Divi­ sion of Financial Stability. Previously, she served as a Research Intern at the US De­ partment of the Treasury in the Office of Economic Policy. She is a graduate of the University of Mississippi with a B.A. in International Studies and Mathematics.

(p. xlv)

María Soledad Martínez Pería

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List of Contributors is Chief of the Macro-Financial Division in the IMF Research Department. She man­ ages a team of economists responsible for conducting research and policy work on macroeconomic and financial issues critical to fund surveillance activities, with a fo­ cus on macro-financial linkages, financial flows, and financial systems. Her published research addresses questions related to financial crises, market discipline, foreign bank participation, bank competition, bank regulation, SME financing, financial inclu­ sion, and remittances. Prior to joining the IMF, she worked at the World Bank, the Brookings Institution, the Central Bank of Argentina, and the Federal Reserve Board. She holds a Ph.D in economics from the University of California, Berkeley and a B.A. from Stanford University.

Donal McKillop

is Professor of Financial Services at Queen’s University Belfast. He has written five books and has published papers in journals such as the European Economic Review, Journal of Applied Econometrics, Journal of Banking and Finance, and the Journal of Economic Perspectives. He has recently completed research for the European Com­ mission on “Integrating Residential Property and Private Pensions” and for the Eco­ nomic and Social Research Council on “The Development of Web-based Tools to Im­ prove the Financial Capability of the Over-Indebted.” Outside of his academic role at Queen’s, he was Chair of the Credit Union Advisory Committee, Ireland (2012–18). He was appointed by Minister of Finance (Ireland) to advise the Minister and the Central Bank on matters relating to credit unions. He has also advised the Office of the First Minister and Deputy First Minister (Northern Ireland) on intervention measures to help mitigate financial hardship due to the introduction of Welfare Reform in North­ ern Ireland.

Loretta J. Mester

is president and chief executive officer of the Federal Reserve Bank of Cleveland. In addition, she is an Adjunct Professor of Finance at the Wharton School, University of Pennsylvania, and a fellow at the Wharton Financial Institutions Center. She is the managing editor of the International Journal of Central Banking and a co-editor of the Journal of Financial Services Research. In addition, she is an associate editor of sever­ al other academic journals and serves on the management committee of the Interna­ tional Journal of Central Banking. Her publications include research on the organiza­ tional structure and production efficiency of financial institutions, the theory and reg­

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List of Contributors ulation of financial intermediation, agency problems in credit markets, credit card pricing, central bank governance, and inflation. Her research has been published in the Journal of Finance, the American Economic Review, the Review of Financial Stud­ ies, and the Review of Economics and Statistics, among other journals. She received her Ph.D in economics from Princeton University.

Frederic S. Mishkin

is the Alfred Lerner Professor of Banking and Financial Institutions at the Graduate School of Business, Columbia University. He is also a Research Associate at the Na­ tional Bureau of Economic Research, and the co-director of the US Monetary Policy Forum. From September 2006 to August 2008 he was a member (governor) of the Board of Governors of the Federal Reserve System. He has (p. xlvi) also been a Senior Fellow at the FDIC Center for Banking Research, and past President of the Eastern Economic Association. Since receiving his Ph.D from the Massachusetts Institute of Technology in 1976, he has taught at the University of Chicago, Northwestern Univer­ sity, Princeton University, and Columbia. He has also received an honorary professor­ ship from the Peoples (Renmin) University of China. From 1994 to 1997 he was Exec­ utive Vice President and Director of Research at the Federal Reserve Bank of New York and an associate economist of the Federal Open Market Committee of the Feder­ al Reserve System.

Paola Morales-Acevedo

is a Researcher at the Central Bank of Colombia, Banco de la República. Prior to that, she was an Economist at the Applied Research and Modelling Division of the Sveriges Riksbank. Her research focuses on empirical banking, financial intermediation, mone­ tary policy, behavioral finance and corporate finance. She holds a Ph.D in Finance from the CentER graduate school of Tilburg University (Netherlands). During her Ph.D studies, she has been a Visiting Scholar at the Department of Banking and Fi­ nance of the University of Zurich, as well as an intern at the Research Department of the Sveriges Riksbank and at the Monetary Capital Markets Department (Financial Crisis) of the International Monetary Fund. She has also been a Junior Fellow of the European Banking Center. Paola received a M. Phil. in Finance from Tilburg Universi­ ty in 2011, an M.Sc. in Industrial Engineering in 2009, a B.A. in Economics in 2009 and a B.Sc. in Industrial Engineering in 2007 from Universidad de los Andes (Colom­

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List of Contributors bia). After finishing her first bachelor degree, she worked for three years at the Fi­ nancial Stability Department of the Central Bank of Colombia.

Fariborz Moshirian

is the Director of the Institute of Global Finance (IGF) in the UNSW Business School, Sydney. The IGF conducts collaborative research on Systemic risk, Financial innova­ tion and Global financial stability with NYU, UCLA and has had joint work with the Asian Development Bank, the International Monetary Fund, the World Bank, PwC and a number of world-class research centers. He was the Bertil Danielsson Professor of Finance for 2006 (sponsored by the Stockholm School of Economics and Nordea Bank). He is a consultant to the Asian Development Bank. He served as the Head of School of Banking and Finance at UNSW for over four years. He has published a num­ ber of influential research works on global financial stability, interconnectedness, gov­ ernance, systemic risk, and the financial and social challenges of the twenty-first cen­ tury in leading finance journals including the Journal of Finance, Journal of Financial Economics, Journal of Financial and Quantitative Analysis, Journal of Financial Mar­ kets, and the Journal of Banking and Finance.

Steven Ongena

is a Professor of Banking at the University of Zurich, a senior chair at the Swiss Fi­ nance Institute, a research Professor at KU Leuven, and a research fellow in financial economics of CEPR. He is also a research Professor at Deutsche Bundesbank. He has published more than sixty-five papers in refereed journals, including in the American Economic Review, Econometrica, Journal of Finance, Journal of Financial Economics, Journal of International Economics, Journal of Political Economy, Management (p. xlvii) Science, and Review of Finance. In 2017, he received an ERC Advanced Grant and in 2012 a NYU-Fordham-RPI Rising Star in Finance Award.

Bruno M. Parigi

is Professor of Economics, University of Padova, Italy. His research interests are in banking and financial economics. He has published in various journals among includ­ ing Journal of Money Credit and Banking, Journal Banking & Finance, Journal of Fi­

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List of Contributors nancial Intermediation, and Journal of Economic Theory. He has been consultant for New York Fed, ECB, BIS, and he has held visiting positions at the Universities of Mu­ nich, Toulouse, Zurich, and the European University Institute. He received his Ph.D in Economics from Rutgers University.

Raluca A. Roman

is Senior Financial Economist at the Federal Reserve Bank of Philadelphia since July 2018. From 2015–18, she was Research Economist at Federal Reserve Bank of Kansas City. She holds a Ph.D in Finance from University of South Carolina. She also holds an M.B.A. with concentration in Finance from University of Bridgeport, and a B.A. in Economics from Alexandru Ioan Cuza University (Romania). Her research areas in­ clude a variety of topics related to banking and financial institutions (including bank government bailouts, internationalization, and corporate governance) and corporate finance. She has published two articles in the Journal of Financial and Quantitative Analysis, one in Management Science, two in the Journal of Financial Intermediation, one in Financial Management, and a book chapter in the Handbook of Finance and Development and has received four awards for her papers at conferences. She also is currently co-authoring the book TARP and other Bank Bailouts and Bail-Ins around the World: Connecting Wall Street, Main Street, and the Financial System (2019, Else­ vier). She has presented her research and discussed the research of others at numer­ ous finance and regulatory conferences. She has over seven years of professional ex­ perience in banking and corporate finance, and worked for top international organiza­ tions like UBS Investment Bank and MasterCard International, where she won vari­ ous awards.

Anna Sarkisyan

is a Lecturer in Banking and Finance at Essex Business School, University of Essex (UK). Her research focuses on securitization, corporate governance, and performance in banking. She holds a Ph.D in Finance from Cass Business School, City, and Univer­ sity of London. In 2010, she was awarded a Lamfalussy Fellowship from the European Central Bank.

Anthony Saunders

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List of Contributors

is the John M. Schiff Professor of Finance and former Chair of the Department of Fi­ nance at the Stern School of Business at New York University. He received his Ph.D from the London School of Economics, and has taught at NYU since 1978. He has served as Visiting Professor all over the world including INSEAD, the Stockholm School of Economics, and the University of Melbourne. He has held positions on the Board of Academic Consultants of the Federal Reserve Board of Governors as well as the Council of Research Advisors at the Federal National Mortgage Association. He is Editor of Financial Markets, Instruments and Institutions. His research has been pub­ lished in all the major banking and finance journals.

(p. xlviii)

Laura Solanko

is Senior Advisor at the Bank of Finland Institute for Economies in Transition (BOFIT), specializing in Russian economic developments. She received her doctoral degree from the University of Helsinki in 2007, majoring in economics. She was the Editor of BOFIT Discussion Papers and responsible for BOFIT Visiting Researchers Programme for 2011–15, and continues to regularly contribute to BOFIT Weekly Re­ view on Russia. Her current research interests include banking and financial markets in Russia and China, Russia–EU energy relations, and political economy in Russia. Her research has been published in, for example, the Journal of Banking and Finance, Public Choice, and Review of International Economics.

Anjan V. Thakor

holds the John E. Simon Professorship of Finance and is Director of the Olin Business School’s Ph.D program, and Director of the WFA Center for Finance and Accounting Research. He has also served as Senior Associate Dean at the Olin Business School at Washington University in St Louis. Until July 2003, he held the Edward J. Frey Profes­ sorship of Banking and Finance and was Chairman of the Finance Group (2000–3) at the University of Michigan Business School. Prior to joining Michigan, he served as the NBD Professor of Finance and Chairman of the Finance Department at the School of Business at Indiana University. He has also served on the faculties of Northwestern University and UCLA as a Visiting Professor. He received his Ph.D in Finance from Northwestern University. He is a research associate of the European Corporate Gov­ ernance Institute and a Fellow of The Financial Theory Group. He has served as man­ aging editor of Journal of Financial Intermediation from 1996–2005 and currently

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List of Contributors serves as an associate editor. He is past-President and a founder of the Financial In­ termediation Research Society.

Hirofumi Uchida

is Professor of Banking and Finance at the Graduate School of Business Administra­ tion at Kobe University. His research interests focus on financial institutions and fi­ nancial system architecture. He was a Visiting Scholar at the Kelley School of Busi­ ness at Indiana University as a 2003 Fulbright Scholar, a Visiting Scholar at the Shorenstein Asia Pacific Research Center at Stanford University as a 2016 Abe Fel­ low, and is an associate editor of the Journal of Money, Credit and Banking.

Gregory F. Udell

is the Chase Chair of Banking and Finance at the Kelley School of Business, Indiana University. He is, or has been, a Visiting Economist, Scholar and/or Consultant to the Board of Governors of the Federal Reserve System, the Bank of Japan, the Bank of Italy, the European Central Bank, the Federal Reserve Banks of Chicago and San Francisco, the International Finance Corporation, the OECD, the Peoples Bank of Chi­ na, the Riksbank and the World Bank. Before joining the Kelley School of Business in 1998, he was Professor of Finance and Director of the William R. Berkley Center for Entrepreneurial Studies at the Stern School of Business at New York University. Prior to his academic career he was a commercial loan officer in Chicago. He has nearly 100 publications mostly focused on financial contracting, credit availability, and finan­ cial intermediation. These have appeared in leading accounting, economics, and fi­ nance journals. He is the author of a textbook on asset-based lending, (p. xlix) AssetBased Finance (2004), a co-author (with L. Ritter and W. Silber) of Principles of Mon­ ey, Banking and Financial Markets, 12th edition (2009), and is, or has been, an asso­ ciate editor/editorial board member of seven academic journals including the Journal of Money, Credit and Banking, Journal of Banking and Finance, Journal of Financial Services Research and Small Business Economics.

Patricio Valenzuela

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List of Contributors is an assistant Professor of Finance and Economics at University of Chile and a re­ search fellow at the Millennium Institute for Research in Market Imperfections and Public Policy (MIPP). His primary areas of research are corporate finance, financial economics, international finance, and development economics. He has published in several peer-reviewed academic journals, including the Review of Finance, Journal of International Money and Finance, Journal of Banking and Finance and Economic In­ quiry. He has also contributed chapters of several books on developing financial sys­ tems, including Handbook of the Economics of Finance, Towards a Better Global Economy: Policy Implications for Citizens in the 21st Century, and African Successes: Modernization and Development.

Paul Wachtel

is a Professor of Economics at New York University Stern School of Business. He has been with Stern for over forty years and has served as department chair and Vice Dean. He is currently the Academic Director for the BS in the Business and Political Economy Program. He has been a research associate at the National Bureau of Eco­ nomic Research, a senior economic advisor to the East West Institute, and a consul­ tant to the Bank of Israel, the IMF, and the World Bank. He received his B.A. from Queens College in 1966, his M.A. in Economics from the University of Rochester, and his D.Phil from the University of Rochester in 1971. His primary areas of research in­ clude the relationship of financial development to economic growth, monetary policy, central banking in the post-crisis world, and financial sector reform in economies in transition. He has published widely in these areas.

Larry Wall

is the research center executive director of the Center for Financial Innovation and Stability (CenFIS) in the research department of the Federal Reserve Bank of Atlanta. He is part of the financial markets team. CenFIS was created to improve knowledge of financial innovation and financial stability and the connection between the two. He joined the financial structure team of the Bank’s research department in 1982 and was promoted to executive director of the CenFIS in 2013. In addition to pursuing his research agenda, he leads CenFIS’s activities, including its newsletter, Notes from the Vault, and conferences. He has served on the editorial boards of various academic journals. He is also on the Academic Advisory Panel for the International Association of Deposit Insurers. He is currently on the boards of Financial Management Associa­

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List of Contributors tion International and the International Banking, Economics and Finance Association. He has also been an adjunct faculty member of Emory University and the Georgia In­ stitute of Technology. A native of Grand Forks, North Dakota, he earned a bachelor’s degree in business administration from the University of North Dakota and a doctoral degree in business administration from the University of North Carolina at Chapel Hill.

(p. l)

Mark E. Van Der Weide

has been the General Counsel of the Board of Governors of the Federal Reserve Sys­ tem in Washington, DC, since August 2017. From 2010 until August 2017, he worked in the Division of Supervision and Regulation of the Federal Reserve Board. In this ca­ pacity, he advised the Division Director and Board members on financial regulatory policy issues and helped coordinate the development of Federal Reserve positions on international and domestic regulatory policy. Mr. Van Der Weide served as a member of the Basel Committee on Banking Supervision from 2015–17 and represented the Federal Reserve on the Financial Stability Board’s Standing Committee on Superviso­ ry and Regulatory Cooperation from 2010–17. Mr. Van Der Weide was detailed to the US Treasury Department during 2009–10, where he provided assistance to the Ad­ ministration in its efforts to design the financial reform legislation that ultimately be­ came the Dodd–Frank Act. Prior to joining the Federal Reserve Board in 1998, he worked as an associate in the Washington, DC, office of Cleary, Gottlieb, Steen & Hamilton. He received a J.D. degree from Yale Law School in 1995 and a B.A. degree in history and philosophy from the University of Iowa in 1992.

Lawrence J. White

is Robert Kavesh Professor of Economics at New York University’s Stern School of Business. During 1986–9 he served as a Board Member for the Federal Home Loan Bank Board, in which capacity he also served as Board Member for Freddie Mac. In the period 1982–3, he was on leave to serve as Director of the Economic Policy Office, Antitrust Division, US Department of Justice. He is the General Editor of the Review of Industrial Organization and was Secretary-Treasurer of the Western Economic As­ sociation International (2006–9). He received the B.A. from Harvard University (1964), the M.Sc. from the London School of Economics (1965), and the Ph.D from Harvard University (1969).

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List of Contributors

Jonathan Williams

is a Professor of Banking and Finance at Bangor University, Wales, where he is Head of Bangor Business School and Co-Director of the Institute of European Finance. His early research focused on the performance of European banks under their organiza­ tional models. Subsequently, he has examined on banking sector developments in emerging market economies, such as bank privatization and competition. His most re­ cent research is concentrated on executive compensation in banking, the characteris­ tics of bank directors, and their effects on firm performance outcomes, including the impact of corporate culture in banking.

Eliza Wu

is an Associate Professor in Finance at the University of Sydney Business School. She has a joint honours degree in Economics and Econometrics and a Ph.D in Finance from the University of New South Wales (UNSW). Her research is focused on financial integration, the impact of financial regulations, credit risk and corporate governance. She has published over fifty international academic journal articles and book chap­ ters. She was an Associate Editor of the Journal of Banking and Finance from 2013– 2019 and serves as an Associate Editor for the Journal of Financial Stability amongst other journals. Outside of academia, she has worked at the Reserve Bank of Australia and at the Bank for International Settlements’ (BIS) Representative Office for (p. li) Asia and the Pacific. She has also worked as a teaching fellow at the University of Cambridge in Banking and Finance, a research fellow at the Hong Kong Institute for Monetary Research, and undertaken consulting and policy work for the BIS.

Jeffrey Y. Zhang

has been an Economist at the Board of Governors of the Federal Reserve System in Washington, DC, since April 2017. He works in the Special Projects Unit of the Divi­ sion of Supervision and Regulation, where he focuses on domestic rulemakings, inter­ national regulatory coordination, and policy research. Prior to his current role, he served as a Staff Economist at the White House Council of Economic Advisers from 2012 to 2013, focusing on energy policy and macroeconomics. He has also worked at

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List of Contributors the Federal Reserve Bank of Boston and the Appeals Unit of the Criminal Division at the US Attorney’s Office in Boston. He received a J.D. degree from Harvard Law School in 2017, a Ph.D degree in economics from Yale University in 2017, and a B.A. degree in economics and mathematics from Boston College in 2010.

Bilal Zia

is a Senior Economist in the Finance and Private Sector Development Team of the De­ velopment Research Group at the World Bank in Washington, DC. His research focus­ es on financial development at the household, firm, and bank levels, and has ap­ peared in top academic journals such as the Journal of Finance, Journal of Financial Economics, American Economic Journal: Applied Economics, Management Science, and Journal of Development Economics. He uses both experimental and non-experi­ mental methods and some of his recent work includes rigorous impact evaluations of financial and business education programs, testing innovative methods to improve fi­ nancial access for households and firms, alternative credit scoring and digital finan­ cial engagement, and applying insights from behavioral economics to development fi­ nance.

(p. lii)

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Banking: A Decade on from the Global Financial Crisis

Banking: A Decade on from the Global Financial Crisis   Allen N. Berger, Philip Molyneux, and John O. S. Wilson The Oxford Handbook of Banking (3rd edn) Edited by Allen N. Berger, Philip Molyneux, and John O. S. Wilson Print Publication Date: Oct 2019 Subject: Economics and Finance, Financial Economics Online Publication Date: Nov 2019 DOI: 10.1093/oxfordhb/9780198824633.013.1

Abstract and Keywords A lot has happened in the ten years since the global financial crisis. This chapter starts with a summary of key regulatory and operational issues that have impacted banks in Eu­ rope, the US and elsewhere. Banks are much more heavily regulated than pre-crisis, their performance in the US and Europe has been subdued although there are signs that those in the former have turned the corner. There continues also to be ongoing discussion as well as regulatory efforts to improve banking system stability with new rules on capital, liquidity, bailouts, and bail-ins to be fully completed. These issues are covered in the first part of the chapter. We then move on to discuss emerging research themes covering ar­ eas including: banks and their impact on the real economy; capital, liquidity, and tax reg­ ulation; systemic risk; unconventional monetary policy; FinTech; bank governance and culture; financial consumer protection and financial literacy; and finally financial inclu­ sion. The final part of the chapter provides summaries of all the chapters in the Hand­ book. Keywords: banking, capital, financial crisis, financial stability, FinTech, liquidity, real economy, regulation, theory of banking

1.1 Introduction IT has been a decade since the worst financial crisis faced since the Great Depression. The banking industry is a very different place to the liberalized environment of the early 2000s. Banks have significantly de-risked and now hold more liquidity and capital than in the past. Capital rules continue to be modified and updated. Tougher capital rules for large banks were agreed in December 2017, but these will not be fully implemented until 2022. Basel III and its European counterpart (Capital Requirements Directive IV) were supposed to be implemented by 2019, but continuous updates mean that full implementa­ tion will not occur until the following decade. The full array of international banking regu­ latory reform proposals will not be fully implemented until 2027.1 The ongoing regulatory process does appear to have been successful in creating a safer global banking system Page 1 of 41

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Banking: A Decade on from the Global Financial Crisis with banks in a sounder financial position to weather large economic shocks compared with a decade earlier. Banks are managed in a more conservative manner. Big banks have retrenched to focus on domestic markets as well as a handful of key overseas areas. Most commercial banks are less reliant on wholesale funding, and less exposed to higher risk trading and investment banking activities. Banks are also embracing new financial and digital technologies in order to offer innovative services and reduce costs. However, over­ all performance remains somewhat subdued. US commercial banks are performing better than European counterparts that struggle to generate returns exceeding their cost of cap­ ital. Moreover, recent developments including a potential trade war, the possible end of the equity bull run, heightened global interest rates, and political (p. 2) polarization have increased economic and financial market uncertainty, making it difficult to predict future bank performance.2 In the light of this rapidly changing operating environment, section 1.2 of this chapter dis­ cusses the major changes that have occurred in banking over the last ten years. Section 1.3 covers recent research areas in the banking literature, discussing research on: real ef­ fects; capital, liquidity and taxation; systemic risk; monetary policy; FinTech; corporate governance; consumer protection and financial literacy; and financial inclusion. Section 1.4 presents details of the Handbook structure and provides a summary of the constituent chapters.

1.2 Banking: A Decade After The Financial Cri­ sis Ten years on from the Global Financial Crisis, the banking industry has changed dramati­ cally. Prior to the crisis, banking was liberalized, shareholder value-driven, and highly profitable. These trends were halted when governments had to intervene to support and bail out troubled banks, and inject liquidity into markets that had “frozen.” Banks in the US and Europe were most affected as securitized mortgage-backed asset values col­ lapsed in response to declining real estate prices. The banking systems of Japan, Aus­ tralia, South Korea, and other developed countries were less affected. Emerging market banks in China and India were also relatively unaffected. The policy responses of US and European governments to the Global Financial Crisis were similar, but not identical. These governments introduced: a broad range of guaran­ tees aimed at preventing runs on banks and money market funds; aggressive recapitaliza­ tion of banks and the wider financial system with expanded deposit insurance coverage; liquidity injections to various markets and institutions; and accommodative fiscal and monetary policy aimed at boosting domestic economic growth. In an important differ­ ence, the lender of last resort facility in the US was expanded beyond the commercial banking system to investment banks and funding markets. In order to preserve the do­ mestic housing market, government conservatorship of the government-sponsored enter­ prises (GSEs) and other policies were put in place to slow the decline in house prices and aid re-financing. In general, the policy actions on both sides of the Atlantic are consid­ Page 2 of 41

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Banking: A Decade on from the Global Financial Crisis ered successes in terms of preserving the stability of banking systems and averting a more severe macroeconomic downturn. However, just when financial commentators believed that the Global Financial Crisis was subsiding, several countries in Europe experienced a sovereign debt crisis. Government deficits and debt, exacerbated by the bailouts of troubled banks, triggered a (p. 3) crisis of confidence in certain Eurozone economies, including Greece, Italy, Ireland, Portugal, and Spain (also known as the GIIPS countries). This was reflected in a widening of bond yields and credit default swap spreads for these countries (compared with the benchmark German Bund). The first crisis hit country was Greece in May 2010 when the Eurozone authorities and the International Monetary Fund (IMF) agreed to a €110 billion loan con­ ditional on the implementation of tough austerity measures. Later in the same month, the European Financial Stability Facility (comprising a broad rescue package amounting to $1 trillion) was established with the aim of ensuring financial stability in the Eurozone. Following the Greek bailout, other programs were approved for Ireland (November 2010), Portugal (May 2011) and Cyprus (March 2013). Support provided to the aforementioned countries was relatively successful, with Ireland and Portugal being the first to exit their bailout programs in the summer of 2014. Greece and Cyprus both managed to gain mar­ ket access to sovereign bond financing over 2014–15. Spain never formally had a bailout package, but did rely on funding from the European Central Bank (ECB) for the establish­ ment of a bank recapitalization fund. The combination of a banking and sovereign debt crisis led to European banks recovering more slowly than US counterparts. Another factor that facilitated a faster banking sector bounce-back in the US is that the legislative process to deal with the crisis and the general de-risking of banks was initiated earlier. The Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010 set a blueprint as to how banks should be re-regulated, such that taxpayers are not liable for future bailouts. However, by late 2018 many of the recommendations of Dodd-Frank had not been implemented fully.3 A bill passed by Congress in May 2018 rolled back various features of the legislation, especially in areas that impacted small to medium-sized banks. In Europe, the structural reforms proposed in the 2012 Liikanen Report were finalized by the ECOFIN Council in the summer of 2015, and are being introduced in a phased man­ ner. By early 2018, a ban on proprietary trading came into force (the similar US Volker rule was in place in 2015), and national regulators across the EU enforced the legal sepa­ ration of high-risk trading from core deposit-taking and lending for Global Systemically Important Banks (GSIBs). As in the US, a new bank resolution regime was created in the shape of the Bank Recovery and Resolution Directive (BRRD) of 2015, albeit this has not been fully introduced in all member states. There also remains discussion as to the way in which the new European deposit insurance arrangements, as part of plans for a Banking Union, will be implemented. Big banks in both the US and Europe are also now subject to stress tests to evaluate capi­ tal strength resilience to adverse economic shocks. The implementation of Basel III con­ tinues as major banks focus on increasing their risk-weighted capital-to-assets ratios. A proposal agreed between central bankers in December 2017 set out tougher Basel III Page 3 of 41

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Banking: A Decade on from the Global Financial Crisis rules relating to capital charges (particularly on trading activities and mortgage assets). These rules will not be implemented until 2022. Overall, the new operating environment has forced banks, particularly those deemed systemically important, to reduce risks in order to meet more demanding capital and liquidity requirements, and pass stress test requirements set by regulatory agencies (such as the US Federal Reserve and the European Banking Authority). Exposure to high­ er-risk (higher regulatory capital) areas (such as investment banking and securities trad­ ing) has been reduced. There has been a shift toward lower risk-asset weighted activities such as retail banking and wealth management. Wholesale funding has also reduced in prominence. Bank de-risking has hit revenues, while increased spending on regulatory compliance and organizational restructuring has increased costs. Large banks have also reduced international operations in order to focus on core domestic markets and key overseas activities. (p. 4)

Many of the aforementioned pressures continue to have a similar influence on banking business globally. The slowdown in economic growth, the low (and in some cases nega­ tive) interest rate environment, coupled with regulatory measures designed to improve safety and soundness have acted as a drag on bank performance. Many European banks do not earn returns sufficient to cover their cost of capital, implying a destruction of shareholder value. Markets continue to be volatile and both banks and regulators still grapple with the complexities of measuring and managing a host of risks. In particular, there is significant interest in the measurement and management of credit, market, liq­ uidity, and operational risks, all of which contribute to systemic risk.4 Of particular recent interest has been the accounting treatment of credit risk indicators such as loan loss pro­ visions and reserves, the fair valuation of financial instruments, as well as issues related to the transparency of off-balance sheet activities. Uncertainty continues to heighten through 2018. Trade wars, Brexit, Italian indebtedness, the possible end of the bull run in equity markets, political polarization (both domestic and international), Middle East pres­ sures, and other factors all add to uncertainty and a less favorable operating environment for banks.

1.3 Emerging Research Themes 1.3.1 Real Effects A substantial body of literature has emerged analyzing the extent to which banks benefit or hinder the development of the real economy (Berger and Roman, 2018). This work has been brought into focus since the Global Financial Crisis. In the US, particular attention is on the Troubled Assets Relief Program (TARP) and its impact on bank lending, real eco­ nomic outcomes. and systemic risk. Most studies find a positive effect of TARP on (p. 5) bank lending, particularly for credit to small businesses and risky borrowers, although some find no change in credit, particularly for larger borrowers (Berrospide and Edge, 2010; Black and Hazelwood, 2013; Li, 2013; Duchin and Sosyura, 2014; Montgomery and Page 4 of 41

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Banking: A Decade on from the Global Financial Crisis Takahashi, 2014; Puddu and Waelchli, 2015; Wu, 2015; Berger and Roman, 2017; Bassett, Demiralp, and Lloyd, forthcoming; Berger, Makaew, and Roman, forthcoming; Chu, Zhang, and Zhao, forthcoming). Moreover, evidence suggests that TARP had a positive im­ pact on job creation and reduced bankruptcies (Berger and Roman, 2017), as well as sys­ temic risk (Berger, Roman, and Sedunov, 2018). It also found that banks that received TARP funding received competitive advantages (Berger and Roman, 2015). A sizable quantity of literature has also emerged to augment earlier literature, and this examines the real effects linked to banking sector deregulation in the US.5 For instance, Krishnan, Nandy, and Puri (2015) find that interstate banking deregulation results in im­ proved firm total factor productivity (TFP), while Cornaggia et al. (2015) find that deregu­ lation increased the innovation of private firms that were dependent on external finance. In contrast, Hombert and Matray (2017) find that intrastate deregulation decreased over­ all innovation. Other studies examine how bank deregulation impacts US households, for instance Kozak and Sosyura (2015) show that interstate banking deregulation encour­ aged households to participate in the stock market and reduce cash holdings. Celerier and Matray (2016) show that an increase in US bank branch density resulting from deregulation reduced the share of unbanked households among low-income populations. The non-US literature that investigates linkages between banks and the real economy tends to focus on the impact of credit shocks (resulting from the Global Financial Crisis or the later Euro sovereign debt crisis) on macroeconomic variables such as investment and employment. Carvalho, Ferreira, and Matos (2015) find that bank shocks are reflect­ ed in equity valuation losses and investment cuts by firms reliant on external finance (es­ pecially those with strong bank-lending relationships). Similarly, Buca and Vermeulen (2017) discover that credit tightening resulted in larger declines in investment in indus­ tries more dependent on bank financing. Other studies focus on credit supply shocks in individual countries namely: Germany (Dwenger, Fossen, and Simmler, forthcoming; Hu­ ber, 2018); Belgium (Degryse et al., 2018); Spain (Alfaro, García-Santana, and Moral-Beni­ to, 2018); Portugal (Amador and Nagengast, 2016); Italy (Cingano, Manaresi, and Sette, 2016) and Japan (Amiti and Weinstein, 2018). In general, the findings of these studies suggest that non-financial firms that are dependent on bank funding exhibit slower growth, investment, and employment after a negative credit shock. Interestingly, Huber (2018) finds that lending reductions influence firms, independent of their banking rela­ tionships, and while productivity falls, output and employment remains low even after lending returns to pre-shock levels. Other related literature focuses on the employment effects of credit supply shocks. A number of papers focus on Spain. Rapid increases in bank lending prior to the financial crisis are found to explain the build-up in employment (and investment) over the same pe­ riod (Moral-Benito, 2018). Jiménez et al. (2018) examine the influence of dynamic provi­ sioning on bank credit supply, and how this feeds through to employment. They find that dynamic provisioning smooths credit supply, and in bad economic times tends to enhance company performance. Laeven, McAdam, and Popov (2018) examine credit shocks and employment laws in Spain (and Germany), and show that labor market flexibility reduces (p. 6)

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Banking: A Decade on from the Global Financial Crisis the negative effect of credit shocks by allowing firms to grow by substituting labor for capital. Bentolila, Jansen, and Jiménez (2018) investigate changes in employment be­ tween 2006 and 2010 at Spanish firms with relationships to bailed-out banks (compared to firms that were not exposed to the aforementioned weak institutions). They find that bailed-out banks cut back lending before the bailout, and this adverse credit shock ac­ counts for around 24 percent of job losses at firms linked to weak banks. Other studies that analyze credit shocks and employment focus on: the UK (Franklin, Rostom, and Thwaites, 2015); Italy (Berton et al., 2018) and Germany (Popov and Rocholl, 2018). Franklin, Rostom, and Thwaites (2015) find that a fall in credit supply reduces labor pro­ ductivity, wages and capital intensity (at the firm level). In their study of Italian firms, Berton et al. (2018) show that a contraction in credit explains about 25 percent of the overall decline in employment (especially for less educated and less skilled workers), and this is concentrated in more levered and less productive firms. Popov and Rocholl (2018) use a sample of German savings banks and their respective links to over 30,000 firms during the financial crisis. They find that firms with relationships with healthy banks were less affected by an adverse credit shock. Following on from the Global Financial Crisis, between 2009 and 2012, the Eurozone faced a sovereign debt crisis. Concerns about the break-up of the Eurozone led Mario Draghi (president of the ECB) to state (in July 2012) that the ECB would do “whatever it takes” to preserve the single currency and Eurozone. Following on from the Draghi state­ ment, the ECB engaged in unconventional monetary policies aimed at reducing yield spreads and strengthening government finances. Acharya, Eisert et al. (2017) investigate the impact of the major Outright Monetary Trans­ actions (OMT) program conducted by the ECB from July 2012 onwards and find that the bond purchase scheme led to a significant decline in the sovereign yields of periphery countries (Greece, Italy, Ireland, Portugal, and Spain). However, they find no impact on employment or investment. Acharya et al. (2018) investigate how the Global Financial Crisis affected the syndicated loan market, and whether this fed through into real eco­ nomic activity. They find that banks that were more heavily exposed to sovereign debt were less likely to initiate new syndicated loans. This lending reduction reduced invest­ ment, employment, and the sales growth of firms linked to the affected banks. De Marco (2018) investigates whether bank exposures to sovereign debt during the crisis affected the real economy. Overall, he finds that realized losses on sovereign debt led to (p. 7) a reduction in bank lending. This, in turn, had negative real effects on small and young firms (even in countries that were not under stress). Several studies use Italian data to investigate the real effects of sovereign debt crises. Bottero, Lenzu, and Mezzanotti (2017) use the Greek bailout in 2010, while Bofondi, Carpinelli, and Sette (2018) use the European sovereign debt crisis of 2011. In both cas­ es, these shocks led to a reduction in credit for Italian firms. Bottero, Lenzu, and Mezzan­ otti (2017) show that the contraction in credit was similar for small and large firms, albeit the investment and employment of small firms only was affected. Bofondi, Carpinelli, and Sette (2018) find that domestic banks were more affected than foreign counterparts, and Page 6 of 41

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Banking: A Decade on from the Global Financial Crisis the credit contraction was mainly determined by an increase in funding costs for Italian banks. Farinha, Spaliarab, and Tsoukas (2018) use Portuguese data (covering the period 2005–14) to investigate how bank shocks (resulting from the Eurozone debt crisis) are transmitted to firms. They find that bank shocks are transmitted to younger, riskier, and generally financially constrained firms. Berthou, Horny, and Mésonnier (2018) use a matched sample of French banks and exporters to investigate how the increase in US dol­ lar funding costs (in the summer of 2011 brought on by the Eurozone debt crisis) affected exporting firms. They find strong evidence that exposed firms (those with larger US dol­ lar liabilities) reduced their exports proportionately more to the US in the twelve months that followed the shock. When there is a credit supply shock, the question arises as to whether firms that have strong relationships with their banks are more “protected” than others. Having a depen­ dence on bank finance, however, may exacerbate credit shocks (Carvalho, Ferreira, and Matos, 2015). One would expect stronger bank–firm relationships to mitigate (to some ex­ tent at least) aggregate credit supply shocks. Beck et al. (2018), in a large cross-country study, find that relationship lending is not linked to credit constraints during a credit boom, and such constraints are alleviated during a downturn. Relationship lending ap­ pears to have a stronger influence on small opaque firms operating in regions suffering from more severe economic downturn. Gobbi and Sette (2014) investigate bank-lending relationships in Italy after the Global Financial Crisis, and find that firms that borrow from fewer banks face a lower probability of being credit-rationed. Other evidence examines how shocks to banks affect credit supply. Nakashima and Taka­ hashi (2017) investigate the impact on credit supply when Japanese banks terminate rela­ tionships with firms. Bank-driven terminations significantly decrease investment and this is especially the case for firms that find it difficult to establish new relationships. Termi­ nation effects are larger than those due to negative credit supply shocks. Cortes and Stra­ han (2017) identify a pattern whereby US multi-market banks increase lending in re­ sponse to increased local demand for credit following natural disasters and reduce lend­ ing in markets in which they do not operate branches. Koetter, Noth, and Rehbein (2018) examine the influence of a natural disaster (the flooding of the river Elbe in 2013) and conclude that local banks appear to be an effective mechanism to mitigate rare disaster shocks (especially for small and medium-sized firms). (p. 8)

1.3.2 Capital, Liquidity, and Tax Regulation

Since the Global Financial Crisis and the European Sovereign Debt Crisis, policy reforms have focused on bank capital. These reforms include the Dodd Frank Wall Street Reform and Consumer Protection Act (2010) in the US; the Fourth Capital Requirement Directive (2013) in the EU; and Basel III (Basel Committee on Banking Supervision, 2010a, 2010b, 2013, 2014, and 2017) internationally. Banks hold capital as a buffer to help prevent dis­ tress and failure after losses are incurred. It also serves to mitigate the ex ante moral hazard incentives to take on excessive risks created by deposit insurance, too-big-to-fail policies, and other government safety net protections. Capital can be increased via re­ Page 7 of 41

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Banking: A Decade on from the Global Financial Crisis tained earnings, and the issuance of equity and quasi-equity instruments. If losses occur, they are absorbed from capital, so the more capital the greater bank safety. The role of capital in regulating banks has been extensively studied. There is also extensive evidence related to changes in capital and the resulting impact on bank risk-taking. Typically, the level of bank equity (the highest quality type of capital) has largely been indicated as hav­ ing a negative link with risk (Delis and Staikouras, 2011; Abedifar, Molyneux, and Tarazi, 2013). Furthermore, there is strong corroborating evidence that capital reduces the prob­ ability of bank failure and increases the chances of surviving financial crises for banks of all sizes (Cole and White, 2012; Berger and Bouwman, 2013). Demirgüç-Kunt, Detra­ giache, and Merrouche (2013) and Beltratti and Stulz (2012) find evidence that bettercapitalized banks had better stock performance during the crisis. Regulators set minimum capital requirements according to the riskiness of various bank assets and off-balance items. The regulatory classification of the riskiness of bank assets and off-balance sheet activities should accurately reflect individual and combined risks, and thus be sensitive to the portfolio risks faced by banks. Mariathasan and Merrouche (2014) find that reported risk levels were lower following the introduction of new Basel II capital rules. Vallascas and Hagendorff (2013) demonstrate that risk weights assigned to bank assets do not reflect overall bank portfolio risks, while Acharya, Engle, and Pierret (2014) also show that risk-weighted assets have a low correlation with market measures of risk. Banks often hold capital buffers well in excess of regulatory minimum requirements (Berger et al., 2008; Flannery and Rangan, 2008). However, in many cases this excess capital failed to prevent bank failure during the Global Financial Crisis. Flannery and Gia­ conimi (2015) and Hasan, Siddique, and Sun (2015) identify that, compared with capital market indicators, accounting-based indicators in banking often understate the risks be­ ing taken. Another strand of bank capital research examines capital targets and adjust­ ment speeds. Evidence suggests the existence of an optimal (target) capital ratio (Allen, Carletti, and Marquez, 2011), which is theoretically determined by the trade-off between the various costs and benefits of holding capital (including the costs of bank failure due to under-capitalization, tax savings from deposits or debt financing, and so on.) Empirical work has focused on the determinants of target capital ratios (Berger et al., 2008; Fonse­ ca and Gonzalez, 2010; Gropp and Heider, 2010) and the adjustment (p. 9) speeds from short- to long-term capital equilibria (Berger et al., 2008; Memmel and Raupach, 2010; Öztekin and Flannery, 2012). Capital adjustment speeds tend to vary country by country and are faster in markets where regulations are tougher. De Jonghe and Öztekin (2015) find in their study of sixty-four countries between 1994 and 2010 that capital adjustment speeds are faster in countries where capital regulations are tougher, have better supervi­ sory monitoring, more developed capital markets, and high inflation. A number of studies investigate how changes in bank capital impact borrowing firms. Laeven and Valencia (2013) study the influence of bank recapitalizations across fifty countries, and find that the growth of more financially dependent firms is linked positive­ ly to bank recapitalizations. Aiyar et al. (2014) analyze how changing capital require­ Page 8 of 41

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Banking: A Decade on from the Global Financial Crisis ments influence the cross-border lending activities of UK banks. They find that increases in bank capital requirements reduce cross-border lending, but this impacts more on lend­ ing to other banks rather than credit provided to firms and households. In a similar man­ ner, Fraisse, Lé, and Thesmar (2017) use French loan-level data over 2008–11 to investi­ gate how capital requirements impact corporate borrowing and investment. They find that an increase in capital requirements reduces lending, which in turn leads to a decline in firm-level investment. Gropp et al. (2019) use the European Banking Authority’s (EBA) capital exercise to investigate how a regulatory request for large banks to boost Tier 1 equity impacted bank lending and real economic activity.6 They find that banks reduced their risk-weighted assets in order to boost Tier 1 capital, which in turn led to a reduction in lending to corporate and retail customers. It also led to lower firm investment and sales growth. Blattner, Farihan, and Rebelo (2017) also use the same EBA event to inves­ tigate the impact on Portuguese banks. They find that the increased capital requirements led to a reduction in credit supply to firms, and that this adversely impacts employment and investment. Even if banks have relatively high capital during crisis times, they may not be able to liq­ uidate assets or borrow rapidly if they are faced with extreme short-term financial pres­ sures. A short-term liquidity crisis, such as the inability of banks to pay depositors on de­ mand or rollover other debt, can rapidly turn into a solvency (capital) crisis at an individ­ ual bank level, and ultimately turn into a systemic problem (Acharya, Shin, and Yorulmaz­ er, 2011). Therefore, together with capital regulations, regulators have sought to strengthen liquidity standards under Basel III. There is extensive theoretical and empiri­ cal literature related to bank liquidity issues (Gertler and Kiyotaki, 2015; Adrian and Bo­ yarchenko, 2018). Other research by Berger and Bouwman (2009) and Berger et al. (2016) has focused on bank liquidity creation, and how this varies over cycles and with regulatory shocks. Iyer et al. (2014) investigate the impact on Portuguese lenders of the interbank freeze during the financial crisis. They find that banks more dependent on interbank funding re­ duced their lending the most. The impact of this lending cut was greater for small firms with weak banking relationships. De Jonghe et al. (2018) also investigate the influ­ ence of a liquidity shock on over 160,000 bank–firm relationships in Belgium. The authors (p. 10)

find that a negative funding shock led banks to reallocate credit toward lower-risk firms, and to industries in which they were more specialized. Other studies investigate the influence of central bank liquidity injections on credit sup­ ply and the real economy. Berger et al. (2017) find that the Federal Reserve’s supply of bank liquidity through the expanded Discount Window and Term Auction Facilities (TAF) resulted in very large increases in bank lending. Daetz et al. (2018) investigate the im­ pact of the ECB’s Long-Term Refinancing Operations (LTROs, where the ECB lent to Eu­ rozone banks at low interest rates) on firm-level investments. They find that Eurozone firms did not increase investments, even when their banks held LTRO funds for a long pe­ riod. The authors argue, however, that the liquidity injections enabled firms to maintain investments. Carpinelli and Crosignani (2017) investigate the same ECB financing activi­ Page 9 of 41

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Banking: A Decade on from the Global Financial Crisis ty and its impact on Italian banks. They find that credit supply is maintained as a result of the liquidity injection, and this positively impacts firms. Compared to the literature on the impact of capital and liquidity regulation, evidence re­ lating to the effect of taxation on bank behavior is relatively scarce. Available evidence appears to suggest that bank taxation can change bank behavior such that depositors and borrowers are affected as banks seek to shift any burden of additional costs by reducing credit supply, lowering deposit rates, or increasing loan rates. Furthermore, changes in the overall tax treatment of debt can have consequences for banks’ capital structure and the extent of reported profitability and losses. Early evidence suggests that taxes on domestic and foreign banks alike are, to some ex­ tent, passed on to banks’ customers, leading to higher pre-tax profitability (DemirgüçKunt and Huizinga, 2001). Other evidence—for example, Chiorazzo and Milani (2011) for large samples of European banks, and Capelle-Blancard and Havrylchyk (2014) for Hun­ gary—also find that banks are able to shift most of their respective tax burdens onto cus­ tomers. Banerji et al. (2018) investigate the impact of taxes on the behavior and perfor­ mance of Japanese banks following an unexpected and significant introduction of a tax on the gross profits of large banks operating in Tokyo. The authors find that this tax caused affected banks to increase both net interest and fee margins. Further analysis reveals that depositors were most affected by adjustments to interest and fee rates at banks fol­ lowing the imposition of the tax. The imposition of the Tokyo bank tax reduced the lend­ ing of affected banks relative to their non-affected counterparts. Contrary to the findings of the aforementioned studies, other studies find no evidence of a change in banks’ loan or deposit rates following the introduction of taxes (Capelle-Blancard and Havrylchyk, 2014; Buch, Hilberg, and Tonzer, 2016). Instead, it is the banks that absorb the tax bur­ den. Lin and Pennachi (2018) find that the burden of bank taxation is passed through to retail depositors in markets where there is excess retail savings relative to retail lending opportunities. In contrast, the burden is passed onto retail borrowers in a market where retail lending exceeds retail savings. Han, Park, and Pennacchi (2015) and Gong, Hu, and Ligthart (2015) find that corporate income taxes create incentives for banks to securitize loans. Taxes can also influence bank capital structure as these lead banks to prefer bor­ rowing over financing by equity. The deductibility against corporate income tax of inter­ est on debt, but not on equity, creates a tax preference for debt over equity finance. There is strong evidence that this leads to higher leverage for non-financial companies (Claessens, Keen, and Pazarbasioglu, 2010). Keen and de Mooij (2016) investigate the re­ lationship between corporate income tax and bank leverage decisions, and find evidence of tax distortions on bank financing. Results point to a tax sensitivity of banks that is com­ parable to that of non-financial firms. In other words, favorable tax treatment of debt causes banks to become more highly leveraged. Schepens (2016) provides evidence that suggests that tax shields on equity can have a significant impact on bank stability. A re­ duction in tax discrimination between debt and equity funding leads to better-capitalized (p. 11)

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Banking: A Decade on from the Global Financial Crisis financial institutions. Consequently, the removal of tax shields on debt may contribute to better bank capital regulation.

1.3.3 Systemic Risk The fact that the Global Financial Crisis was system wide has encouraged researchers to look at “new” ways to measure systemic risk. The Conditional Value at Risk, CoVaR, pro­ posed by Adrian and Brunnermeier (2016), measures a financial institution’s contribution to systemic risk and its contribution to the risk of other financial institutions using a VaR (Value at Risk) methodology. The latter looks at extreme losses over certain time horizons using various probability distributions. CoVaR uses this methodology to examine relations between financial institution stock price and credit risk indicators and for the system overall. The measure can therefore be used to identify systemically important institutions. Because measuring CoVaR does not rely on contemporaneous price movements, it can al­ so be used as an indicator to help identify the build-up of systemic risk. Brownlees and Engle (2017) develop SRISK, which measures the capital shortfall of an in­ stitution conditional on a severe market decline, and is estimated as a function of bank size, leverage, and risk. The SRISK measure provides a good indication of the systemic importance of institutions in the US. Acharya, Pedersen et al. (2017) model risk based on financial sector undercapitalization. Each financial institution’s contribution to systemic risk is measured as its systemic expected shortfall (SES), namely, the propensity of a bank to be undercapitalized when the system as a whole is undercapitalized. SES is a weighted sum of market leverage (LVG) and the bank’s marginal expected shortfall (MES), namely losses in the tail of the system’s loss distribution (for instance, one indicator of MES is the average return of a bank’s equity during the 5 percent worst days of the overall market return).7 (p. 12)

1.3.4 Monetary Policy

Since the Global Financial Crisis, policymakers have faced a challenging economic situa­ tion characterized by economic stagnation and deflation. As a first monetary policy re­ sponse, central banks cut interest rates aggressively through conventional accommoda­ tive monetary policies. However, when interest rates approached the zero lower bound (ZLB) without producing the hoped-for effects on nominal spending and inflation, many central banks implemented a range of unconventional monetary policies (UMP) including Large Scale Asset Purchases (LSAPs), in the form of Quantitative Easing (QE) as well as policy rate forward guidance (Borio and Zabai, 2016). UMP took a step further from 2012 onwards when several countries/regions (Denmark, the Eurozone, Hungary, Norway, Swe­ den, Switzerland, and Japan) implemented negative interest rate policy (NIRP) in order to provide further economic stimulus to weakened economies (see Bech and Malkhozov, 2016; Bräuning and Wu, 2017; Demiralp, Eisenschmidt, and Vlassopoulos, 2017). Heider, Saidi, and Schepens (2017) find that when policy rates remain positive, deposit rates closely track official rates. However, when policy rates turn negative, banks that re­ Page 11 of 41

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Banking: A Decade on from the Global Financial Crisis ly on deposits are reluctant to reduce deposit rates fearing a loss of their funding base. In cases in which sticky deposit rates compress lending margins, banks tend to shift activi­ ties toward fee-based services. Claessens, Coleman, and Donnelly (2018) find that in envi­ ronments with persistently low interest rates, both margins and profits are depressed. Ball et al. (2016) survey recent developments of monetary policy transmission in NIRPadopter countries. They argue that policy rate cuts below zero are generally transmitted to bank lending rates, although sluggishly. They also conclude that there is no clear rela­ tionship between NIRP and bank credit expansion. Arteta et al. (2016) suggest that lend­ ing rates generally decline under NIRP, particularly in countries with greater bank com­ petition, but pass-through is only partial due to downward rigidities in retail deposit rates (reflecting the importance of retail deposits as a source of bank funding). Fiordelisi and Ricci (2016) examine the influence of monetary policy announcements on the stock price of globally systemically important banks (G-SIBs) between June 2007 and June 2012. The authors find that monetary policy interventions (whether restrictive or expansionary) have a positive impact on returns. In contrast, bank failures and bailouts generate strong negative returns. Alcaraz et al. (2018) find that ECB monetary policy interventions led to the improved lending standards of European banks.

1.3.5 FinTech There has been an explosion in commercial interest in technology firms providing finan­ cial services. Both independent and bank-based FinTech developments have been grow­ ing rapidly. A recent survey by the EBA (2017) finds that there are over 1,500 firms oper­ ating in the EU that can be regarded as FinTech operators. The aforementioned survey defines firms as operating in the FinTech space if they have: only online distribution (p. 13) channels; only mobile distribution (mobile or digital wallets); are value transfer networks; employed technology to enable trading on a high frequency basis; copy trading (technology used to emulate investors behavior); venture capital activities (whereby tech­ nology is used to enable buying/holding/selling venture capital, and technology enables exchanging venture capital into fiat currency); biometric technology (for instance, au­ thentication); data analytics; electronic personal financial management tools; robo-ad­ vice; online platforms (for example, to enable crowdfunding or peer-to-peer transfers); cloud computing; data aggregation services; distributed ledger technology (for example, blockchain); customer digital identification; smart contracts; and RegTech (using new technology to enhance regulatory processes). The EBA (2017) survey notes that the most popular area where FinTech firms operate is in the payments, clearing, and settlements area. Deloitte (2017) report than in the US there are around 4,500 FinTech firms, of which 2,040 operate in banking and capital markets areas (the most popular areas being in payments, and deposit and lending businesses) as well as 1,500 in InsurTech. Most of these have been set up since 2015. Much of the interest around the FinTech business is driven by the emergence of cryp­ tocurrencies that have the underlying distributed ledger (updated by each participant across a large network) mainly based on a Blockchain system. Bitcoin is the largest and most famous cryptocurrency. As of October 21, 2018 Coinmarketcap.com listed 2,112 Page 12 of 41

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Banking: A Decade on from the Global Financial Crisis cryptocurrencies of which 1,710 had details of the circulating supply. Total market capi­ talization of all these currencies stood at $211 billion. The three largest are Bitcoin (54 percent of total market capitalization); Ethereum (10 percent) and XRP (9 percent). The underlying Blockchain (or related) technology has the advantage of providing a distrib­ uted ledger and strong cryptographic security features that enable users to access and validate data and undertake transactions and clear them rapidly. This means that the new technology could revolutionize any area that involves the tracking and processing of transactions and payments. Many banks see this new technology as a way of redesigning their business models, thus improving the efficiency of their systems. Legacy systems are likely to be gradually replaced with technology based on distributed ledger technology and Blockchain. Efficiency and the speed of their transactional capabilities are also likely to be enhanced. This is all good for banks and their customers, although the new indepen­ dent operators pose a potential competitive threat to incumbent banks. KPMG (2018) estimate that in the three years up to the end of 2017, some $122 billion was invested in global FinTech developments. During 2017, the report notes that both In­ surTech (technology firms offering insurance services) and Blockchain saw record levels of investment and deal volume, with InsurTech accounting for US$2.1 billion across 247 deals and Blockchain generating $512 million of investment across 92 deals. The US ac­ counted for almost half of the full-year 2017 global total invested in the FinTech sector. Catalini and Gans (2018) find that distributed ledger technologies like Blockchain are likely to help create new markets. Others such as Cong and He (2018) suggest that Blockchains could also be used to facilitate collusion. There is a modest amount of litera­ ture that looks at the volatility of cryptocurrencies that trade on unregulated markets that may be more susceptible to manipulation (Griffin and Shams, 2018). However, these currencies do provide an innovative mechanism for start-up financing through ini­ (p. 14)

tial coin offerings (ICOs) (Howell, Niessner, and Yermack, 2018).8

1.3.6 Corporate Governance and Culture Misaligned managerial incentives in the financial sector, including excessive compensa­ tion practices, are viewed by many as a key contributor to the Global Financial Crisis (Be­ bchuk, Cohen, and Spamann, 2010). Evidence before and during the crisis does find that bank CEOs who followed strategies more aligned to shareholder wealth creation did ap­ pear to fare worse when the crisis hit (Fahlenbrach and Stulz, 2011; Mehran, Morrison, and Shapiro, 2012). Other empirical evidence also finds that banks that took on greater risk led to more volatility in earnings but not necessarily higher performance (DeYoung, Peng, and Yan, 2013). Various regulations have been introduced to limit compensation ex­ cesses. Strict rules are those introduced in Europe under the Fourth Capital Requirement Directive (2013). This states that the variable part of total compensation cannot exceed 100 percent of the fixed component. The UK introduced a Remuneration Code in 2009 (FSA, 2009). The main element was to force executives to defer a larger proportion of their bonuses with the stipulation that at least 50 percent of their bonus must be deferred for three years. The aim of the UK rules is to encourage bank executives to have a longerPage 13 of 41

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Banking: A Decade on from the Global Financial Crisis term perspective. The Dodd–Frank Wall Street Reform and Consumer Protection Act (2010) in the US introduced an advisory vote on executive compensation (Say-on-Pay, SOP). Assessments of these regulations are now emerging. Kleymenova and Tuna (2016) examine the influence of the UK and EU regulations and find that the market reacted pos­ itively to the UK Remuneration Code, but negatively to the EU bonus cap. UK banks also deferred more bonuses and reduced risks. Evidence on Europe is further confirmed by Díaz Díaz, García-Ramos, and García Olalla (2017), who also find that investors negative­ ly perceived the EU bonus cap legislation. Another area that has interested bank researchers relates to the monitoring capabilities of boards (and in particular their characteristics such as board size, the proportion of in­ dependent directors, director experience, and gender). There is evidence in banking that board size is positively linked to performance (Adams and Mehran, 2012) and that banks with more independent directors incurred bigger losses during the Global Financial Crisis (Adams, 2012; Erkens, Hung, and Matos, 2012). Minton, Taillard, and Williamson (2014) for instance, find no link between board expertise and the performance of US banks over the crisis. Another area discusses gender issues. Palvia, Vähämaa, and Vähämaa (2015) find that US banks with female CEOs hold more capital (p. 15) after controlling for asset risk and other features. They also find that smaller banks with female CEOs and board Chairs were less likely to fail during the crisis. In contrast to this, Berger, Kick, and Schaeck (2014) study German savings banks and find that those with a higher proportion of female board members tended to be riskier, possibly because females tend to have less experience and/or are appointed to the boards of more problematic banks. The aforemen­ tioned evidence suggests that existing governance arrangements in some cases appear to create a culture where excessive risk-taking and even fraud are condoned (Thakor, 2019). This is evidenced by the large number of cases of fraud and misconduct following the fi­ nancial crisis (Cohn, Fehr, and Maréchal, 2014, 2017; Nguyen, Nguyen, and Sila, forth­ coming).

1.3.7 Consumer Protection There is growing interest in how the legal environment influences bank behavior. For con­ sumers of retail financial services, this relates to customer protection legislation, which typically has been slow to develop compared to legislation covering non-financial indus­ tries. The Dodd–Frank Act (2010) set up the Consumer Financial Protection Bureau in 2010 to strengthen consumer protection in the US financial sector. Similar moves have al­ so been made in Europe, although consumer protection issues tend to be national and not harmonized across EU countries. The growing interest in this area is very much related to concern that some banks mis-sell products and services to their clients or engage in other bad practice that takes advantage particularly of uninformed customers. Key recent cases include the Wells Fargo fraudulent account opening (1.4 million cases), the mis-selling of payment protection insurance (PPI) in the UK, and other retail investment products else­ where in the EU.

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Banking: A Decade on from the Global Financial Crisis The literature on the effects of consumer protection in the banking sector is somewhat scarce. Pasiouras (2018) uses an extensive cross-country sample from the World Bank and finds that consumer protection laws tend to reduce the cost of intermediation for banks located in developed economies. In contrast, in developing countries such legisla­ tion tends to increase intermediation costs. Lumpkin (2010) suggests that for consumer protection to be effective, financial institutions need to develop appropriate systems and regulators should impose tougher penalties to address mis-selling, fraud, or misconduct. Wehinger (2012) points out that financial consumer protection has not received appropri­ ate attention from regulators, and that it is as important as enhancing efficiency and com­ petition.

1.3.8 Financial Inclusion Financial inclusion plays a critical role in reducing poverty and boosting prosperity (Demirgüç-Kunt and Klapper, 2013; World Bank, 2014). Access to finance provides indi­ viduals with resources to meet their financial needs, such as saving for retirement, (p. 16) investing in education, and purchasing a house. Financial exclusion, in contrast, can exacerbate economic disadvantages that may lead to social exclusion. Globally, there are around 2 billion working-age individuals without access to basic financial services. The IMF and World Bank have taken the lead by reporting on survey data. The IMF has built the Financial Access Survey database (FAS) that includes more than 150 series re­ lating to financial inclusion for up to 189 economies spanning the period 2004–15. This information is obtained from banks, microfinance institutions, and other financial firms so can be considered supply-side information. In contrast, the World Bank has built the Glob­ al Financial Inclusion Database (FINDEX), which provides 100 indicators (shown by gen­ der, income, and age) of financial inclusion for more than 140 countries, most recently for 2014—this information is obtained from individual survey data so is demand-side based. Several studies use these two databases to examine financial inclusion (Beck, DemirgüçKunt, and Pería, 2008; Demirgüç-Kunt and Klapper, 2013; Naceur, Barajas, and Massara, 2015). These studies generally tend to find that those most likely to be excluded tend to be poor, have low levels of education, and are more likely to be women. More recent stud­ ies use indexes of inclusion to take account of its multidimensional nature (Cámara and Tuesta, 2014).

1.4 Book Structure and Chapter Summaries 1.4.1 The Theory of Banking Part I of this Handbook comprises six chapters and examines why banks exist, how they function, the risks to which they are exposed and how these are managed, and their legal, organizational, and governance structures.

Page 15 of 41

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Banking: A Decade on from the Global Financial Crisis In Chapter 2, Franklin Allen, Elena Carletti, and Xian Gu examine the role of banks in ameliorating informational asymmetries that can arise between lenders and borrowers, providing intertemporal smoothing of risk, and contributing to economic growth. The au­ thors note that banks play a crucial role as delegated monitors in order to ensure that firms make effective use of loans made to them. Furthermore, banks play a central role in diversification of risks and smoothing consumption. However, banks are by their very na­ ture fragile, and small shocks can have large effects on the financial system and the real economy. Nations around the globe have very different degrees of development of their stock and bond markets, and therefore rely on their banks to greater or lesser extents. In general, Eurozone countries have small but rapidly developing stock markets. Bank lending rela­ tive to GDP is substantial, and bond markets play an important role in the financial sys­ tem. The UK has a large stock market and a large banking sector, but the UK bond (p. 17) market is relatively small. The US banking sector is small in relation to the size of the US economy, but both the stock market and the bond market are relatively large. Japan has a relatively large banking sector and highly developed capital markets. Competition among banks, non-banking financial institutions, and financial markets has intensified in recent years. This competition has led to the transformation of banks, and the growing complementarities between banks and capital markets. In Chapter 3, Arnoud Boot and Anjan Thakor examine the implications of these changes for the recent evolu­ tion of financial institutions and markets, and for regulatory design. The authors illustrate how banks depend on the capital market for sources of revenue, for raising equity capital and for risk management, while capital market participants rely increasingly on banks’ skills in financial innovation and portfolio management. The increased integration of banks with financial markets raises domestic and cross-border financial stability con­ cerns, which in turn has implications for the design of domestic and international finan­ cial system regulation. As commercial banks have diversified into investment banking, a number of large system­ ically important financial institutions (SIFIs) have emerged. In Chapter 4, Jacopo Carmas­ si and Richard Herring examine the phenomenon of global systemically important banks (G-SIBs) and examine how their complexity has changed since the onset of the financial crisis. The authors note that taxation and regulation have increased corporate complexity, and this continues to hinder efforts to supervise G-SIBs. Some G-SIBs have simplified their organizational structures and reduced their size in recent years. However, many others have grown more complex and larger. Higher capital requirements, improved bank resolution schemes, and living wills may help in supervising G-SIBs, but there is an addi­ tional need for enhanced transparency and market discipline. In order to reflect differences in capital structure, opacity, and complexity as well as their importance to the wider economy, the corporate governance of banks should be different from that of non-financial firms. In Chapter 5, Jens Hagendorff focuses on aspects of cor­ porate governance and culture in which banks should differ from non-financial firms. He Page 16 of 41

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Banking: A Decade on from the Global Financial Crisis provides an extensive overview of literature related to executive compensation, board composition, ownership, and risk management. The main observation from his chapter is that bank governance structures geared to aligning the interests of shareholders and managers lead to higher risk-taking. The chapter posits various ways to address this problem and argues that the Global Financial Crisis provides an opportunity for acade­ mics and policymakers alike to rethink the corporate governance of banks. Banks are exposed to credit risk, liquidity risk, interest rate risk, market risk, and opera­ tional risk. For any bank, the measurement and management of these risks is of the ut­ most importance. In Chapter 6, Linda Allen and Anthony Saunders describe the widely used Value at Risk (VaR) method of risk measurement. Accurate risk measurement en­ ables banks to develop risk management strategies, using derivative instruments such as futures, forwards, options, and swaps. The recent financial crisis shows that we still have a lot to learn about risk measurement and risk management. A greater understanding of how to measure and manage systemic risk is required. One of the key functions of the banking sector is to create liquidity. In Chapter 7, Christa Bouwman provides a review and synthesis of the theoretical and empirical litera­ ture on bank liquidity creation. The author provides a discussion of the impact on liquidi­ (p. 18)

ty creation of new approaches that combine originate-to-hold with originate-to-distribute business models, and how this has implications for regulation and supervision. The analy­ sis raises interesting research questions concerning the design of both liquidity and capi­ tal requirements for traditional and shadow banks. It is also important to investigate how liquidity and capital interact, as inefficient bank bailouts may occur because regulators cannot easily distinguish between insolvency and illiquidity.

1.4.2 Activities and Performance Part II of the book comprises ten chapters dealing with bank performance and operations. A number of issues are assessed, including efficiency, technological change, globalization, and the ability to deliver small business, consumer, and mortgage lending services. Secu­ ritization and shadow banking are also examined. The crucial roles that banks play in op­ erating the retail and wholesale payments systems are also discussed. In Chapter 8, Joseph Hughes and Loretta Mester outline the different approaches used to examine the efficiency and overall performance of banks. The authors discuss various structural and non-structural approaches to efficiency measurement. The structural ap­ proach requires a choice of the underlying production features of banking (intermedia­ tion, production, value-added, or other) and the specification of cost, profit, or revenue functions, from which (using various optimization techniques) one can derive relative per­ formance measures. The role of risk is important in banks’ production features and there­ fore should be included in evaluations of bank performance. The authors show that re­ search which does not incorporate risk reports little evidence of scale economies at very large banks, while the results of other studies that control for differing levels of risk across banks tend to find that there are scale economies at the largest banks. Page 17 of 41

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Banking: A Decade on from the Global Financial Crisis Technological advances and financial innovation have led to fundamental changes in the nature of banking over the last 25 years. In Chapter 9, W. Scott Frame, Larry Wall, and Lawrence White focus on innovations in banking products (subprime mortgages, retail services including the growth of debit cards, online banking, and the use of prepaid cards) and processes (automated clearing houses, small businesses credit scoring, asset securitization, and risk management). In addition, various new organizational forms, such as Internet-only banks and the establishment of Section 20 securities subsidiaries are dis­ cussed. They discuss features of recent FinTech developments including the distributed ledger technology and Blockchain. Financial and technological innovations have affected bank performance and the wider economy. However, the authors note that there is still scant research on why financial innovations take place, and suggest that this is an area future research could focus on. Payment systems were relatively unaffected during the recent financial crisis. In Chapter 10, David Humphrey analyzes the use of retail payments systems (cash, checks, debit cards, credit cards, automated clearing houses), and wholesale payment systems (wire transfer networks) across countries. The costs and benefits of different systems to the banking system are highlighted, and policy avenues are explored with respect to both (p. 19)

retail (privacy issues, card interchange fees) and wholesale payment systems (integration of back-office systems and uses of large value payment systems, systemic risk). Banking organizations are characterized by different ownership and operational features. In many countries, large private banks (typically publicly listed) compete with different types of banks. The role and features of community and mutual banks are discussed in de­ tail by Dasol Kim and Donal McKillop in Chapter 11. They note that changes in the regula­ tory environment and technological advances have dramatically changed the competitive landscape for community banking institutions. While only accounting for a fraction of the overall size of the banking industry’s assets, community banks are dominant, in terms of numbers around the world, for a broad range of depository institution types, including commercial banks, savings banks, cooperative banks, and credit unions. The steep de­ cline in the number of community banks in recent times has raised questions on the po­ tential consequences associated with the gradual disappearance of these institutions. The authors consider factors that contributed to the growth and decline of these types of banks and how they can maintain competitiveness in the current economic climate. The last two decades have witnessed rapid growth in Islamic finance and banking around the world. Global Islamic financial assets in the banking, capital markets, and insurance sectors have reached over $2 trillion and more than 350 Islamic banks are operating worldwide. In Chapter 12, Narjess Boubakri, Ruiyuan (Ryan) Chen, Omrane Guedhami, and Xinming Li discuss the development of Islamic banking and its main features. Islamic banking refers to banking operations constrained by Sharia law. Their chapter provides a brief review of the growth of Islamic banking along with its key characteristics and com­ mon financial products. They also review the extensive empirical literature that analyzes the differences between Islamic and conventional banking.

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Banking: A Decade on from the Global Financial Crisis In Chapter 13, Robert Lensink and Erwin Bulte examine ways in which microfinance pro­ grams can be made more effective. The authors discuss features of the microfinance in­ dustry and point to two important reasons why the impact of several microcredit pro­ grams is lower than expected: (1) the rigidity of credit contracts; and (2) the human capi­ tal of end users. As reforming contract terms and building human capital through busi­ ness training and technical assistance are costly, the authors argue that perhaps subsi­ dies are needed. The chapter focuses on studies dealing with end users, and the authors pay specific attention to the evolving discussion on group lending and the role of joint lia­ bility to reduce asymmetric information problems and improve repayment rates. They al­ so discuss the literature focusing on the recent shift of several microfinance institutions to individual lending, and the related trend toward commercialization of microfinance. Banks are the single largest provider of external finance to small businesses. In lending to such firms, banks use a number of different lending technologies to overcome a lack of publicly available financial information. In Chapter 14, Allen Berger and Lamont Black discuss bank small business lending. In particular, they cover how some of the tech­ nologies used to make lending decisions to small business have evolved over time from relationship-based models relying on qualitative soft information to more sophisticated (p. 20)

models based on different combinations of quantitative hard and qualitative soft informa­ tion. They also examine the effects of banking industry consolidation and technological progress on the use of the lending technologies and their effects on small business credit. They find that consolidation and technological progress and their interactions appear to have resulted in banks placing a greater reliance on hard information to make lending de­ cisions. This is reflected in greater distances between banks and their small business clients. Mortgage lending is an important part of the banking industry. In Chapter 15, Andreas Lehnert and Alex Martin note that deregulation and process and product innovations al­ lowed banks to separate origination, funding, and servicing functions. This enabled smallscale financial institutions to originate mortgages, and securitize them and sell securities backed by them to other financial institutions and investors. This unbundling process in­ troduced tensions among borrowers, mortgage funders, investors, and regulators. Since the Global Financial Crisis, underwriting standards have increased. The chapter also as­ sesses recent changes in regulation aimed at promoting financial stability in mortgage markets. Securitization has become an integral part of modern financial systems by alleviating credit constraints and allowing transfer of certain risks. However, since the Global Finan­ cial Crisis, securitization activities have diminished. In Chapter 16, Barbara Casu and An­ na Sarkisyan provide an extensive review of the theoretical and empirical research that has been conducted to explain why banks securitize, and what the effects of such activi­ ties are on consumers, financial institutions, and the wider economy. The authors point to a number of imperfections, including misaligned incentives and opacity. Recent measures

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Banking: A Decade on from the Global Financial Crisis to tackle misaligned incentives and information asymmetries to improve the quality of the credit rating process are also discussed in detail. In Chapter 17, Tobias Adrian, Adam Ashcraft, Peter Breuer, and Nicola Cetorelli examine shadow banking. The official definition of shadow banking as formulated by the Financial Stability Board (FSB) is “the system of credit intermediation that involves entities and ac­ tivities outside the regular banking system.” This chapter notes that the transformation of the credit intermediation process from a single to multiple financial institutions not only resulted in a reduction in the costs of intermediation, but also boosted the growth of shadow-banking activities that take place outside the confines of the traditional banking system. The authors explore the underlying causes for the emergence of the shadowbanking industry, and how connections to the traditional financial system can increase systemic risk. Recent developments, including agency mortgage real estate investment trusts (REITs), reinsurance, tri-party Repos, money market mutual funds, and develop­ ments in Chinese shadow banking are also discussed. (p. 21)

1.4.3 Regulatory and Policy Perspectives

Part III of this Handbook comprises eight chapters that examine the various roles of cen­ tral banks, regulatory and supervisory authorities, and other government agencies which directly impact the banking industry. Central banks execute monetary policy, which oper­ ates to a large degree through the banking system; act as a lender of last resort; and per­ form various other functions such as operating parts of the payments system. The scale and scope of central bank activities has increased dramatically since the onset of the re­ cent financial crisis. In order to prevent widespread or systemic bank failure, government agencies provide safety-net protection such as explicit or implicit deposit insurance, un­ conditional payment system guarantees, and takeovers of troubled institutions. In part to protect against systemic failure, and in part to offset some of the perverse incentive ef­ fects of government safety net protection, government authorities also engage in pruden­ tial regulation and supervision, and set policies concerning bank closure. Competition policy aimed at preventing abuses of market power also directly affect the banking indus­ try. So, too, does explicit and implicit government policy on foreign entry into domestic markets and foreign ownership of domestic industry. The role of central banks within the financial system has been influenced by successive monetary and financial crises. In Chapter 18, Frederic Mishkin examines issues related to modern central banking. The chapter examines how central banking has evolved in re­ cent decades, covering central bank governance, monetary policy, and financial stability policy. The chapter discusses the academic literature on how central banks should oper­ ate, which the author refers to as “the science of central banking.” This is then used to provide a framework for understanding how modern central banks conduct monetary and financial stability policies. The author notes that central banks now focus far more on es­ tablishing a strong nominal anchor, which has resulted in changes in central bank gover­ nance so they are more insulated from short-term political considerations. Central banks are also now far more transparent than they were in the past, requiring that they commu­ Page 20 of 41

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Banking: A Decade on from the Global Financial Crisis nicate far more clearly to the public and the markets. The Global Financial Crisis and the recognition of the constraints posed by the zero lower bound on the policy rate has led central banks to increase their focus on financial stability and to develop new tools to pro­ mote financial stability and to conduct unconventional monetary policy. The author con­ cludes that central banking has entered a brave new world in which challenges have be­ come greater and the conduct of policy has become more complex. Central banks also play an important role as lender of last resort to banks experiencing liquidity problems. Lending of last resort provides troubled banks with liquidity and al­ lows them to escape market discipline. In Chapter 19, Xavier Freixas and Bruno Parigi ex­ amine this lender of last resort function and its relationship with bank closure policy. The difficulties in distinguishing liquidity and solvency shocks are highlighted. The lender of last resort function is usually handled by the central bank, while scrutiny of bank closure is commonly the responsibility of a separate agency, often the deposit insurer. (p. 22) The financial crisis highlights the complexity of the lender of last resort function, which en­ compasses issues relating to monetary policy, bank supervision and regulation, and the operation of the interbank market. The authors posit that the lender of last resort func­ tion should be an integral and interdependent part of an overall banking safety net, which encompasses a deposit insurance system, a system of capital regulation, and a set of legal procedures to bail out or liquidate troubled banks. During the Global Financial Crisis, many governments used taxpayer funds to bail out dis­ tressed banks and stabilize the banking system. Such actions led to increased govern­ ment deficits and debt, and reduced market discipline. In Chapter 20, Raluca Roman in­ vestigates the benefits and cost of bank bailouts, and discusses developments in bank res­ olution since the Global Financial Crisis, including bail-ins. She notes that new bail-in tools appear to improve market discipline and lead to financial stability without the need to use taxpayer funds. However, bail-ins are not without limitations, and can lead to unde­ sirable outcomes, including deteriorations in conditions facing bank borrowers and other stakeholders, and resultant declines in investment and employment. Deposit insurance is intended to prevent “runs” on individual banks by depositors. It also limits losses to depositors in the event of bank failure, and reduces the risk that a run on one bank might undermine confidence in others through contagion effects. The authors argue that a flawed deposit insurance system might cause more harm than good if moral hazard created by the insurance results in excessive risk-taking or recklessness on the part of banks. In Chapter 21, Deniz Anginer and Asli Demirgüç-Kunt provide a detailed analysis of deposit insurance guarantee systems. They note that deposit insurance is now an accepted and widely adopted policy to promote stability in the banking sector. It has long been part of the International Monetary Fund’s best practice recommendations to developing countries. The Global Financial Crisis increased the focus on deposit insur­ ance, with many countries either introducing or significantly increasing existing deposit insurance coverage. The crisis also highlights both the strengths as well as some of the shortcomings of deposit insurance schemes. All in all, the authors suggest that (apart from a few exceptions) there have not been contagious runs by retail depositors, despite Page 21 of 41

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Banking: A Decade on from the Global Financial Crisis the devastating impact of the crisis on major economies. The empirical evidence points out the importance of design features and shows that poorly designed schemes can in­ crease the likelihood that a country will experience a banking crisis. To absorb unforeseen risks and reduce moral hazard, regulators require banks to hold capital. Standards developed by the Basel Committee on Banking Supervision have gone some way to aligning such capital requirements with banks’ risk profiles. In Chapter 22, Mark Van Der Weide and Jeffery Zhang examine the rationale for capital regulation, and describe the key features of the Basel Accords. The authors focus on the theoretical and empirical underpinnings of capital regulation, and the challenges in rating the riskiness of assets contained in bank portfolios. In the final parts of the chapter, the authors de­ scribe the development and implementation of Basel III and discuss ongoing Basel Com­ mittee initiatives. As banking has become increasingly complex, the usefulness of the traditional tools of su­ pervision in monitoring risk-taking by banks has been called into question. (p. 23) The effi­ cient markets hypothesis suggests that private investors can identify the risks associated with investing in shares of banks and other complex financial institutions, and thus exert market discipline. However, the recent financial crisis led some commentators to assert that market participants failed to exert discipline. In Chapter 23, Mark Flannery and Rob Bliss define the concept of market discipline and explain its importance. Particular atten­ tion is paid to the theory and practice of both direct and indirect channels of market disci­ pline and especially the role of equity and bond markets. Since the recent financial crisis, regulators have sought to realign incentives in order to restore market discipline in the banking and financial sector. The authors note that proponents of market discipline still argue that sophisticated market participants are best placed to assess complex risks be­ ing undertaken by banks and other firms, and may provide the ultimate sanction against such firms taking on excessive risk. However, this traditional view is based on weak theo­ retical and empirical foundations and the authors contend that behavioral factors influ­ ence market participants, particularly during crisis times, making market discipline sub­ stantially less effective. Competition in banking is important, because any form of market failure or anti-competi­ tive behavior on the part of banks has far-reaching implications for productive efficiency, consumer welfare, and economic growth. In Chapter 24, Hans Degryse, Paola MoralesAcevedo, and Steven Ongena review the methods used by researchers and policymakers to assess the form and intensity of competition in the banking industry. The relative mer­ its of market structure and “non-market structure” indicators such as the Panzar-Rosse H-statistic, the Lerner index, and the Boone indicator are discussed. The chapter notes how the literature has developed along two main themes. First, this relates to studies that model market structure as endogenous. A second development looks to capture the spe­ cial nature of banking competition by also looking at non-price dimensions of banking products. The authors also illustrate how regulation and information sharing between

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Banking: A Decade on from the Global Financial Crisis banks impacts on bank competition. The effects of competition on bank performance, credit availability, and risk are also examined. Increased competition in liberalized banking markets can have a positive impact by dri­ ving down prices and fees for financial services, but excessive competition can potentially lead to excessive risk-taking as well as aggressive selling and other bad practice. Unin­ formed consumers are likely to be poorly placed to learn rapidly about such bad practice because of various behavioral biases that can distort financial decision-making. Many consumers have low levels of financial literacy and this makes it difficult for them to make informed decisions. In Chapter 25, Gregory Elliehausen discusses financial literacy and consumer protection issues in financial services. The chapter reviews research in be­ havioral economics and financial literacy that raises concerns that consumers lack com­ petence to make complex financial decisions. Given evidence from behavioral economics and studies on financial literacy, the author concludes that neither existing behavioral evi­ dence nor conventional economic evidence supports a general conclusion that con­ sumers’ financial decisions are not rational or that markets do not work reasonably well. (p. 24)

1.4.4 Macroeconomic Perspectives

Part IV of the book comprises five chapters discussing the interactions among banks, firms, and the macroeconomy. This part of the book includes a discussion of the determi­ nants of bank failures and crises, and the impact on financial stability, institutional devel­ opment, and economic growth. In Chapter 26, Olivier de Bandt and Philipp Hartmann present a comprehensive review of systemic risk in banking in order to understand how extreme financial crises cause se­ vere negative effects to the macroeconomy. A clearer understanding of the causes and consequences of systemic risk also helps policymakers formulate better banking regula­ tion, prudential supervision, and more effective crisis management tools. The first part of the chapter outlines key analytical elements of systemic risk and brings them together as a coherent working concept that can be used as a benchmark for policies, ensuring the stability of financial systems. Three important sources of systemic risk are identified as contagion effects, aggregate shocks exogenous to the financial system, and the endoge­ nous build-up and unraveling of widespread financial imbalances. The authors then go on to discuss aspects of public policy designed to contain such risks—both from ex ante (pre­ ventative) and ex post (crisis-management) perspectives. The second part of the chapter presents an extensive theoretical and empirical literature review on a wide range of is­ sues relating to systemic risk that aims to identify fruitful areas for future research. There has been a substantial increase in interest in analyzing systemic risk and banking/ financial crises, although the authors caution that much more work is needed on identify­ ing the effects of macro prudential policies and the role of bank business models. In Chapter 27, Gerard Caprio and Patrick Honohan chart the frequency and severity of banking crises. A combination of factors is attributed to causing banking crises including: low real interest rates; unsound macroeconomic policies; the expansion of deposit insur­ Page 23 of 41

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Banking: A Decade on from the Global Financial Crisis ance schemes; the accumulation of official foreign exchange reserves; and the over-ex­ pansion of derivatives and securitization. The authors point out that the Global Financial Crisis illustrates information problems in the financial system, which lead investors to take excessive risks on products they do not understand. The chapter notes that the most damaging of systemic banking crises, including but not limited to the Global Financial Crisis, have ultimately involved, or were significantly exacerbated by, what the authors refer to as “bad banking and bad policies” that permitted or encouraged excessive risktaking. The authors call for more dynamic and accountable regulation to help mitigate fu­ ture crises. In Chapter 28, Charles Calomiris reviews the theory and historical evidence related to the prevalence of bank failures, panics, and contagion. He argues that banking system panics are neither random events nor inherent to the function of banks or the structure of bank balance sheets, but are caused by temporary confusion about the incidence of shocks within the banking system. Several policies have come into existence to deal with such shocks, including mechanisms intended to protect banks from unwarranted withdrawals of deposits (central bank lending during crises, deposit insurance, and (p. 25) govern­ ment-sponsored bank bailouts), and a host of prudential regulatory policies (intended to promote banking system stability, and especially to prevent banks from taking advantage of government protection by increasing their riskiness—the so-called moral-hazard prob­ lem of protection). Drawing on empirical evidence, Calomiris argues that government safety nets have led to increased banking instability by lessening market discipline, in turn leading to excessive risk-taking. International bank mergers increased rapidly up to the onset of the financial crisis, but have since declined. In Chapter 29, Claudia Buch and Gayle DeLong examine the causes and effects of international bank mergers. The authors examine the determinants of, and barriers to, cross-border bank mergers, and their impact on the efficiency, competitive­ ness, and riskiness of financial institutions and systems. Mergers tend to take place most­ ly between banks from large and developed countries, between institutions based in countries in close regional proximity, and between banks from countries that share a com­ mon cultural background. The authors also note that literature has emerged looking at the link between cross-border entry and bank risk. This also covers the bank risk-shifting incentives faced by domestic and foreign regulators. Assessing the importance of these effects empirically has been difficult and relatively few empirical studies analyze the risk effects of bank acquisitions, including effects on financial stability. At the bank level, stud­ ies find little evidence for a systematic change in risk following bank acquisitions. In Chapter 30, Nicola Cetorelli and Michael Blank examine the links between financial de­ velopment and the real economy, focusing on the specific mechanisms, such as competi­ tion, which link banks to real economic activity. Evidence suggests that bank concentra­ tion is inversely related to economic growth due to lower credit availability, although this effect varies across industries. For instance, concentration allows for the development of long-lasting lending relationships and this seems to enhance growth in industries where young firms are more dependent on external finance. The authors note that after two Page 24 of 41

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Banking: A Decade on from the Global Financial Crisis decades of rigorous research we now know that banking does matter for real economic activity. Banking can have a large impact on various measures of output growth and there is now a much better understanding of the channels through which bank activity feeds through to the real economy.

1.4.5 Banking Systems Around the World Part V of the Handbook focuses on the features of banking systems in different parts of the world. Eight chapters highlight the main structural and institutional features of vari­ ous systems. The chapters cover banking in the US, the EU, Japan, Africa, China, Russia and Central Europe, Latin America, and Australia and New Zealand. The US banking system has undergone dramatic changes in recent years. In Chapter 31, Robert DeYoung discusses in detail the evolution of the US banking industry over the past 40 years. He examines how deregulation, technological change, and financial innovation have affected industry structure and the strategies banks pursue. The author (p. 26) presents persuasive evidence that suggests that small and large banks can coexist and pursue very different strategies in long-run equilibrium. In such equilibrium, large banks use advantages afforded by scale to pursue a transaction-based banking business model that is reliant on technology and hard information, while small banks maintain a geo­ graphically focused strategy to build and maintain long-term lending relationships. Large banks can thus produce high-volume standardized products at low cost, while small banks can produce lower volumes of more tailored products at a higher price. DeYoung notes that while this new equilibrium brought substantial benefits to the banking industry and the wider economy, it also delivered the instability evidenced by the losses and govern­ ment bailouts during the Global Financial Crisis. Banking in the European Union has experienced marked changes in recent years. In Chapter 32, John Goddard, Philip Molyneux, and John Wilson explain that the structural and conduct deregulation, which took place up to the Global Financial Crisis, reduced or eliminated many of the lines of demarcation between banks and other financial service providers, and helped to facilitate both domestic and cross-border competition. The Glob­ al Financial Crisis and the later European sovereign debt crisis have led to large losses and the failure and closure of many banks, and forced the intervention of both central banks and governments in domestic banking systems. This has necessitated regulatory change aimed at ensuring the stability of the financial system, including a wide range of reforms, such as new capital and liquidity requirements (in line with those set out under Basel III) as well as new governance rules for banks. The EU also set-out a roadmap for the establishment of a European Banking Union in 2012 that has two (of its three) pillars already in place, namely, the Single Supervisory Mechanism (SSM) and the Single Resolu­ tion Mechanism (SRM). The third pillar—a Single European Deposit Insurance Scheme— will not be in place until 2024. Japan has a banking system with a wide array of different types of private, cooperative, and government-owned banks, all undertaking a range of business. The system has un­ Page 25 of 41

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Banking: A Decade on from the Global Financial Crisis dergone dramatic changes over recent decades as a result of the country’s major finan­ cial crisis that started in the early 1990s and peaked in 1997–8. This was caused to some extent by the bursting of an asset price bubble in real estate, which was amplified by ex­ cessive bank lending to the sector. This resulted in the failure of a number of banks and a massive build-up of non-performing loans in the banking system. The perilous state of the banking system in the late 1990s resulted in a wide range of reforms aimed at improving financial sector soundness and bank credit expansion including substantial industry re­ structuring as well as the use of quantitative easing from 1997–8 onwards. In Chapter 33, Hirofumi Uchida and Gregory Udell analyze the segmented nature of the Japanese bank­ ing system and market structure, competition, and bank efficiency. The authors also ex­ plore the Japanese main bank system, lending technologies, the banking crisis in the 1990s, and developments in the post-crisis period. The authors also note that there is a relative scarcity of research on Japanese banking. Banking in Africa has experienced rapid development over the past 20 years. Globaliza­ tion, technological change, and financial liberalization have led to more open, stable, and deeper financial systems. However, in most countries, there remains a lack of (p. 27) bank competition and relatively high levels of financial exclusion. In Chapter 34, Thorsten Beck, Robert Cull, and Patricio Valenzuela use a range of different data sources to docu­ ment various dimensions of the development of African banking systems, highlighting variation within the region and changes over time. The chapter compares Africa’s bank­ ing systems to those of comparable low- and lower-middle income countries outside the region, and gauges whether there is an “Africa-specific” element to banking development. The chapter also discusses progress in policies and institutions underpinning financial deepening and the results of specific innovations, including innovative branch expansion programs, mobile banking, and other new financial products aimed at reaching out to previously unbanked populations. In Chapter 35, Leora Klapper, María Soledad Martínez Pería, and Bilal Zia examine bank­ ing in China. The sector has grown at a rapid pace over the last decade, and the top five banks are now the largest (by assets size) in the world. China has also experienced a credit boom, which makes the need to better understand how the Chinese financial sector functions even more important. This chapter describes the structure and performance of the financial sector in China, focusing largely on banks. Next, the chapter discusses how regulators’ efforts to slow the growth of bank intermediation have been accompanied by rapid growth in shadow-banking products, as banks try to circumvent limits on their abili­ ty to grow. Finally, the authors document China’s progress in expanding consumer access to formal financial services and track the recent expansion of FinTech, especially digital payment products. The chapter concludes by noting that the regulators’ attempts to re­ strict shadow banking are a welcome development. In Chapter 36, Zuzana Fungáčová, Iftekhar Hasan, Laura Solanko, and Paul Wachtel ex­ amine banking in the transition countries of Central, Southern, and Eastern Europe and the former Soviet Union. The authors note that 30 years since the break-up of the Soviet bloc many advanced transition countries have replaced state-owned mono-banking struc­ Page 26 of 41

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Banking: A Decade on from the Global Financial Crisis tures with market-oriented banking systems. Much of the transformation has been brought about by improvements in banking technologies arising from the entry of foreign banks. However, there are many aspects of the industry that reflect the legacy of the transition experience. For instance, persistent structural problems in some countries have led to equally persistent bad loan problems. The development of a business lending culture, particularly to SMEs has been slow and firms complain about the difficulty in finding funding. Finally, the slow pace of institutional reform in many countries and gov­ ernment interference in the banking sector in some countries inhibits development. Extensive deregulation has taken place in the banking systems of Latin America in recent years. In Chapter 37, Fernando Carvalho, Luiz de Paula, and Jonathan Williams assess the extent to which interest rate deregulation, bank privatization, and the removal of barriers to foreign banking led to banking crises in Brazil, Chile, Argentina, and Mexico. The au­ thors note that banking crises in the 1980s and 1990s did not lead to reversals in the fi­ nancial liberalization process. Instead, most countries in the area invested in building regulatory and supervisory infrastructures to ensure the future stability of the banking system. Banking systems in Latin America were left relatively unscathed by the Global Fi­ nancial Crisis. Over the last thirty years the banking systems in the region have (p. 28) been transformed from predominantly state-owned to market-oriented with modern insti­ tutional arrangements and updated regulatory structures. In Chapter 38, Fariborz Moshirian and Eliza Wu discuss banking in Australia and New Zealand. Australian banks weathered the Global Financial Crisis and still recorded strong profits and minimal losses while other global banks failed internationally. To understand why this was the case, the authors examine the composition of the closely integrated banking sectors in Australia and New Zealand, their respective performance, capital lev­ els and some defining regulatory reforms that have particularly shaped the Australian banking system. The Australian and New Zealand banking systems are highly integrated with all “top four” Australian banks having significant investments and operations within the relatively smaller New Zealand banking sector. The features of these systems are dis­ cussed and attention is also paid to the ongoing regulatory concerns over the competi­ tiveness of their respective banking systems.

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Banking: A Decade on from the Global Financial Crisis Beck, T., Levine, R., and Levkov, A. (2010). “Big Bad Banks? The Winners and Losers from Bank Deregulation in the United States,” Journal of Finance, 65, 1637–67. (p. 30)

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Banking: A Decade on from the Global Financial Crisis Berger, A. N., Kick, T., and Schaeck, K. (2014). “Executive Board Composition and Bank Risk Taking,” Journal of Corporate Finance, 28, 48–65. Berger, A. N., Makaew, T., and Roman, R. A. (forthcoming). “Do Borrowers Benefit from Bank Bailouts During Financial Crises? The Effects of TARP on Loan Contract Terms,” Fi­ nancial Management. Berger, A. N., Roman, R. A., and Sedunov, J. (2018). “Did TARP Reduce or Increase Sys­ temic Risk? The Effects of Government Aid on Financial System Stability,” University of South Carolina Working Paper. Berrospide, J. M. and Edge, R. M. (2010). “The Effects of Bank Capital on Lending: What Do We Know, and What Does It Mean?” FEDS Working Paper No. 2010–44. Berthou, A., Horny, G., and Mésonnier, J.-S. (2018). “Dollar Funding and Firm-Level Ex­ ports,” Banque de France Working Paper No. 666, available at SSRN: https://ssrn.com/ abstract=3135724 or http://dx.doi.org/10.2139/ssrn.3135724. Berton, F., Mocetti, S., Presbitero, A. F., and Richiardi, M. (2018). “Banks, Firms and Jobs,” Review of Financial Studies, 31, 2113–56. (p. 31)

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Banking: A Decade on from the Global Financial Crisis Buca, A. and Vermeulen, P. (2017). “Corporate Investment and Bank-Dependent Borrow­ ers During the Recent Financial Crisis,” Journal of Banking & Finance, 78, 164–80. Buch, C. M., Hilberg, B., and Tonzer, L. (2016). “Taxing Banks: An Evaluation of the Ger­ man Bank Levy,” Journal of Banking & Finance, 72, 52–66. Cámara, N. T. and Tuesta, D. (2014). “Measuring Financial Inclusion: A Multidimensional Index,”, BBVA Madrid, BBVA Working Paper No. 14/26, September. Capelle-Blancard, G. and Havrylchyk, O. (2014). “The Ability of Banks to Shift Corporate Income Taxes to Customers,” in R. de Mooij and G. Nicodème (eds.), Taxation and Regula­ tion of the Financial Sector (Cambridge, MA: MIT Press), 253–78. Carpinelli, L. and Crosignani, M. (2017). “The Effect of Central Bank Liquidity Injections on Bank Credit Supply,” Finance and Economics Discussion Series 2017–038, Board of Governors of the Federal Reserve System, Federal Reserve, Washington, DC. Carvalho, D., Ferreira, M., and Matos, P. (2015). “Lending Relationships and the Effect of Bank Distress: Evidence from the 2007–2008 Financial Crisis,” Journal of Financial and Quantitative Analysis, 6, 1165–97. Catalini, C. and Gans, J. S. (2018). “Initial Coin Offerings and the Value of Crypto Tokens,” available at SSRN: https://ssrn.com/abstract=3137213 or http://dx.doi.org/10.2139/ ssrn.3137213. Célérier, C. and Matray, A. (2016). “Unbanked Households: Evidence of Supply-Side Fac­ tors,” Working Paper. Chiorazzo, V. and Milani, C. (2011). “The Impact of Taxation on Bank Profits: Evidence from EU Banks,” Journal of Banking & Finance, 35, 3202–12. Chu, Y., Zhang, D., and Zhao, Y. (forthcoming). “Bank Capital and Lending: Evidence From Syndicated Loans,” Journal of Financial and Quantitative Analysis. Cingano, F., Manaresi, F., and Sette, E. (2016). “Does Credit Crunch Investments Down? New Evidence on the Real Effects of the Bank-Lending Channel,” Review of Financial Studies, 29, 2737–73. Claessens, S., Coleman, N. S., and Donnelly, M. (2018). “Low-for-Long Interest Rates and Banks’ Interest Margin and Profitability: Cross-Country Evidence,” Journal of Financial Intermediation, 35(Part A), 1–16. (p. 32)

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Banking: A Decade on from the Global Financial Crisis Cohn, A., Fehr, E., and Maréchal, M. (2017). “Do Professional Norms in the Banking In­ dustry Favor Risk-Taking?” Review of Financial Studies, 30, 3801–23. Cole, R. A. and White, L. J. (2012). “Deja Vu All Over Again: The Causes of US Commercial Bank Failures This Time Around,” Journal of Financial Services Research, 42, 5–29. Cong, L. W. and He, Z. (2018). “Blockchain Disruption and Smart Contracts,” NBER Work­ ing Paper No. W24399, available at SSRN: https://ssrn.com/abstract=3138382, NBER, Cambridge, MA. Cornaggia, J., Mao, Y., Tian, X., and Wolfe, B. (2015). “Does Banking Competition Affect Innovation?” Journal of Financial Economics, 115, 189–209. Cortés, K. R. and Strahan, P. E. (2017). “Tracing Out Capital Flows: How Financially Inte­ grated Banks Respond to Natural Disasters,” Journal of Financial Economics, 125, 182– 99. Crump, R. K. and Santos, J. A. C. (2018). “Review of New York Fed Studies on the Effects of Post-Crisis Banking Reforms,” New York Economic Policy Review, 24, 71–90. Daetz, S. L., Subrahmanyam, M. G., Tang, D. Y., and Wang, S. (2018). “Did ECB Liquidity Injections Help the Real Economy?” mimeo. Degryse, H., de Jonghe, O., Jakovljevic, S., Mulier, K., and Schepens, G. (2018). “The Im­ pact of Bank Shocks on Firm-Level Outcomes and Bank Risk-Taking,” available at SSRN: https://ssrn.com/abstract=2788512. De Jonghe, O., and Öztekin, Ö. (2015). “Bank Capital Management: International Evi­ dence,” Journal of Financial Intermediation, 24, 154–77. De Jonghe, O., Dewachter, H., Mulier, K., Ongena, S., and Schepens, G. (2018). “Some Borrowers are more Equal than Others: Bank Funding Shocks and Credit Reallocation,” available at SSRN: https://ssrn.com/abstract=2774441. Delis, M. D. and Staikouras, P. K. (2011). “Supervisory Effectiveness and Bank Risk,” Re­ view of Finance, 15, 511–43. Deloitte (2017). Fintech by the Numbers. Incumbents, Startups, Investors Adapt to Ma­ turing Ecosystem (San Francisco, CA: Deloitte). De Marco, F. (2018). “Bank Lending and the European Sovereign Debt Crisis,” Austrian Central Bank Working Paper No. 213, Austrian Central Bank, Vienna. Demiralp, S., Eisenschmidt, J., and Vlassopoulos, T. (2017). “Negative Interest Rates, Ex­ cess Liquidity and Bank Business Models: Banks’ Reaction to Unconventional Monetary Policy in the Euro Area,” Koç University-TUSIAD Economic Research Forum Working Pa­ per No. 1708, Istanbul, Koç University-TUSIAD Economic Research Forum.

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Banking: A Decade on from the Global Financial Crisis Demirgüç-Kunt, A. and Huizinga, H. (2001). “The Taxation of Domestic and Foreign Bank­ ing,” Journal of Public Economics, 79, 429–53. Demirgüç-Kunt, A. and Klapper, L. (2013). “Measuring Financial Inclusion: Explaining Variation in Use of Financial Services across and within Countries,” Brookings Papers on Economic Activity, (Spring), 279–340. Demirgüç-Kunt, A., Detragiache, E., and Merrouche, O. (2013). “Bank Capital: Lessons from the Financial Crisis,” Journal of Money, Credit and Banking, 45, 1147–64. (p. 33)

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Banking: A Decade on from the Global Financial Crisis Flannery, M. J. and Giaconimi, E. (2015). “Maintaining Adequate Bank Capital: An Empiri­ cal Analysis of the Supervision of European Banks,” Journal of Banking & Finance, 59, 236–49. Flannery, M. J. and Rangan, K. P. (2008). “What Caused the Bank Capital Build-Up of the 1990s?” Review of Finance, 12, 391–429. Fonseca, A. R. and Gonzalez, F. (2010). “How Bank Capital Buffers Vary Across Countries: The Influence of Cost of Deposits, Market Power and Bank Regulation,” Journal of Bank­ ing & Finance, 34, 892–902. Fourth Capital Requirement Directive (2013). (Known as CRD 1V), European Union, 2013/36/EU, 23 June, EU, Brussels. Fraisse, H., Lé, M., and Thesmar, D. (2017). “The Real Effects of Bank Capital Require­ ments,” ESRB Working Paper No. 47, European Systemic Risk Board, Frankfurt. Franklin, J., Rostom, M., and Thwaites, G. (2015). “The Banks That Said No: Banking Re­ lationships, Credit Supply and Productivity in the UK,” Bank of England Working Paper No. 557. Franks, J., Serrano-Velarde, N., and Sussman, O. (2018). “Marketplace Lending, Informa­ tion Aggregation, and Liquidity,” London Business School Working Paper. Financial Services Authority (FSA) (2009). “Reforming Remuneration Practices in Finan­ cial Services,” Policy Statement 9/15, August, Financial Services Authority, London. Fuster, A., Goldsmith-Pinkham, P., Ramadorai, T., and Walther, A. (2018). “Pre­ dictably Unequal? The Effects of Machine Learning on Credit Markets,” available at (p. 34)

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Banking: A Decade on from the Global Financial Crisis Gropp, R., Mosk, T., Ongena, S., and Wix, C. (2019). “Bank Response to Higher Capital Requirements: Evidence from a Natural Experiment,” Review of Financial Studies, 32 (January), 266–99. Han, J., Park, K., and Pennacchi, G. (2015). “Corporate Taxes and Securitization,” Journal of Finance, 70, 1287–321. Hasan, I., Siddique, A., and Sun, X. (2015). “Monitoring the ‘Invisible’ Hand of Market Discipline: Capital Adequacy Revisited,” Journal of Banking & Finance, 50, 475–92. Heider, F., Saidi, F., and Schepens, G. (2017). “Life Below Zero: Bank Lending Under Neg­ ative Policy Rates,” available at SSRN: https://ssrn.com/abstract=2788204. Hombert, J. and Matray, A. (2017). “The Real Effects of Lending Relationships on Innova­ tive Firms and Inventor Mobility,” Review of Financial Studies, 30, 2413–45. Howell, S., Niessner, M., and Yermack, D. (2018). “Initial Coin Offerings: Financing Growth with Cryptocurrency Token Sales,” NBER Working Paper No. 24774, NBER, Cam­ bridge, MA. Huang, R. R. (2008). “Evaluating the Real Effect of Bank Branching Deregulation: Com­ paring Contiguous Counties across US State Borders,” Journal of Financial Economics, 87, 678–705. Huber, K. (2018). “Disentangling the Effects of a Banking Crisis: Evidence from German Firms and Counties,” American Economic Review, 108, 868–98. Iyer, R., Lopes, S., Peydro, J.-L., and Schoar, A. (2014). “Interbank Liquidity Crunch and the Firm Credit Crunch: Evidence from the 2007–2009 Crisis,” Review of Financial Stud­ ies, 27, 347–72. Jayaratne, J. and Strahan, P. E. (1996). “The Finance–Growth Nexus: Evidence from Bank Branch Deregulation,” Quarterly Journal of Economics, 111, 639–70. Jiménez, G., Ongena, S., Peydro, J. L., and Saurina, J. (2018). “Macroprudential Policy, Countercyclical Bank Capital Buffers, and Credit Supply: Evidence from the Spanish Dy­ namic Provisioning Experiments,” Journal of Political Economy, 126, 2126–77. Keen, M. and De Mooij, R. A. (2016). “Debt, Taxes, and Banks,” Journal of Money Credit and Banking, 48, 5–33. Kleymenova, A. and Tuna, A. (2016). “Regulation of Compensation,” Chicago Booth Re­ search Paper 16–07, available at SSRN: https://ssrn.com/abstract=2755621. Koetter, M., Noth, F., and Rehbein, O. (2018). “Borrowers Under Water! Rare Disasters, Regional Banks and Recovery Lending,” mimeo. Kozak, S. and Sosyura, D. (2015). “Access to Credit and Stock Market Participa­ tion,” Working Paper. (p. 35)

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Banking: A Decade on from the Global Financial Crisis KPMG (2018). “The Pulse of Fintech,” Q4 2017, February, KPMG International, Zug, Switzerland. Krishnan, K., Nandy, D., and Puri, M. (2015). “Does Financing Spur Small Business Pro­ ductivity? Evidence from a Natural Experiment,” Review of Financial Studies, 28, 1768– 809. Kritzman, M. and Li, Y. (2010). “Skulls, Financial Turbulence, and Risk Management,” Fi­ nancial Analysts Journal, 66, 30–41. Kritzman, M., Li, Y., Page, S., and Rigobon, R. (2010). “Principal Components as a Mea­ sure of Systemic Risk,” MIT Sloan Research Paper 4785–10, available at SSRN: https:// ssrn.com/abstract=1633027. Kroszner, R. S. and Strahan, P. E. (2013). “Regulation and Deregulation of the US Banking Industry: Causes, Consequences and Implications for the Future,” in N. L. Rose (ed.), Eco­ nomic Regulation and its Reform: What Have We Learned? (Chicaco, IL: University of Chicago Press), 485–543. Laeven, L. and Valencia, F. (2013). “The Real Effects of Financial Sector Interventions During Crises,” Journal of Money, Credit and Banking, 45, 147–77. Laeven, L., McAdam, P., and Popov, A. A. (2018). “Credit Shocks, Employment Protection, and Growth: Firm-Level Evidence from Spain,” ECB Working Paper No. 2166, ECB Frank­ furt. Li, L. (2013). “TARP Funds Distribution and Bank Loan Supply,” Journal of Banking and Finance, 37, 4777–92. Lin, L. and Pennachi, G. (2018). “Who Bears the Burden of Banks’ Corporate Taxes?” mimeo. Lumpkin, S. (2010). “Consumer Protection and Financial Innovation: A Few Basic Proposi­ tions,” OECD Journal: Financial Market Trends, 1, 117–39. Mariathasan, M. and Merrouche, O. (2014). “The Manipulation of Basel Risk-Weights,” Journal of Financial Intermediation, 23, 300–21. Mehran, H., Morrison, A., and Shapiro, J. (2012). “Corporate Governance and Banks: What Have We Learned from the Financial Crisis?” in M. Dewatripont and X. Freixas (eds.), The Crisis Aftermath: New Regulatory Paradigms (London: Centre For Economic Policy Research), 11–44. Memmel, C. and Raupach, P. (2010). “How Do Banks Adjust Their Capital Ratios?” Journal of Financial Intermediation, 19, 509–28.

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Banking: A Decade on from the Global Financial Crisis Minton, B. A., Taillard, J. P., and Williamson, R. (2014). “Financial Expertise of the Board, Risk Taking, and Performance: Evidence from Bank Holding Companies,” Journal of Fi­ nancial and Quantitative Analysis, 49, 351–80. Montgomery, H. and Takahashi, Y. (2014). “The Economic Consequences of the TARP: The Effectiveness of Bank Recapitalization Policies in the US,” Japan and The World Economy, 32, 49–64. Moral-Benito, E. (2018). “The Microeconomic Origins of the Spanish Boom,” Bank of Spain Working Paper No. 1805, Bank of Spain, Madrid. Morgan, D., Rime, B., and Strahan, P. E. (2004). “Bank Integration and State Business Cy­ cles,” Quarterly Journal of Economics, 119, 1555–85. Naceur, S. B., Barajas, A., and Massara, A. (2015). “Can Islamic Banking Increase Finan­ cial Inclusion?” IMF Working Paper No. WP/15/31, International Monetary Fund, Wash­ ington, DC. Nakashima, K. and Takahashi, K. (2017). “The Real Effects of Bank-Driven Termination of Relationships: Evidence from Loan-Level Matched Data,” mimeo. Nguyen, D. D., Nguyen, H. L., and Sila, V. (forthcoming). “Does Corporate Culture Affect Bank Risk-Taking? Evidence from Loan-Level Data,” British Journal of (p. 36)

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Banking: A Decade on from the Global Financial Crisis Schepens, G. (2016). “Taxes and Bank Capital Structure,” Journal of Financial Economics, 120, 585–600. Thakor, A. (2019). The Purpose of Banking (New York: Oxford University Press). Vallascas, F. and Hagendorff, J. (2013). “The Risk Sensitivity of Capital Requirements: Evi­ dence from an International Sample of Large Banks,” Review of Finance, 17, 1947–88. Wehinger, G. (2012). “Banking in a Challenging Environment: Business Models, Ethics and Approaches towards Risks,” OECD Journal: Financial Market Trends, 2, 79–88. World Bank (2014). Global Financial Development Report (Washington, DC: World Bank). Wu, D. (2015). “The Effects of Government Capital and Liquidity Support Programs on Bank Lending: Evidence from the Syndicated Corporate Credit Market,” Journal of Finan­ cial Stability, 21, 13–25.

Notes: (1) Financial Times (2017) “New Basel rules on capital hit European banks,” December 7. (2) Research suggests that economic policy uncertainty results in increased bank liquidity hoarding in the form of greater bank demand for liquid assets, reduced supply of bank credit, and increased bank demand for deposits (Berger, Guedhami et al., 2018). (3) Crump and Santos (2018) provide a selective review of studies on the effects of the Dodd–Frank Act on the banking industry. (4) While operational risk is usually considered idiosyncratic and without systemic impli­ cations, research suggests that operational risk tail events do contribute significantly to systemic risk (Berger, Curti et al., 2018). (5) Notable examples include Jayaratne and Strahan (1996), Morgan, Rime, and Strahan (2004), Demyanyk (2008), Huang (2008), Beck, Levine, and Levkov (2010), and Rice and Strahan (2010). Kroszner and Strahan (2013) provide an extensive review. (6) The EBA exercise, announced in October 2011, required large European banking groups to meet a higher Tier 1 capital ratio by June 2012. (7) Other systemic risk measures have been developed by Kritzman et al. (2010), Kritz­ man and Li (2010), Billio et al. (2012), Allen, Bali, and Tang (2012), and Giglio, Kelly, and Pruitt (2016). (8) Academic evidence on FinTech-related issues to date is rather limited. Useful discus­ sions can be found in Berg et al. (2018) who examine the use of digital footprints for cred­ it scoring; Franks, Serrano-Velarde, and Sussman (2018) who examine marketplace lend­ ing; and Fuster et al. (2018) who examine the effects of machine learning in credit mar­ kets. A review of other selected studies can be found in Chapter 9, this volume. Page 39 of 41

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Banking: A Decade on from the Global Financial Crisis

Allen N. Berger

Allen N. Berger is the H. Montague Osteen, Jr., Professor in Banking and Finance and Ph.D coordinator of the Finance Department, Darla Moore School of Business; Caroli­ na Distinguished Professor, University of South Carolina; Senior Fellow, Wharton Fi­ nancial Institutions Center; and Fellow, European Banking Center. He also currently serves on the editorial boards of seven professional finance and economics journals. He is co-author of Bank Liquidity Creation and Financial Crises (2016, Elsevier) and is currently co-authoring TARP and other Bank Bailouts and Bail-Ins around the World: Connecting Wall Street, Main Street, and the Financial System (2019, Elsevi­ er). He has published well over 100 professional articles including papers in top fi­ nance journals. His research has been cited over 70,000 times according to Google Scholar, and he has given invited keynote addresses on five continents. He was Se­ nior Economist from 1989 to 2008 and Economist from 1982–9 at the Board of Gover­ nors of the Federal Reserve System. He received a Ph.D in Economics from the Uni­ versity of California, Berkeley in 1983, and a B.A. in Economics from Northwestern University in 1976. Philip Molyneux

Philip Molyneux is Dean of the College of Business Administration at the University of Sharjah (in the UAE). His main area of research is on the structure and efficiency of banking markets and he has published widely in this area. Recent publications ap­ pear in the Journal of Money, Credit and Banking, Journal of Financial Intermedia­ tion, Journal of Banking & Finance and the Review of Finance. He has co-written/ edited over thirty-five books and is also the series editor of the Palgrave Macmillan Studies in Banking and Financial Institutions—with over 135 books in the series to date. In the past, Philip has acted as a consultant to the New York Federal Reserve Bank, World Bank, European Commission, UK Treasury, Citibank Private Bank, Bar­ clays Wealth, McKinsey, Credit Suisse and various other international banks and con­ sulting firms. John O. S. Wilson

John O. S. Wilson is Professor of Banking and Finance and Director of the Centre for Responsible Banking & Finance based at the University of St Andrews. He is also a Member of the Scientific Advisory Board of Chartered Association of Business Schools Academic Journal Guide. Previously, he was Treasurer and General Secretary of the British Accounting and Finance Association during the period 2009–11, and the founding Chair of the British Accounting and Finance Association Financial Mar­ kets and Institutions Special Interest Group over the period 2007–18. He has guest edited special issues for Journal of Corporate Finance, Journal of Banking & Finance, Journal of Economic Behaviour & Organization, European Journal of Finance, Public Money & Management, British Accounting Review and Managerial Finance. In the period June 2011 to April 2012, John served as a full member of a Commission on Credit Unions established by the Irish Government. The Commission delivered inter­ Page 40 of 41

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Banking: A Decade on from the Global Financial Crisis im and final reports to the Minister for Finance in September 2011 and April 2012 respectively. In 2018, John delivered evidence on the impact of Brexit on UK small and medium-sized enterprises to the House of Lords EU Internal Markets Committee.

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The Roles of Banks in Financial Systems

The Roles of Banks in Financial Systems   Franklin Allen, Elena Carletti, and Xian Gu The Oxford Handbook of Banking (3rd edn) Edited by Allen N. Berger, Philip Molyneux, and John O. S. Wilson Print Publication Date: Oct 2019 Subject: Economics and Finance, Financial Economics Online Publication Date: Nov 2019 DOI: 10.1093/oxfordhb/9780198824633.013.2

Abstract and Keywords Banks perform various roles in the economy. First, they ameliorate the information prob­ lems between investors and borrowers by monitoring the latter and ensuring a proper use of the depositors’ funds. Second, they provide intertemporal smoothing of risk that cannot be diversified at a given point in time as well as insurance to depositors against unexpected consumption shocks. Because of the maturity mismatch between their assets and liabilities, however, banks are subject to the possibility of runs and systemic risk. Third, banks contribute to the growth of the economy. Fourth, they perform an important role in corporate governance. The relative importance of the different roles of banks varies substantially across countries and times but banks are always critical to the finan­ cial system. Keywords: banking crisis, banks, corporate governance, growth, risk sharing

2.1 Introduction UNDERSTANDING the many roles that banks play in the financial system is one of the fundamental issues in theoretical economics and finance. The crisis of 2007–9 underlines just how important banks are to the economy. The efficiency of the process through which savings are channeled into productive activities is crucial for growth and general welfare. Banks are one part of this process. Lenders of funds are primarily households and firms. These lenders can supply funds to the ultimate borrowers, who are mainly firms, govern­ ments, and households, in two ways. The first is through financial markets, which consist of money markets, bond markets, and equity markets. The second is through banks and other financial intermediaries such as money market funds, mutual funds, insurance com­ panies, and pension funds. Despite the trend of globalization in recent years, the importance of banks in different economies varies significantly. Figure 2.1 shows a comparison of the long-term financing structure of the Euro Area, the UK, the US, and Japan in 2001 and 2016. The figures are given as a percentage of GDP. Bank assets consist of domestic credit to the private sector. Page 1 of 27

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The Roles of Banks in Financial Systems The figures in the stock market column are the total market capitalization. The bond mar­ ket figures are divided into public and private sector bonds.

Figure 2.1 Size of the Financial Markets by Country/ Region 2001 and 2016, Percentage of GDP. Source: IMF, World Bank and national authorities.

It can be seen from Figure 2.1a that in 2001 the Euro Area had small stock markets but large bank loans and in that sense could be considered as bank-based. However, it also had a more significant bond market, both in terms of public and private sector debt, than a stock market. The UK was significantly different with a large stock market and bank loans but a small bond market, particularly in terms of public sector debt. It is both mar­ ket-based and bank-based. The main features of the US financial structure are a smaller amount of bank assets, a more significant stock market and a much larger bond market than any of the other areas in relative terms. It is the most market-based (p. 40) economy. Japan has significant amounts of finance in all categories. It is very much a bank- and market-based economy. Emerging Asia is more similar to the Euro Area, bank assets are important but the market is not. Figure 2.1b shows the situation in 2016, several years after the 2008 global financial cri­ sis. It can be seen that the structure is similar but with a few important differences. While bank assets in Japan have increased relative to GDP, they have decreased everywhere else. This is particularly true for the US.

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The Roles of Banks in Financial Systems

Figure 2.2 Portfolio Allocation of Households and Non-financial Corporations (Average 1997–2016), Percentage of GDP. Source: Bank of Japan, ECB, EUROSTAT, Federal Re­ serve Board, Bank of England and the UK Office for National Statistics.

Figure 2.2 focuses on the claims that are issued by borrowers. Another way of consider­ ing the importance of banks is to look at household assets. These are shown in Figure 2.2a. This shows that all the economies are distinctly different. Households in the Euro Area own significantly fewer financial assets than in the other economies with a total of 205 percent of GDP compared with 289 percent, 347 percent, and 296 percent for the UK, the US, and Japan, respectively. In terms of the composition of assets there are also large differences. In the Euro Area, assets held in insurance and pension funds and in banks are the most important two, with direct holdings of shares after that. One striking thing is that household portfolios in the UK are very similar to those in the Euro Area with one significant difference: the investment in insurance and pension funds is dramati­ cally higher. This is presumably a result of the difference in public sector pension schemes. In the UK, the basic pension from the state is minimal, while in the Euro Area state pensions are usually generous. The US is an outlier in terms of the direct holdings of shares and other equity. Also, households hold relatively little in banks. Meanwhile, Japan is an outlier in terms of the amount of assets held in banks where households hold much more in this form than households in other countries. In fact, the Japanese post of­ fice bank is the largest deposit-taker in the world. Japanese households also have signifi­ cant amounts in insurance and pension funds. This is, to a large extent, in insurance com­ panies that offer debt-like contracts. Given the small holdings of shares (p. 41) and other equity, the Japanese bear significantly less financial risk than the households in the US and UK. Uchida and Udell, in Chapter 33 of this volume, examine the structure and char­ acteristics of the Japanese banking system. The US has somewhat less intermediation than the other economies, although the total amount of intermediation is significant in all economies. Figure 2.2b shows the assets of non-financial corporations. These again underline signifi­ cant differences across the economies. The Euro Area and the UK are quite similar except for the amount of shares and other equity, which is larger in the Euro Area. The US has much less investment than the other countries except for the “other” category. This in­ Page 3 of 27

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The Roles of Banks in Financial Systems cludes holdings of other assets, which are not identified explicitly in the flow of funds da­ ta.1 Japan is perhaps the most different. It has significantly more assets in banks and more trade credit than other countries. The implication of Figures 2.1 and 2.2 is that the importance of banks and their roles is significantly different in different economies. We start by considering the basic rationales for the existence of banks. Section 2.2 considers the monitoring role of banks while sec­ tion 2.3 considers their risk-sharing role. The bearing of risks by banks can have impor­ tant implications for financial stability. Section 2.4 considers various aspects of banking crises, including how they occur and how they disrupt the economy. The role (p. 42) of banks in spurring growth is considered in section 2.5. Section 2.6 is concerned with the corporate governance role of banks, section 2.7 with relationship banking, and section 2.8 contains concluding remarks.

2.2 Delegated Monitoring and Banks An argument that is often put forward in favor of bank-based systems is that banks allow various informational problems to be solved. One important problem is whether borrow­ ers must take some action to make proper use of the funds they have borrowed. This ac­ tion could be the level of effort or the choice of project from among various different risky alternatives. The borrower can always claim that a low outcome is due to bad luck rather than from not taking the correct action. Lenders cannot observe the borrower’s action un­ less they pay a fixed cost to monitor the borrower. In a financial market with many lenders, there is a free-rider problem. Each lender is small, so it is not worth paying the fixed cost. Everybody would like to free ride, leaving it to someone else to bear the moni­ toring cost. As a result, no monitoring would be done. A possible solution is to hire a single monitor to check what the borrower is doing. The problem then becomes one of monitoring the monitor, to make sure that she actually monitors the borrowers. Diamond (1984) develops a model of delegated monitoring to solve this problem. Intermediaries have a diversified portfolio of projects for which they provide finance. They pre-commit to monitor borrowers by promising lenders a fixed re­ turn. If the intermediary does not monitor, then it will be unable to pay the promised re­ turn to lenders. Diamond’s model thus illustrates how banks have an incentive to act as a delegated monitor and produce the information necessary for an efficient allocation of re­ sources. Boot and Thakor (1997) develop a model of financial system architecture that builds on this view of banks as delegated monitors. They assume there are three types of informa­ tion problem. The first is that there is incomplete information about the future projects a firm has available to it. Outside investors can gather information about these possibilities. The second problem is that lenders cannot observe whether borrowers invest the funds in a risky or a safe project. The third problem is the likelihood that borrowers will have the opportunity to invest in a risky project. Boot and Thakor are able to show that the first problem can best be solved by a financial market, and the second and third problems can Page 4 of 27

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The Roles of Banks in Financial Systems best be solved by intermediaries. They argue that banks will predominate in an emerging financial system, while the informational advantages of markets may allow them to devel­ op in a mature financial system.

2.3 The Risk-Sharing Role of Banks One of the most important functions of the financial system is to share risk and it is often argued that financial markets are well suited to achieve this aim. As shown in (p. 43) Fig­ ure 2.2 and discussed in the Introduction, if both direct holdings of equities and indirect holdings in insurance companies and mutual funds are taken account of, a large amount of household assets are held in equity and only a small amount in banks in the US and UK. In both countries, households are exposed to substantial amounts of risk through their holdings of equities. At the other extreme, households in Japan are shielded from risk because they ultimately hold a majority of their assets in banks and very little in equi­ ties. Although not as safe as in Japan, the asset holdings of households in the Euro Area are much safer than those in the US and UK. Although the proportions of risky assets held by households in the US and UK are much higher than in Japan, and the Euro Area, this does not necessarily mean that the absolute amount of risk borne by households is greater because the amount invested in financial assets could be higher in the latter countries. However, it can be seen from Figure 2.1 that the Euro Area has a significantly lower amount of financial assets relative to GDP. Thus, taking into account the amount of wealth held in financial assets increases the dif­ ferences in the amount of risk borne by households in the different countries, rather than reducing it. Not only do households hold much higher proportions in risky securities in the US and UK, they also hold more financial assets. How can one explain these differences in the amount of risk that households are appar­ ently exposed to in different financial systems? Standard financial theory suggests that the main purpose of financial markets is to improve risk sharing. Financial markets in the US and UK are more developed by most measures than in Japan and the Euro Area. How can it be that households are exposed to much more risk in the US and UK than in Japan and the Euro Area? Allen and Gale (1997, and 2000a, chapter 6) have provided a resolution to this paradox. They point out that traditional financial theory has little to say about hedging non-diversi­ fiable risks. It assumes that the set of assets is given and focuses on the efficient sharing of these risks through exchange. For example, the standard diversification argument re­ quires individuals to exchange assets so that each investor holds a relatively small amount of any one risk. Risks will also be traded so that more risk-averse people bear less risk than people who are more risk tolerant. This kind of risk sharing is termed cross-sec­ tional risk sharing, because it is achieved through exchanges of risk among individuals at a given point in time. However, importantly, these strategies do not eliminate macroeco­ nomic shocks that affect all assets in a similar way. Page 5 of 27

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The Roles of Banks in Financial Systems Departing from the traditional approach, Allen and Gale focus on the intertemporal smoothing of risks that cannot be diversified at a given point in time. They argue that such risks can be averaged over time in a way that reduces their impact on individual welfare through intertemporal smoothing by banks. This involves banks building up re­ serves when the returns on the banks’ assets are high and running them down when they are low. The banks can thus pay a relatively constant amount each period and do not im­ pose very much risk on depositors. The authors show that the incentives for engaging in intertemporal smoothing are very different in market-based financial systems. Incomplete financial markets, on the one hand, may not allow effective intertemporal smoothing. The problem is that the long-lived asset “crowds out” the storage technology because it can be bought and sold for the same price and in addition it pays a (p. 44) dividend. Long-lived banks, on the other hand, can achieve intertemporal smoothing as explained above. How­ ever, for this result to hold it is necessary that the banks are not subject to substantial competition from financial markets. In fact, competition from financial markets can lead to disintermediation and the unraveling of intertemporal smoothing provided by longlived institutions.

2.4 Banking Crises Banks perform an important role in terms of maturity transformation. They collect de­ mandable deposits and raise funds in short-term capital markets and invest them in longterm assets. This maturity mismatch allows them to offer risk sharing to depositors but also exposes them to the possibility that all depositors withdraw their money early. Runs can involve the withdrawal of funds by depositors (retail runs) or the drying up of liquidi­ ty in the short-term capital markets (wholesale runs). In the case of the run on Northern Rock in the UK in late 2007, both occurred. Caprio and Honohan (Chapter 27, this vol­ ume) give a review of the aspects of the historical and recent banking crises and further discuss the importance of prevention and corrective policies. There were traditionally two theories to explain the origins of banking crises. One line of argument maintains that they are undesirable events caused by random deposit with­ drawals unrelated to changes in the real economy. In this case they occur spontaneously as a panic resulting from “mob psychology” or “mass hysteria” (e.g., Kindleberger, 1978). Alternatively they may arise from fundamental causes that are part of the business cycle (see, e.g., Mitchell, 1941). Depositors use leading economic indicators to identify when the economy may be going into a recession, where banks will be unable to meet their lia­ bilities and they withdraw as a result. The panic view suggests that crises are random events, unrelated to changes in the real economy. In the influential work of Bryant (1980) and Diamond and Dybvig (1983) bank runs are sunspot phenomena as documented in Cass and Shell (1983). Given the assump­ tion of first-come, first-served and the costly liquidation of some assets there are multiple equilibria. If everybody believes no panic will occur only those with genuine liquidity needs will withdraw their funds and these demands can be met without costly liquidation Page 6 of 27

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The Roles of Banks in Financial Systems of assets. However, if everybody believes a crisis will occur then it becomes a self-fulfill­ ing prophecy as people rush to avoid being last in line. Which of these two equilibria oc­ curs depends on extraneous variables or “sunspots.” Although sunspots have no effect on the real data of the economy, they affect depositors’ beliefs in a way that turns out to be self-fulfilling. The second view is that banking crises are a natural outgrowth of the business cycle. An economic downturn will reduce the value of bank assets, raising the possibility that banks are unable to meet their commitments. Jacklin and Bhattacharya (1988) develop a theo­ retical model where, if depositors receive information about an impending downturn in the cycle, they will anticipate financial difficulties in the banking sector and try (p. 45) to withdraw their funds. This attempt will precipitate the crisis. According to this interpreta­ tion, crises are not random events but a response of depositors to the arrival of sufficient­ ly negative information on the unfolding economic circumstances. Gorton (1988) provides evidence that in the US in the late nineteenth and early twentieth centuries, a leading economic indicator based on the liabilities of failed businesses could accurately predict the occurrence of banking crises. A number of authors have developed models of banking crises caused by aggregate risk. For example, Chari and Jagannathan (1988) focus on a signal extraction problem where part of the population observes a signal about future re­ turns. Others must then try to deduce from observed withdrawals whether an unfavor­ able signal was received by this group or whether liquidity needs happen to be high. Chari and Jagannathan are able to show that crises occur not only when the outlook is poor but also when liquidity needs turn out to be high. Building on the empirical work of Gorton (1988) that nineteenth century banking crises were predicted by leading economic indicators, Allen and Gale (1998) develop a model that is consistent with the business cycle view of the origins of banking crises. They as­ sume that depositors can observe a leading economic indicator that provides public infor­ mation about future bank asset returns. If there are high returns then depositors are quite willing to keep their funds in the bank. However, if the returns are sufficiently low they will withdraw their money in anticipation of low returns. There is thus a crisis. Allen and Gale (2004) develop a general equilibrium framework for understanding the normative aspects of crises. This framework is used to investigate the welfare properties of financial systems and to discover conditions under which regulation might improve the allocation of resources. An interesting feature of the Allen–Gale framework is that it ex­ plicitly models the interaction of banks and markets. Financial institutions are the main players in financial markets, which allow banks and intermediaries to share risks and liq­ uidity. Individuals do not have direct access to markets; instead, they access markets indi­ rectly by investing in intermediaries. Financial intermediaries and markets play impor­ tant but distinct roles in the model. Intermediaries provide consumers with insurance against idiosyncratic liquidity shocks. Markets allow financial intermediaries and their de­ positors to share risks from aggregate liquidity and asset return shocks.

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The Roles of Banks in Financial Systems Financial markets are said to be complete if it is possible for intermediaries to hedge all aggregate risks in the financial markets. This would be possible if securities contingent on all the possible combinations of aggregate liquidity and asset return shocks, or in oth­ er words all the states of nature, were available. Similarly, the risk-sharing contracts be­ tween intermediaries and consumers are said to be complete if the payoffs can be explic­ itly conditioned on all the possible combinations of aggregate liquidity and asset return shocks. An example of an incomplete contract would be something like debt, where the payoff on the contract does not depend explicitly on the aggregate state of liquidity de­ mand and asset returns. Allen and Gale (2004) show that the laissez-faire allocation of re­ sources is efficient provided markets are complete. This is the case even if contracts are incomplete. However, crises are inefficient if markets are incomplete. In this case finan­ cial fragility and contagion can occur. While the multiple equilibria theory of bank runs explains how panics may occur, it is silent on which of the two equilibria will be selected. Depositors’ beliefs are self-fulfill­ ing and are coordinated by “sunspots.” Sunspots are convenient pedagogically but they do not have much predictive power. Since there is no real account of what triggers a cri­ sis, it is difficult to use the theory for any policy analysis. The business cycle theory also (p. 46)

has panic runs as well as fundamental runs. Again, there is no natural way to choose the equilibria. Carlsson and van Damme (1993) showed how the introduction of a small amount of asym­ metric information could eliminate the multiplicity of equilibria in coordination games. They called the games with asymmetric information about fundamentals “global games.” Their work showed that the existence of multiple equilibria depends on the players hav­ ing common knowledge about the fundamentals of the game. Introducing noise ensures that the fundamentals are no longer common knowledge and thus prevents the coordina­ tion that is essential to multiplicity. Morris and Shin (1998) applied this approach to mod­ els of currency crises. Rochet and Vives (2004) and Goldstein and Pauzner (2005) have applied the same technique to banking crises. Using a global games approach to ensure the uniqueness of equilibrium is theoretically appealing. However, what is really needed in addition to logical consistency is empirical evidence that such an approach is valid. In an important contribution, Chen, Goldstein, and Jiang (2010) develop a global games model of mutual fund withdrawals. Using a de­ tailed data set they find evidence consistent with their model. This represents significant evidence supporting the global games approach. A number of subsequent papers have contributed significantly to the banking crisis litera­ ture. One example is He and Xiong (2012). They depart from the static framework and de­ velop a dynamic model of bank runs. The model highlights the dynamic coordination problem between creditors who make rollover decisions at different times. There exists a unique equilibrium in which preemptive debt runs occur through a “rat race” among the creditors based on the publicly observable time-varying firm fundamental. He and Krish­ namurthy (2011) offer an account of a financial crisis in which intermediaries play a cen­ Page 8 of 27

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The Roles of Banks in Financial Systems tral role as the marginal investors. They show that the crisis occurs because shocks to the capital of intermediaries reduce their risk-bearing capacity, leading to the dynamic pat­ terns during crises in Sharpe ratios, conditional volatility, correlation in price movements, as well as riskless interest rates. Gennaioli, Shleifer, and Vishny (2013) present a model in which banks originate and trade loans, assemble them into diversified portfolios, and then get financed through external riskless debt, and show that this process of securitization allows banks to diversify idio­ syncratic risk and become more interconnected through markets while concentrating their exposure to systemic risk. When tail risks are neglected, the increase in the total amount of risk-taking that securitization facilitates makes the whole system extremely fragile (see also, Shleifer and Vishny, 2010; Gennaioli, Shleifer, and Vishny, 2015). Martin, Skeie, and von Thadden (2014) develop an infinite horizon model of shadow-bank runs. The non-banks engage in maturity transformation that involves borrowing short term to invest in long-term assets. An important difference with standard banking (p. 47) models is that the long-term assets can be traded in a market. It is shown that net asset sales in the form of securitization weakens a borrower’s balance sheet and makes the non-bank more fragile. It is also shown that if there is a shock to asset values that is suffi­ ciently strong then a run on all the non-banks is possible as a self-fulfilling expectation. Carletti and Leonello (forthcoming) develop a model where banks invest in reserves and loans, and trade loans on the interbank market to deal with liquidity shock. In one equilib­ rium, all banks keep enough reserves and remain solvent; while in the other, when com­ petition is not too intense and the probability of large liquidity shocks is small enough, a group of banks hold few reserves and go bankrupt when a large liquidity shock realizes. Besides the theoretical literature, Reinhart and Rogoff (2009) provide a comprehensive empirical investigation of bank runs and bank failures in Europe from the Napoleonic Wars to the recent global financial crises that began with the US subprime crisis of 2007. They show that banking crises are an equal-opportunity menace affecting rich and poor countries alike and remain a recurring problem everywhere. Their identification of bank­ ing crises is based on narrative information about events such as bank runs or large-scale government intervention. More recently, Romer and Romer (2017) construct a quantita­ tive, real-time, and systematic measure of financial distress for 25 OECD economies from 1967 to 2012 and find that the average decline in output following a crisis is statistically significant and persistent. Baron, Verner, and Xiong (2018) use bank equity returns and re-identify historical banking crises in forty-six countries from 1870 to 2016. Through comparing their revised chronology to previous ones based on narrative information, the aftermath of banking crises appears more severe. The prevalence of financial crises and their large impact has led many to conclude that the financial sector is unusually susceptible to shocks. One theory is that small shocks can have a large impact. A shock that initially affects only a particular region or sector, or perhaps even a few institutions, can spread by contagion through interlinkages between Page 9 of 27

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The Roles of Banks in Financial Systems banks and financial institutions to the rest of the financial sector and then infect the larg­ er economy. The theoretical literature on contagion takes two approaches. On the one hand, there are a number of papers that look for contagious effects via direct linkages. Allen and Gale (2000c) study how the banking system responds to contagion when banks are connected under different network structures. In a setting where consumers have the Diamond and Dybvig (1983) type of liquidity preferences, banks perfectly insure against liquidity shocks by exchanging interbank deposits. The connections created by swapping deposits expose the system to contagion. The authors show that incomplete networks are more prone to contagion than complete structures. Better-connected networks are more re­ silient to contagion since the proportion of the losses in one bank’s portfolio is trans­ ferred to more banks through interbank agreements. Other models capture well the network externalities created from an individual bank risk. Freixas, Parigi, and Rochet (2000) consider the case of banks that face liquidity needs as consumers are uncertain about where they are to consume. In their model, the (p. 48) connections between banks are realized through interbank credit lines that enable these institutions to hedge regional liquidity shocks. In the same way as in Allen and Gale (2000c), interbank connections enhance the resilience of the system to the insolvency of a particular bank. The drawback is that this weakens the incentives to close inefficient banks. Moreover, the authors find that the stability of the banking system depends cru­ cially on whether or not many depositors choose to consume at the location of a bank that functions as a money. Dasgupta (2004) uses a global games approach to show how a unique equilibrium with contagion can arise when banks hold cross deposits. In the same spirit, Brusco and Cas­ tiglionesi (2007) show that there is a positive probability of bankruptcy and propagation of a crisis across regions when banks keep interbank deposits, and they may engage in excessive risk taking if they are not well enough capitalized. Leitner (2005) develops a model of financial networks and demonstrates that agents may be willing to bail out other agents because of the threat of contagion. However, in some cases an agent may not have enough of a case to make the necessary investment, thus the whole network may col­ lapse. A number of papers have linked the risk of contagion to financial innovation and the ac­ counting system in use. The common feature in this analysis is the presence of incom­ plete markets where liquidity provision is achieved by selling assets in the market when required. Asset prices are determined by the available liquidity or, said differently, by the “cash in the market.” It is necessary that people hold liquidity and stand ready to buy as­ sets when they are sold. These suppliers of liquidity are no longer compensated for their opportunity cost of providing liquidity state by state. The cost must be made up on aver­ age across all states. This implies volatility in the asset prices that can in turn lead to costly and inefficient crises. In order for people to be willing to supply liquidity they must be able to make a profit in some states. In equilibrium, prices of assets will be such that Page 10 of 27

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The Roles of Banks in Financial Systems the profit in the states where banks and intermediaries sell assets is sufficient to compen­ sate the providers of liquidity for all the other states where they are not called upon to provide liquidity and simply bear the opportunity cost of holding it. In other words, asset prices are low in the states where banks and intermediaries need liquidity. But from an efficiency point of view this is exactly the wrong time for there to be a transfer from the banks and intermediaries who need liquidity to the providers of liquidity. This is because the banks’ depositors who need liquidity will already have low income because they have to withdraw early. Allen and Carletti (2006) rely on cash-in-the-market pricing to show how financial innova­ tion in the form of credit risk transfer can create contagion across sectors and lower wel­ fare relative to the autarky solution. They focus on the structure of liquidity shocks hit­ ting the banking sector as the main mechanism determining contagion. When banks face a uniform demand for liquidity, they keep a sufficient amount of the short-term asset and do not need to raise additional liquidity in the market. In this case, credit risk transfer is beneficial as it improves risk sharing across sectors. Differently, when banks face idiosyn­ cratic liquidity shocks, they invest also in the long risk-free asset and trade it in the mar­ ket. The presence of credit risk transfer turns out now to be (p. 49) detrimental as it in­ duces a higher need of liquidity in the market and consequently a greater variability in asset prices. This, in turn, affects banks’ ability to face their liquidity shocks as it implies a severe reduction in the price of the long asset, which banks use to hedge their liquidity risk. The banks that are selling the long asset receive a lower amount and may be unable to pay their depositors. The effect of introducing credit risk transfer depends crucially also on the accounting sys­ tem in use, be it historical cost or mark-to-market accounting, as shown by Allen and Car­ letti (2008). When banks need to liquidate a long-term asset on an illiquid market, it may not be desirable to value such assets according to market values as it reflects the price volatility needed to induce liquidity provision. Another approach to modeling contagion focuses on indirect balance-sheet linkages. La­ gunoff and Schreft (2001) construct a model where agents are linked in the sense that the return on an agent’s portfolio depends on the portfolio allocations of other agents. In their model, agents who are subject to shocks reallocate their portfolios, thus breaking some linkages. Two related types of financial crisis can occur in response. One occurs gradually as losses spread, breaking more links. The other type occurs instantaneously when forward-looking agents preemptively shift to safer portfolios to avoid future losses from contagion. Similarly, de Vries (2005) shows that there is dependency between banks’ portfolios, given the fat tail property of the underlying assets, and this carries the poten­ tial for systemic breakdown. Cifuentes, Ferrucci, and Shin (2005) present a model where financial institutions are connected via portfolio holdings. The network is complete as everyone holds the same asset. Although the authors incorporate in their model direct linkages through mutual credit exposures as well, contagion is mainly driven by changes in asset prices.

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The Roles of Banks in Financial Systems Complementary to the literature on network effects, Babus (2016) considers a model where banks form links with each other in order to reduce the risk of contagion. The net­ work is formed endogenously and serves as an insurance mechanism. At the base of the link formation process lays the same intuition developed in Allen and Gale (2000c): bet­ ter-connected networks are more resilient to contagion. The model predicts a connectivi­ ty threshold above which contagion does not occur, and banks form links to reach this threshold. However, an implicit cost associated with being involved in a link prevents banks from forming connections more than required by the connectivity threshold. Banks manage to form networks where contagion rarely occurs. Castiglionesi and Navarro (2007) are also interested in whether banks manage to decentralize the network struc­ ture a social planner finds optimal. In a setting where banks invest on behalf of deposi­ tors and there are positive network externalities on the investment returns, fragility aris­ es when banks that are not sufficiently capitalized gamble with depositors’ money. When the probability of bankruptcy is low, the decentralized solution approximates the first best. Allen, Babus, and Carletti (2012) develop a model of contagion based on the interaction of asset commonality between banks and the use of short-term debt. Banks swap assets to diversify their individual risk. Two asset structures arise. In a clustered structure, groups of banks hold common asset portfolios and default together. In an (p. 50) unclustered structure, defaults are more dispersed. The portfolio quality of individual banks is opaque but can be inferred by creditors from aggregate signals about bank solvency. When bank debt is short term, creditors do not roll over in response to adverse signals and all banks are inefficiently liquidated. This information contagion is more likely under clustered as­ set structures. In contrast, when bank debt is long term, welfare is the same under both asset structures. Two other important recent contributions on contagion risk and network architecture are Elliott, Golub, and Jackson (2014) and Acemoglu, Ozdaglar, and Tahbaz-Saleshi (2015). El­ liott, Golub, and Jackson (2014) develop a general model and examine network structure and contagion. They document two key aspects of the crossholding of financial organiza­ tions: integration (greater dependence on counterparties) and diversification (more coun­ terparties per organization), which have different, non-monotonic effects on the extent of cascades. Integration can increase the likelihood of a cascade once an initial failure oc­ curs, while it can also reduce the likelihood of the first failure due to less sensitivity to fi­ nancial organizations’ own investments. Diversification also faces trade-offs: contagion versus better insurance against one another’s failures. Acemoglu, Ozdaglar, and TahbazSaleshi (2015) argue that when the magnitude of negative shocks affecting financial insti­ tutions is beyond a certain point, concentrated interconnections serve as a mechanism for the propagation of negative shocks and lead to a more fragile financial system. In addition to these theoretical investigations, there has been considerable empirical in­ terest in considering whether there is evidence of contagious failures of financial institu­ tions that result from the mutual claims they have on one another. Most of these papers use balance-sheet information to estimate bilateral credit relationships for different bank­ Page 12 of 27

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The Roles of Banks in Financial Systems ing systems. Subsequently, the stability of the interbank market is tested by simulating the breakdown of a single bank. For example, Upper and Worms (2004) analyze the Ger­ man banking system. They show that the failure of a single bank could lead to the break­ down of up to 15 percent of the banking sector in terms of assets. Cocco, Gomes, and Martins (2009) consider Portugal; Furfine (2003) the US; Boss et al. (2004) Austria; and Degryse and Nguyen (2007) Belgium. Iyer and Peydró (2011) conduct a case study of in­ terbank linkages resulting from a large bank failure due to fraud. Jorion and Zhang (2009) provide evidence of credit contagion via direct counterparty effects. Using evi­ dence from interbank lending, Gai, Haldane, and Kapadia (2011) simulate how greater complexity and concentration in the network may amplify the fragility during systemic liquidity crises with the interbank market collapses. Upper (2010) contains a survey of this literature. The main conclusion of the literature is that contagion is usually not a seri­ ous risk provided there are no significant price movements in response to the turmoil. If there are, as in Cifuentes, Ferrucci, and Shin (2005), then contagion effects can be signif­ icant. The crisis that started in 2007 illustrates the practical importance of contagion. The usual justification for intervention by central banks and governments to prevent the bankruptcy of systemic financial institutions is that this will prevent contagion. This was the argu­ ment used by the Federal Reserve for intervening to ensure Bear Sterns did not go bank­ rupt in March 2008, for example (see Bernanke, 2008). The bankruptcy of (p. 51) Lehman Brothers a few months later in September of 2008 illustrated just how damaging conta­ gion can be. The process did not work in quite the way envisaged in the academic litera­ ture and occurred despite the judgment of the Federal Reserve and Treasury that Lehman should not be saved. The first spillover was to the money market mutual fund sector. Reserve Capital “broke the buck” as it held a significant amount of paper issued by Lehman. This led to many withdrawals from other money market mutual funds and four days after Lehman announced bankruptcy, the government was forced to announce guarantees for the entire sector. After seeing Lehman Brothers collapse, confidence in the creditworthiness of banks and other financial institutions and firms fell significantly and this is when the financial crisis started to spill over into the real economy and had such a damaging effect on it. Going forward, much more research is needed to under­ stand the many channels of contagion in a crisis. The crisis that started in 2007 also provides a dramatic example of how damaging bank­ ing crises can be. The causes for its occurrence are not fully agreed, but many attribute them to the bad incentives in the origination of mortgages and their securitization, the provision of ratings for securitizations, and the risk management systems of investment firms. The large global impact of the crisis suggests, however, that the problems with sub­ prime mortgages are a symptom rather than the cause. One main problem is that there was a bubble, first in stock prices and then in property prices, and the economic system is now suffering the fallout from the collapse of these bubbles. The monetary policies of cen­ tral banks, particularly the US Federal Reserve, appear to have been too loose and have focused too much on consumer price inflation while ignoring asset price inflation. More­ over, the Asian crisis of 1997 and the policies of the IMF during that crisis led to a desire Page 13 of 27

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The Roles of Banks in Financial Systems among Asian governments to hoard funds. This created important global imbalances that expanded the credit available and helped to fuel the bubble. Allen and Gale (2000b) show how such an expansion of credit can create a bubble. Whatever the reasons behind the crisis, its effects certainly spread to the real economy. Most industrialized and non-industrialized countries experienced problems with many of their industries entering into recession. The problems were multiple. On the one hand, the difficulties of the financial sector induced intermediaries to tighten their credit stan­ dards, thus making it more difficult for firms to obtain credit and at good rates. On the other hand, the sharp fall in consumer demand decreased sales and future orders. As in the financial sector, the problems were not confined to single firms but affected whole in­ dustries. The car industry is one dramatic example, but also other manufacturing indus­ tries, construction, and many others were placed under considerable pressure. The after­ math of a systemic banking crisis also puts significant strain on government resources. As shown in Reinhart and Rogoff (2011), on average, government debt rises by 86 percent during the three years following a banking crisis due to the large scale of bank bailouts or the collapsing revenues. In some circumstances, if banks are overly exposed to govern­ ment paper, banking crisis and debt crisis may also be more or less simultaneous. There is a large body of literature on policies to prevent banking crises that are outside the scope of this chapter. Surveys in this area that cover this literature are Benoit et al. (2017) and Allen, Goldstein, and Jagtiani (2018).

(p. 52)

2.5 Banks and Growth

Another important role of banks is in spurring growth. There has been a debate on the relative effectiveness of banks compared to financial markets in doing this. This debate was originally conducted in the context of German and UK growth in the late nineteenth and early twentieth centuries. Gerschenkron (1962) argued that the bank-based system in Germany allowed a closer relationship between bankers providing the finance and indus­ trial firms than was possible in the market-based system in the UK. Goldsmith (1969) pointed out that, although the manufacturing industry grew much faster in Germany than in the UK in the late nineteenth and early twentieth centuries, the overall growth rates were fairly similar. More recently, Levine (2002) uses a broad database covering fortyeight countries over the period 1980–95. He finds that the distinction between bankbased and market-based systems is not an interesting one for explaining the finance– growth nexus. Rather, elements of a country’s legal environment and the quality of its fi­ nancial services are most important for fostering general economic growth. In contrast, in a study of thirty-six countries from 1980–95, Tadassee (2002) does find a difference be­ tween bank-based and market-based financial systems. For underdeveloped financial sec­ tors, bank-based systems outperform market-based systems, while for developed financial sectors, market-based systems outperform bank-based systems. Levine and Zervos (1998) show that higher stock market liquidity or greater bank development leads to higher growth, irrespective of the development of the other. There is some evidence that finan­ Page 14 of 27

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The Roles of Banks in Financial Systems cial markets and banks are complements rather than substitutes. Demirgüç-Kunt and Maksimovic (1998) show that more developed stock markets tend to be associated with increased use of bank finance in developing countries. More recent evidence in Beck and Demirgüç-Kunt (2009), shows that a general deepening of the financial sector over time is more pronounced in the high-income countries, and more significant for markets than for banks. Consistent findings are documented also by Demirgüç-Kunt, Feyen, and Levine (2013) using a new database that covers seventy-two countries over the period from 1980 to 2008. Furthermore, they also find evidence of the changing importance of banks and securities markets throughout the development of the real economy. As the economy grows, the association between output growth and bank development becomes less pro­ nounced, while the association between output growth and market development gets stronger. There is extensive theoretical literature on the relative merits of bank-based and marketbased systems for innovation and growth. Bhattacharya and Chiesa (1995) consider a model of R&D incentives and financing. In a market system, lenders learn the value of each firm’s R&D at the interim stage after R&D has been undertaken but before produc­ tion takes place. The lenders can share the information among the firms and will do so if it is in their interest. Bhattacharya and Chiesa show that their incentives to do this corre­ spond to maximizing the aggregate value of the firms’ R&D projects. Also, a collusive agreement can be structured so that only one firm actually produces at the (p. 53) produc­ tion stage. However, this collusion creates a free-rider problem and reduces incentives to undertake R&D at the first stage. If this incentive problem is severe enough, bilateral fi­ nancing may be preferable. Under this arrangement, each firm is financed by one bank and there is no scope for information sharing. As a result, each firm’s R&D information remains proprietary. Allen and Gale (1999 and 2000a, chapter 13) ask whether financial markets or banks are better at providing finance for projects where there is diversity of opinion as in the devel­ opment of new technologies. Diversity of opinion arises from differences in prior beliefs, rather than differences in information. The advantage of financial markets is that they al­ low people with similar views to join together to finance projects. This will be optimal provided the costs necessary for each investor to form an opinion before investment deci­ sions are made are sufficiently low. Finance can be provided by the market even when there is great diversity of opinion among investors. Intermediated finance involves dele­ gating the financing decision to a manager who expends the cost necessary to form an opinion. There is an agency problem in that the manager may not have the same prior be­ lief as the investor. This type of delegation turns out to be optimal when the costs of form­ ing an opinion are high and there is likely to be considerable agreement in any case. The analysis suggests that market-based systems will lead to more innovation than bankbased systems. A recent survey of the literature on the financial structure of the economy and economic growth is contained in Allen, Gu, and Kowalewski (2018). Cettorelli and Blank (Chapter 30, this volume) conduct a literature survey on banking and growth more specifically. Page 15 of 27

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The Roles of Banks in Financial Systems

2.6 The Corporate Governance Role of Banks The importance of equity ownership by financial institutions in Japan and Germany, and the lack of a strong market for corporate control in these countries, have led to the sug­ gestion that the agency problem in these countries is solved by banks acting as outside monitors for large corporations. In Japan, this system of monitoring is known as the main bank system. The characteristics of this system are the long-term relationship between a bank and its client firm, the holding of both debt and equity by the bank, and the active intervention of the bank should its client become financially distressed. It has been wide­ ly argued that this main bank relationship ensures the bank acts as a delegated monitor and helps to overcome the agency problem between managers and the firm. However, the empirical evidence on the effectiveness of the main bank system is mixed (see, e.g., Hoshi, Kashyap, and Scharfstein, 1990, 1993; Aoki and Patrick, 1994; Hayashi, 2000). Overall, the main bank system appears important in times of financial distress, but less important when a firm is doing well. More recently, Dass and Massa (2011) find that a stronger bank–firm relationship can introduce better monitoring and improve the borrower’s corporate governance as it increases the sensitivity of CEO compensation to performance. Some other studies document that one key mechanism that facilitates the governance role of banks is the covenants in loan contracts (Nini, Smith, and Sufi, 2012; Vashishtha, 2014) because covenant violations give banks the right to demand immediate repayment of the loan and terminate future lending commitments, allowing banks to dis­ cipline managers and influence firms’ decisions. In Germany, the counterpart of the main bank system is the Hausbank system. Banks tend to have very close ties with industry and form long-run relationships with firms, not only because of the loans they make and the shares they directly own, but also because of the proxies they are able to exercise. A number of studies have provided evidence on the ef­ fectiveness of the outside monitoring of German banks (see, e.g., Gorton and Schmid, 2000). In an important book, Edwards and Fischer (1994) have argued that in Germany the cor­ porate governance role of banks has been overemphasized in the literature. They provide a variety of evidence that banks do not have the degree of influence as lenders, share­ holders, or voters of proxies that is usually supposed. For example, they find that the number of votes controlled in a company is only weakly related to the number of repre­ sentatives the bank has on the supervisory board. Hellwig (1991, 1994) also provides a number of theoretical arguments concerning the disadvantages of the banking system in Germany.

2.7 Relationship Banking There is growing literature that analyzes the advantages and disadvantages of relation­ ships in banking (see, for reviews, Boot, 2000; Gorton and Winton, 2003; Degryse and On­ gena, 2008; Boot and Thakor, Chapter 3, this volume). If on the one hand, close and Page 16 of 27

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The Roles of Banks in Financial Systems durable relationships provide better access to firms and ameliorate some of the informa­ tion problems characterizing lending relationships, they also involve inefficiencies related to the hold-up and the soft-budget-constraint problems, on the other. The hold-up prob­ lem refers to the possibility that a relationship bank uses the superior private information it possesses about the firm to extract rents, thus distorting entrepreneurial incentives and causing inefficient investment choices (Sharpe, 1990; Rajan, 1992; von Thadden, 1995). The soft-budget-constraint problem concerns the inability of a relationship lender to com­ mit itself to a particular course of action in advance. Although it is optimal to threaten to terminate the availability of credit in advance, once the borrower has defaulted, the first loan becomes a “sunk cost.” If the firm has another good project we should expect that the lender will continue to extend credit, even if the borrower defaults. Renegotiation thus creates a time-consistency problem. The threat to terminate credit creates good in­ centives for the borrower to avoid the risk of default. Termination of credit is not Paretoefficient ex post, but the incentive effect makes both parties better (p. 55) off. However, if the borrower anticipates that the lender will not carry out the threat in practice, the in­ centive effect disappears. Although the lender’s behavior is now ex post optimal, both parties may be worse off ex ante. Multiple-bank relationships can help mitigate the drawbacks of single-bank relationships in terms of the hold-up and the soft-budget-constraint problems. As for the former, bor­ rowing from multiple banks can restore competition among banks and, consequently, im­ prove entrepreneurial incentives (Padilla and Pagano, 1997). As for the latter, Dewa­ tripont and Maskin (1995) argue that, by complicating the refinancing process and mak­ ing it less profitable, multiple-bank lending allows banks to commit not to extend further inefficient credit. Similarly, Bolton and Scharfstein (1996) show that multiple-bank lend­ ing reduces entrepreneurial incentives to default strategically because it complicates debt renegotiation. The number of bank relationships also has important implications for banks’ role as moni­ tors. In a context where both firms and banks are subject to moral hazard problems, Car­ letti (2004) analyzes how the number of bank relationships influences banks’ monitoring incentives, the level of loan rates, and a firm’s choice between single and multiple bank relationships. Multiple-bank lending suffers from duplication of effort and free-riding but it benefits from diseconomies of scale in monitoring, thus involving a lower level of moni­ toring but not necessarily higher loan rates than single lending. Since banks choose their monitoring effort to maximize their expected profits, they may choose a level of monitor­ ing which is excessive from the firm’s perspective. When this is the case, the firm may choose multiple-bank relationships in order to reduce the overall level of monitoring. The attractiveness of such a choice increases with the cost of monitoring, the firm’s private benefit and expected profitability. In a similar framework, Carletti, Cerasi, and Daltung (2007) analyze the circumstances where banks with limited diversification opportunities find it profitable to enter into multiple-bank relationships. They show that sharing lending allows banks to better diversify their portfolios but still entail duplication of effort and free-riding. When the benefit of greater diversification dominates, multiple-bank lending leads to higher overall monitoring as a way to mitigate the agency problem between Page 17 of 27

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The Roles of Banks in Financial Systems banks and depositors and achieve higher banks’ expected profits. The attractiveness of multiple-bank lending now decreases with the level of banks’ (inside) equity and firms’ prior profitability, while it increases with the cost of monitoring. Other rationales for multiple-bank relationships relate to firms’ desire to reduce liquidity risk and disclose information through credit relationships. Detragiache, Garella, and Guiso (2000) show that, when relationship banks face internal liquidity problems, borrow­ ing from multiple banks can avoid early liquidation of profitable projects. Yosha (1995) suggests that firms may prefer multiple-bank lending as a way to disclose confidential in­ formation about the quality of their projects and to avoid aggressive behavior by competi­ tors. Recently, Bolton et al. (2016) extend the existing multiple relationship-lending model by introducing an aggregate shock together with idiosyncratic cash-flow risk for non-finan­ cial corporations. They find that the firms relying on a banking relationship (p. 56) are better able to weather a crisis and are less likely to default than firms only relying on transaction lending. The relationship firms pay higher borrowing costs on their relation­ ship loans in normal times. Moreover, relationship banks need a capital buffer that is used to preserve the lending relationship in bad times. There have also been some empirical evidences on the benefits of relationship banking. For example, through conducting face-to-face interviews with bank chief executive offi­ cers in twenty-one countries, Beck et al. (2018) find that relationship banking is not asso­ ciated with credit constraints during a credit boom, which significantly alleviates the con­ straints during a downturn. Such a positive role of relationship banking is more pro­ nounced for small and opaque firms and in regions with more severe recessions. A few studies (e.g., Agarwal and Hauswald, 2010; Ergungor and Moulton, 2014) argue that rela­ tionship banking reduces default risks based on unobservable soft information. However, using the setting of consumer credit markets, Agarwal et al. (2018) show that relation­ ship accounts exhibit lower probabilities of default and attrition, and higher utilization rates, suggesting that relationship can also benefit retail banking through providing hard information instead of soft information. As a final remark, note that there are ways, other than multiple-bank relationships, to solve the problem of a lack of commitment affecting exclusive bank relationships. For ex­ ample, financial institutions may develop a valuable reputation for maintaining commit­ ments. In any one case, it is worth incurring the small cost of a suboptimal action in order to maintain the value of the reputation. Incomplete information about the borrower’s type may lead to a similar outcome. If default causes the institution to believe it is more likely that the defaulter is a bad type, then it may be optimal to refuse to deal with a firm after it has defaulted. Institutional strategies such as delegating decisions to agents who are given no discretion to renegotiate may also be an effective commitment device. Several authors (Hart and Moore, 1988; Huberman and Kahn, 1988; Gale, 1991; Allen and Gale, 2000a, chapter 10) have argued that, under certain circumstances, renegotiation is wel­ fare-improving. In that case, the argument is reversed. Intermediaries that establish longPage 18 of 27

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The Roles of Banks in Financial Systems term relationships with clients may have an advantage over financial markets precisely because it is easier for them to renegotiate contracts.

2.8 Concluding Remarks We have covered a number of roles of banks in the financial system in this chapter. Banks act as delegated monitors and ensure that firms use the resources allocated to them ef­ fectively. They also play an important role in sharing risk in the economy by diversifying and smoothing fluctuations over time. These are positive aspects of the roles banks play. However, the fixed nature of the claims they issue can cause fragility in the financial sys­ tem. Banks are often at the center of financial crises as in the crisis that started in the summer of 2007. They can help spread crises if there is contagion and small shocks can have a large effect on the financial system and the economy. Banks play an important (p. 57) role in providing funds for firms and helping them and the economy to grow. They are also important for corporate governance, particularly in countries like Germany where bankers sit on boards and control a significant number of proxy votes. Finally, banks can help overcome asymmetric information problems by forming long-lived rela­ tionships with firms. There are a number of other roles that we have not covered as they are the subjects of other chapters of this Handbook, including the role of banks in payments systems, pre­ sented in Chapter 10 of this volume. Another of interest, which featured in the last edition of this Handbook, is the role of banks in underwriting securities (see Morrison, 2014). There remain other roles that are just as important, but less well understood. Many of these involve the interaction of banks with financial markets of various kinds. The recent crisis has illustrated that securitization can lead to significant problems because bank in­ centives are fundamentally different when loans are sold rather than retained. The role that banks play in derivative markets is also not fully understood. If there is a chain of counterparties, how can that risk be fully assessed if the chain is opaque as it usually is? Finally, how can banks be prevented from taking risks if they retain the profits when there are good outcomes but are bailed out by the government in times of crisis? These are all important issues for future research.

References Acemoglu, D., Ozdaglar, A., and Tahbaz-Saleshi, A. (2015). “Systemic Risk and Stability in Financial Networks,” American Economic Review, 105, 564–608. Agarwal, S. and Hauswald, R. (2010). “Distance and Private Information in Lending,” Re­ view of Financial Studies, 23, 2757–88. Agarwal, S., Chomsisengphet, S., Liu, C., and Song, C. (2018). “Benefits of Relationship Banking: Evidence from Consumer Credit Markets,” Journal of Monetary Economics, 96, 16–32. Page 19 of 27

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The Roles of Banks in Financial Systems Allen, F. and Carletti, E. (2006). “Credit Risk Transfer and Contagion,” Journal of Mone­ tary Economics, 53, 89–111. Allen, F. and Carletti, E. (2008). “Mark-to-Market Accounting and Liquidity Pricing,” Jour­ nal of Accounting and Economics, 46(2–3), 358–78. Allen, F. and Gale, D. (1997). “Financial Markets, Intermediaries, and Intertemporal Smoothing,” Journal of Political Economy, 105, 523–46. Allen, F. and Gale, D. (1998). “Optimal Financial Crises,” Journal of Finance 53, 1245–84. Allen, F. and Gale, D. (1999). “Diversity of Opinion and the Financing of New Technolo­ gies,” Journal of Financial Intermediation, 8, 68–89. Allen, F. and Gale, D. (2000a). Comparing Financial Systems (Cambridge, MA: MIT Press). Allen, F. and Gale, D. (2000b). “Bubbles and Crises,” Economic Journal, 110, 236–55. Allen, F. and Gale, D. (2000c). “Financial Contagion,” Journal of Political Economy, 108, 1–33. Allen, F. and Gale, D. (2004). “Financial Intermediaries and Markets,” Econometrica, 72, 1023–61. Allen, F., Babus, A., and Carletti, E. (2012). “Asset Commonality, Debt Maturity and Sys­ temic Risk,” Journal of Financial Economics, 104, 519–34. Allen, F., Goldstein, I., and Jagtiani, J. (2018). “The Interplay Among Financial Regula­ tions, Resilience and Growth,” Journal of Financial Services Research, 53, 141–62. Allen, F., Gu, X., and Kowalewski, O. (2018). “Financial Structure, Economic Growth and Development,” in T. Beck and R. Levine (eds.), Handbook of Finance and De­ (p. 58)

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The Roles of Banks in Financial Systems Beck, T., Degryse, H., Haas, R., and van Horen, N. (2018). “When Arm’s Length is Too Far: Relationship Banking over the Credit Cycle,” Journal of Financial Economics, 127, 174–96. Benoit, S., Colliard, J., Hurlin, C., and Perignon, C. (2017). “Where the Risks Lie: A Survey on Systemic Risk,” Review of Finance, 21, 109–52. Bernanke, B. (2008). “Reducing Systemic Risk,” opening speech at the 2008 Jackson Hole Symposium, Federal Reserve Bank of Kansas City. Bhattacharya, S. and Chiesa, G. (1995). “Financial Intermediation with Proprietary Infor­ mation,” Journal of Financial Intermediation, 4, 328–57. Bolton, P. and Scharfstein, D. (1996). “Optimal Debt Structure and the Number of Credi­ tors,” Journal of Political Economy, 104, 1–25. Bolton, P., Freixas, X., Gambacorta, L., and Mistrulli, P. (2016). “Relationship and Transac­ tion Lending in a Crisis,” Review of Financial Studies, 29, 2643–76. Boot, A. (2000). “Relationship Banking: What Do We Know?” Journal of Financial Interme­ diation, 9, 7–25. Boot, A. and Thakor, A. (1997). “Financial System Architecture,” Review of Financial Studies, 10, 693–733. Boss, M., Elsinger, H., Thurner, S., and Summer, M. (2004). “Network Topology of the In­ terbank Market,” Quantitative Finance, 4, 1–8. Brusco, S. and Castiglionesi, F. (2007). “Liquidity Coinsurance, Moral Hazard and Finan­ cial Contagion,” Journal of Finance, 62, 2275–302. Bryant, J. (1980). “A Model of Reserves, Bank Runs, and Deposit Insurance,” Journal of Banking and Finance, 4, 335–44. Carletti, E. (2004). “The Structure of Bank Relationships, Endogenous Monitoring and Loan Rates,” Journal of Financial Intermediation, 13, 58–86. Carletti, E. and Leonello, A. (forthcoming). “Credit Market Competition and Liquidity Crises,” Review of Finance. Carletti, E., Cerasi, V., and Daltung, S. (2007). “Multiple-bank Lending: Diversification and Free-Riding in Monitoring,” Journal of Financial Intermediation, 16, 425–51. Carlsson, H. and van Damme, E. (1993). “Global Games and Equilibrium Selection,” Econometrica, 61, 989–1018. Cass, D. and Shell, K. (1983). “Do Sunspots Matter?” Journal of Political Economy, 91, 193–227.

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The Roles of Banks in Financial Systems Castiglionesi, F. and Navarro, N. (2007). “Optimal Fragile Financial Networks,” CentER Discussion Paper 2007-100, Tilburg University. Chari, V. and Jagannathan, R. (1988). “Banking Panics, Information, and Rational Expec­ tations Equilibrium,” Journal of Finance, 43, 749–60. Chen, Q., Goldstein, I., and Jiang, W. (2010). “Payoff Complementarities and Finan­ cial Fragility: Evidence from Mutual Fund Flows,” Journal of Financial Economics, 97, 239–62. (p. 59)

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The Roles of Banks in Financial Systems Diamond, D. and Dybvig, P. (1983). “Bank Runs, Deposit Insurance, and Liquidity,” Journal of Political Economy, 91, 401–19. Edwards, J. and Fischer, K. (1994). Banks, Finance and Investment in Germany (Cambridge: Cambridge University Press). Elliott, M., Golub, B., and Jackson, M. (2014). “Financial Networks and Contagion,” Amer­ ican Economic Review, 104, 3315–153. Ergungor, O. and Moulton, S. (2014). “Beyond the Transaction: Banks and Mortgage De­ fault of Low-Income Homebuyers,” Journal of Money, Credit and Banking, 46, 1721–52. Freixas, X., Parigi, B., and Rochet, J. (2000). “Systemic Risk, Interbank Relations and Liq­ uidity Provision by the Central Bank,” Journal of Money, Credit and Banking, 32, 611–38. Furfine, C. (2003).“The Interbank Market During a Crisis,” Journal of Money, Credit and Banking, 35, 111–28. Gai, P., Haldane, A., and Kapadia, S. (2011). “Complexity, Concentration and Contagion,” Journal of Monetary Economics, 58, 453–70. Gale, D. (1991). “Optimal Risk Sharing through Renegotiation of Simple Contracts,” Jour­ nal of Financial Intermediation, 1, 283–306. Gennaioli, N., Shleifer, A., and Vishny, R. (2013). “A Model of Shadow Banking,” Journal of Finance, 68, 1331–63. (p. 60)

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The Roles of Banks in Financial Systems Hart, O. and Moore, J. (1988). “Incomplete Contracts and Renegotiation,” Econometrica, 56, 755–85. Hayashi, F. (2000). “The Main Bank System and Corporate Investment: An Empirical Re­ assessment,” in M. Aoki and G. Saxonhouse (eds.), Finance, Governance, and Competi­ tiveness in Japan (Oxford and New York: Oxford University Press), 81–97. He, Z. and Krishnamurthy, A. (2011). “A Model of Capital and Crises,” Review of Econom­ ic Studies, 79, 735–77. He, Z. and Xiong, W. (2012). “Dynamic Debt Runs,” Review of Financial Studies, 25, 1799–843. Hellwig, M. (1991). “Banking, Financial Intermediation and Corporate Finance,” in A. Giovannini and C. Mayer (eds.), European Financial Integration (New York: Cambridge University Press), 35–63. Hellwig, M. (1994). “Liquidity Provision, Banking, and the Allocation of Interest Rate Risk,” European Economic Review, 38, 1363–89. Hoshi, T., Kashyap, A., and Scharfstein, D. (1990). “The Role of Banks in Reducing the Costs of Financial Distress in Japan,” Journal of Financial Economics, 27, 67–8. Hoshi, T., Kashyap, A., and Scharfstein, D. (1993). “The Choice Between Public and Pri­ vate Debt: An Analysis of Post-Deregulation Corporate Financing in Japan,” NBER Work­ ing Paper No. 4421. Huberman, G. and Kahn, C. (1988). “Limited Contract Enforcement and Strategic Rene­ gotiation,” American Economic Review, 78, 471–84. Iyer, R. and Peydro, J. L. (2011). “Interbank Contagion at Work: Evidence from a Natural Experiment,” Review of Financial Studies, 24(4), 1337–77. Jacklin, C. J. and Bhattacharya, S. (1988). “Distinguishing Panics and Information-based Bank Runs: Welfare and Policy Implications,” Journal of Political Economy, 96(3), 568–92. Jorion, P. and Zhang, G. (2009). “Credit Contagion from Counterparty Risk,” Journal of Fi­ nance, 64(5), 2053–87. Kindleberger, C. (1978). Manias, Panics, and Crashes: A History of Financial Crises (New York: Basic Books). Lagunoff, R. and Schreft, S. (2001). “A Model of Financial Fragility,” Journal of Economic Theory, 99, 220–64. Leitner, Y. (2005). “Financial Networks: Contagion, Commitment and Private Sector Bailout,” Journal of Finance, 60(6), 2925–53.

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The Roles of Banks in Financial Systems Upper, C. (2010). “Simulation Methods to Assess the Danger of Contagion in Interbank Markets,” Journal of Financial Stability, 7, 111–25. Upper, C. and Worms, A. (2004). “Estimating Bilateral Exposures in the German Inter­ bank Market: Is there a Danger of Contagion?” European Economic Review, 48, 827–49. Vashishtha, R. (2014). “The Role of Bank Monitoring in Borrowers’ Discretionary Disclo­ sure: Evidence from Covenant Violations,” Journal of Accounting and Economics, 57, 176– 95. von Thadden, E. (1995). “Long-Term Contracts, Short-Term Investment and Monitoring,” Review of Economic Studies, 62, 557–75. Yosha, O. (1995). “Information Disclosure Costs and the Choice of Financing Source,” Journal of Financial Intermediation, 4, 3–20.

Notes: (1) The column representing “other” assets is unidentified miscellaneous assets. It is a residual item, arising after accounting for all asset or liability items reported by classified flow of funds sectors. In other words, accounting items that do not represent claims on another party are all classified as “other”. One example would be the accounting value of goodwill after M&A activities.

Franklin Allen

Franklin Allen is Professor of Finance and Economics and Director of the Brevan Howard Centre at Imperial College London and has held these positions since July 2014. He was on the faculty of the Wharton School of the University of Pennsylvania from July 1980 to June 2016. He now has Emeritus status there. He was formerly Vice Dean and Director of Wharton Doctoral Programs, Co-Director of the Wharton Financial Institutions Center, Executive Editor of the Review of Financial Studies and Managing Editor of the Review of Finance. He is a past President of the American Fi­ nance Association, the Western Finance Association, the Society for Financial Stud­ ies, the Financial Intermediation Research Society and the Financial Management Association, and a Fellow of the Econometric Society and the British Academy. He re­ ceived his doctorate from Oxford University. His main areas of interest are corporate finance, asset pricing, financial innovation, comparative financial systems, and finan­ cial crises. He is a co-author with Richard Brealey and Stewart Myers of the eighth through twelfth editions of the textbook Principles of Corporate Finance. Elena Carletti

Elena Carletti is Professor of Finance at Bocconi University and Scientific Director of the Florence School of Banking and Finance at the European University Institute (EUI). Previously she was Professor of Economics at the EUI, holding a joint chair in the Economics Department and the Robert Schuman Centre for Advanced Studies. Page 26 of 27

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The Roles of Banks in Financial Systems She is a member of the Board of Directors of Unicredit SpA and of the Advisory Sci­ entific Committee of the European Systemic Risk Board. Furthermore, she is Re­ search Fellow at CEPR, Fellow of the Finance Theory Group, CESifo, IGIER, and the Wharton Financial Institutions Center. Among other appointments, she has worked as consultant for the OECD and the World Bank, has served in the review panel of the Irish Central Bank and of the Riskbank, and has been a board member of the Fi­ nancial Intermediation Research Society and of the Fondazione della Cassa di Risparmio di La Spezia. Her main research areas are Financial Intermediation, Fi­ nancial Crises and Regulation, Competition Policy, Corporate Governance, and Sover­ eign Debt. Xian Gu

Xian Gu is an Assistant Professor of Finance at the Central University of Finance and Economics in Beijing. Previously she worked as a post-doctoral research fellow at Wharton Financial Institutions Center and an economist at CITIC Securities in Bei­ jing. She was also a Visiting Researcher at central banks including Bank of Finland and Hong Kong Monetary Authority. She earned her Ph.D from Beijing Normal Uni­ versity. Her main research interests are banking, corporate finance, and China’s economy.

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Commercial Banking and Shadow Banking: The Accelerating Integration of Banks and Markets and its Implications for Regulation

Commercial Banking and Shadow Banking: The Accel­ erating Integration of Banks and Markets and its Impli­ cations for Regulation   Arnoud W. A. Boot and Anjan V. Thakor The Oxford Handbook of Banking (3rd edn) Edited by Allen N. Berger, Philip Molyneux, and John O. S. Wilson Print Publication Date: Oct 2019 Subject: Economics and Finance, Financial Economics Online Publication Date: Nov 2019 DOI: 10.1093/oxfordhb/9780198824633.013.3

Abstract and Keywords We review in this chapter the market developments related to the increasing blurring of the boundaries between banks and financial markets, and the literature associated with this. While traditionally viewed as competitors, institutions and markets are now viewed as engaging in three forms of interaction: competition, complementarity, and co-evolu­ tion. The blurring boundaries between banks and markets are evidenced by the growth in shadow banking and P2P lending. We discuss how this has led to economic gains as banks become increasingly dependent on and intertwined with markets. But we also point to a dark side of this intertwining, which is the consequent increase in systemic risk and fi­ nancial institution fragility. The increased importance of “gatekeepers,” like credit rating agencies, and the implications of these developments for the regulation of banks and mar­ kets, are also discussed. Keywords: banks, intertwining, markets, securitization, systemic risk

3.1 Introduction THE financial sector has evolved rapidly over the last decades, with the impetus for change provided by deregulation and advances in information technology. Competition has become more intense. Interbank competition within domestic markets as well as across national borders and competition from financial markets have gained importance. Both the institutional structure of financial institutions and the boundary between finan­ cial institutions and financial markets have been transformed. At no stage has this blur­ ring of boundaries been more evident than during years leading up to the 2007–9 finan­ cial crisis, with the emergence of a large shadow-banking sector as a key manifestation. Pozsar et al. (2010) estimate the size of the shadow-banking system in the US at its peak in June 2007 at $22 trillion, surpassing easily total US banking assets, and $16 trillion in 2010, but estimates (and measures) vary greatly (see Claessens et al., 2012).1 A major is­ Page 1 of 38

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Commercial Banking and Shadow Banking: The Accelerating Integration of Banks and Markets and its Implications for Regulation sue with shadow banking is that because it involves qualitative asset transformation, it is inherently risky and may pose systematic risk that threatens financial stability (p. 63) (FSB, 2018).2 There have been other developments that have the potential for creating unforeseen risks. For example, since the 2007–9 financial crisis, P2P lending has grown rapidly both in the US and Europe, raising questions about the role of non-intermediated credit relative to intermediated credit. This chapter reviews the literature related to these developments and uses it to examine the importance of this changing landscape for the structure of the financial services industry and the design and organization of regula­ tion. As we will argue, the increasingly intertwined nature of banks and financial markets is not without costs. In particular, as the financial crisis of 2007–9 has illustrated, systemic risks may have become more prevalent. In response, some retrenchment is observed, par­ ticularly within the EU (Emter, Schmitz, and Tirpak, 2018). Generally, there has been some de-risking: banks hold more liquid assets and depend less on wholesale financing (BIS, 2018). In this chapter, we seek to provide a fundamental analysis of the underlying forces that could explain the evolution of the banking industry. We begin by discussing the key insights from the financial intermediation literature, including the potential com­ plementarities and conflicts of interest between intermediated relationship banking activ­ ities and financial market activities (underwriting, securitization, etc.). While debt con­ tracts dominate the financial intermediation literature, the impressive growth of private equity firms has turned the spotlight on equity. In a sense, one could interpret private eq­ uity (PE) as intermediation driven from the equity side. Given their economic functions as debt and equity intermediaries, respectively, how do banks and PE firms interact? Our discussion reveals that the interaction between banks and PE firms is only one as­ pect of an increasing integration of banks and markets. Banks have a growing depen­ dence on the financial markets not only as a source of funding but also for hedging pur­ poses and offloading risks via securitization, and possibly for engaging in proprietary trading. Financial market linkages often also imply that intra-financial sector linkages mushroom; for example, the asset-backed securities created by securitization can serve as the collateral that financial institutions use to fund themselves in the shadow-banking system. The multiple dimensions of bank dependence on markets generate both risk re­ duction and risk elevation possibilities for banks. For example, while hedging may reduce risk, proprietary trading, providing liquidity guarantees for securitized debt, and taking positions in credit default swaps can increase risk as well. This raises potential regulatory concerns. What do these developments imply for prudential regulation and supervision? Will the increasing interactions between banks and markets increase or decrease finan­ cial (p. 64) system fragility? The financial crisis of 2007–9 suggests an increase in fragili­ ty, but how much can we generalize from this crisis? These developments have also focused attention on the role of “gatekeepers” (Coffee, 2002), like credit rating agencies. While the financial intermediation literature has ac­ knowledged the role of credit rating agencies as information processors and sellers for some time now (e.g., Ramakrishnan and Thakor, 1984; Allen, 1990), the literature has not Page 2 of 38

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Commercial Banking and Shadow Banking: The Accelerating Integration of Banks and Markets and its Implications for Regulation discussed how rating agencies may affect the fragility of the financial sector through the important role they play as “spiders in the web of institutions and markets.” We take up this issue in our discussion. The organization of the chapter is as follows. In section 3.2, we focus on the economic role of financial intermediaries. The primary focus here is on the banks’ role in lending and how this compares to non-intermediated finance directly from the financial market. We will also analyze the effects of competition on the banks’ lending relationships. Does competition harm relationships and reduce their value and hence induce more transac­ tion-oriented banking, or does competition augment the value of relationships? This dis­ cussion will summarize the key insights from the modern literature of financial intermedi­ ation. In section 3.3 we discuss the increasingly interconnected nature of banks and fi­ nancial markets, with a focus on securitization. This “technology” has been at the center of the 2007–9 financial crisis. What are the future prospects for securitization? The prolif­ eration of non-banking financial institutions, and particularly private equity firms, is dis­ cussed in section 3.4. We will argue that much of this activity might be complementary to the role of banks, rather than threatening their raison d’être. Subsequently, in section 3.5 we focus on the role of credit rating agencies. These agencies have been indispensable for the explosive growth (and temporary demise) of securitization. How will their role de­ velop? We then discuss in section 3.6 regulatory implications. Here we link the role of banks in lending (as emphasized in our earlier discussions) to their role as providers of liquidity. This brings in the issue of fragility, which is at the heart of the current regulato­ ry debate.

3.2 Understanding Banks as Information-Pro­ cessing Intermediaries In this section we discuss two issues: (1) what is the key role of banks vis-à-vis markets? and (2) how does competition impinge on this role?

3.2.1 The Economic Role of Banks We first discuss the role of banks in qualitative asset transformation—that is, the process by which banks absorb risk to transform both the liquidity and credit risk characteristics (p. 65) of assets (see Bhattacharya and Thakor, 1993). For example, banks invest in risky loans but finance them with riskless deposits (e.g., Diamond, 1984; Ramakrishnan and Thakor, 1984; Millon and Thakor, 1985; Coval and Thakor, 2005). They also invest in illiq­ uid loans and finance them with liquid demandable deposits (e.g., Diamond and Dybvig, 1983). The theory of financial intermediation has placed special emphasis on the role of banks in monitoring and screening borrowers in the process of lending. Bank lending is typically contrasted with direct funding from the financial markets. What are the compar­ ative advantages of bank loans over public capital market-bond financing?3

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Commercial Banking and Shadow Banking: The Accelerating Integration of Banks and Markets and its Implications for Regulation The most striking insight of the contemporary theory of financial intermediation is that banks are better than markets at resolving informational problems. The possession of bet­ ter information about their borrowers allows banks to get closer to, and possibly more aligned with, their borrowers. Interestingly, a feedback loop is generated, as this proximi­ ty between the financier and the borrowing firm in bank-lending arrangements may also help mitigate the information asymmetries that typically plague arm’s length arrange­ ments in market transactions. This has several aspects. A borrower might be prepared to reveal proprietary information to its bank that it may have been reluctant to reveal to the financial markets (Bhattacharya and Chiesa, 1995). A bank might also gather information about prospective borrowers through their depository relationship with the bank,4 and may also have better incentives to invest in costly information acquisition. While costly, the substantial stake that it has in the funding of the borrower and the enduring nature of its relationship with the borrower—with the possibility of information reusability over time—increase the marginal benefit of information acquisition to the bank.5 Boot and Thakor (2000) analyze the economic surplus that relationship banking can generate. Such borrower–lender proximity may also have a dark side. An important one is the holdup problem that stems from the information monopoly that the bank may develop (p. 66) due to the spontaneous generation of proprietary information on borrowers. Such an in­ formational monopoly may permit the bank to charge higher loan interest rates ex post (for theories, see Sharpe, 1990; Rajan, 1992; and see Boot, 2000, for a review). The threat of being “locked in,” or informationally captured by the bank, may dampen loan demand ex ante, causing a loss of potentially valuable investment opportunities. Alternatively, firms may opt for multiple-bank relationships (see Carletti, Cerasi, and Daltung, 2007). This may reduce the informational monopoly of any individual bank, but possibly at a cost. Ongena and Smith (2000) show that multiple-bank relationships indeed reduce the hold-up problem, but can worsen the availability of credit (see Thakor, 1996, for a theo­ retical rationale). Another aspect is that relationship banking could accommodate an intertemporal smooth­ ing of contract terms (see Boot and Thakor, 1994; Allen and Gale, 1995, 1997) that would entail losses for the bank in the short term that are recouped later in the relationship.6 Petersen and Rajan (1995) show that credit subsidies to young or “de novo” companies may reduce the moral hazard problem and the informational frictions that banks face in lending to such borrowers. Banks may be willing to provide such subsidized funding if they can expect to offset the initial losses through the long-term rents generated by these borrowers. The point is that, without access to subsidized credit early in their lives, “de novo” borrowers would pose such serious adverse selection and moral hazard problems that no bank would lend to them. Relationship lending makes these loans feasible be­ cause the proprietary information generated during the relationship produces “competi­ tion-immune” rents for the bank later in the relationship and permits the early losses to be offset. The importance of intertemporal transfers in loan pricing is also present in Berlin and Mester (1999). They show that rate-insensitive core deposits allow for in­ tertemporal smoothing in lending rates. This suggests a complementarity between de­ posit taking and lending. Moreover, the loan commitment literature has emphasized the Page 4 of 38

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Commercial Banking and Shadow Banking: The Accelerating Integration of Banks and Markets and its Implications for Regulation importance of intertemporal tax subsidy schemes in pricing to resolve moral hazard (see Boot, Thakor, and Udell, 1991; Shockley and Thakor, 1997) and also the complementarity between deposit taking and commitment lending (see Kashyap, Rajan, and Stein, 2002). The bank–borrower relationship also displays greater contractual flexibility than that nor­ mally encountered in the financial market. This flexibility inheres in the generation of hard and soft proprietary information during a banking relationship. The information gives the bank the ability to adjust contractual terms to the arrival of new information and hence encourages it to write “discretionary contracts” ex ante that leave room for such ex post adjustments. This is in line with the important ongoing discussion in eco­ nomic theory on rules versus discretion, where discretion allows for decision-making based on more subtle—potentially non-contractible—information (see, for example, Si­ mons, 1936; Boot, Greenbaum, and Thakor, 1993). The papers by Stein (2002), and Berger et al. (2005) highlight the value of “soft in­ formation” in lending. Soft information could be an example of more subtle and non-con­ tractible information. On this issue, two dimensions can be identified. One dimension is related to the nature of the bank–borrower relationship, which is typically long term, with accompanying reinforcing incentives for both the bank and the borrower to enhance the (p. 67)

durability of the relationship. This allows for implicit—non-enforceable—long-term con­ tracting. An optimal information flow is crucial for sustaining these “contracts.” Informa­ tion asymmetries in the financial market, and the non-contractibility of various pieces of information, would rule out long-term alternative capital market funding sources as well as explicit long-term commitments by banks. Therefore, both the bank and the borrower may realize the added value of their relationship, and have an incentive to foster the rela­ tionship.7 The other dimension is related to the structure of the explicit contracts that banks can write. Because banks write more discretionary contracts, bank loans are generally easier to renegotiate than bond issues or other public capital market funding vehicles (see Berlin and Mester, 1992). Such renegotiability may be a mixed blessing because banks may suffer from a “soft-budget constraint” problem: borrowers may realize that they can renegotiate ex post, which could give them perverse ex ante incentives (see Dewatripont and Maskin, 1995; Bolton and Scharfstein, 1996). The soft-budget-constraint problem is related to the potential lack of toughness in enforcing contracts due to the ex post distrib­ ution of “bargaining power” linked with relationship banking proximity (see Boot, 2000). In practice, one way that banks can deal with this issue is through the priority structure of their loan contracts. If the bank has priority/seniority over other lenders, it could strengthen the bank’s bargaining position and allow it to become tougher. These issues are examined in Diamond (1993), Berglöf and von Thadden (1994), and Gorton and Kahn (1993). The bank could then credibly intervene in the decision process of the borrower when it believes that its long-term interests are in jeopardy. For example, the bank might believe that the firm’s strategy is flawed, or a restructuring is long overdue. Could the bank push Page 5 of 38

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Commercial Banking and Shadow Banking: The Accelerating Integration of Banks and Markets and its Implications for Regulation for the restructuring? If the bank has no priority, the borrower may choose to ignore the bank’s wishes. The bank could threaten to call the loan, but such a threat may lack credi­ bility because the benefits of liquidating the borrower’s assets are larger for higher-prior­ ity lenders, and the costs from the termination of the borrower’s business are higher for lower-priority lenders. When the bank loan has sufficiently high priority, the bank could credibly threaten to call back the loan, and this may offset the deleterious effect of the soft-budget constraint. This identifies a potential advantage of bank financing: timely in­ tervention. Of course, one could ask whether bondholders could be given priority and al­ located the task of timely intervention. Note that bondholders are subject to more severe information asymmetries (p. 68) and are generally more dispersed (i.e., have smaller stakes). Both characteristics make them ill-suited for an “early intervention” task.

3.2.2 Intermediation and Competition Since relationship banking is an integral part of the economic services provided by banks and generates rents for banks, it also potentially invites multiple-bank entry, which then generates interbank competition. An interesting question this raises is how competition might affect the incentives for relationship banking. While this may ultimately be an em­ pirical question, two diametrically opposite points of view have emerged theoretically. One is that competition among financiers encourages borrowers to switch to other banks or to the financial market. The consequent shortening of the expected “life span” of bank– borrower relationships may induce banks to reduce their relationship-specific invest­ ments, thereby inhibiting the reusability of information and diminishing the value of infor­ mation (Chan, Greenbaum, and Thakor, 1986). Banks may then experience weaker incen­ tives to acquire (costly) proprietary information, and relationships may suffer. There is empirical evidence that an increase in relationship length benefits the borrower. Brick and Palia (2007) document a 21-basis point reduction in the loan interest rate due to a one-standard deviation increase in relationship length. Moreover, increased credit market competition could also hurt relationship lending by im­ posing tighter constraints on the ability of borrowers and lenders intertemporally to share surpluses (see Petersen and Rajan, 1995). In particular, it becomes more difficult for banks to “subsidize” borrowers in earlier periods in return for a share of the rents in the future. Thus, the funding role for banks that Petersen and Rajan (1995) see in the case of young corporations (as already discussed) may no longer be sustainable in the face of sufficiently high competition. This implies that interbank competition may have an ex post effect of diminishing bank lending.8 Another way in which competition can hurt relationship lending is through consolidation. Extensive empirical literature focuses on the effect of consolidation in the banking sector on small-business lending. This consolidation may in part be a response to competitive pressures. The effects on small-business lending, however, are not clear-cut. Sapienza (2002) finds that bank mergers involving at least one large bank result in a lower supply of loans to small borrowers by the merged entity. This could be linked to the difficulty that larger organizations have in using “soft information” (Stein, 2002; Berger et al., Page 6 of 38

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Commercial Banking and Shadow Banking: The Accelerating Integration of Banks and Markets and its Implications for Regulation 2005). However, Berger et al. (1998) show that the actual supply of loans to small busi­ nesses may not go down after bank mergers, since they invite entry of “de novo” banks that specialize in small-business lending (see also Strahan, 2007). The opposite point of view is that competition may actually elevate the importance of a relationship-orientation as a distinct competitive edge. The idea is that competition pressures profit margins on existing products and increases the importance of financier differentiation, and more intense relationship lending may be one way for the bank to achieve this. Boot and Thakor (2000) formalize this argument to show that a more com­ petitive environment may encourage banks to become more client-driven and customize services, thus generating a stronger focus on relationship banking.9 They distinguish be­ tween “passive” transaction lending and more intensive relationship lending by banks. Transaction lending competes head-on with funding in the financial market. Greater in­ terbank competition results in banks engaging in more relationship lending, but each re­ lationship loan has lower value to the borrower. By contrast, greater competition from the capital market leads to a lower volume of relationship lending, but each relationship loan has greater value. In this context, it is also interesting to note that Berger et al. (2008) find empirically that bank ownership type (foreign, state-owned, or private domestic) af­ (p. 69)

fects the bank’s choice between transaction and relationship lending. Relationships may foster the exchange of information, but may simultaneously give lenders an information monopoly and undermine competitive pricing. As discussed above, the informational monopoly on the “inside” lender’s side may be smaller if a borrower en­ gages in multiple-banking relationships. This would mitigate the possibilities for rent ex­ traction by informed lenders and induce more competitive pricing (see Sharpe, 1990; Pe­ tersen and Rajan, 1995). Transaction-oriented finance, however, may give banks little in­ centive to acquire information but is potentially subject to more competition. This sug­ gests that markets for transaction-oriented finance may fail when problems of asymmet­ ric information are insurmountable without explicit information acquisition and informa­ tion-processing intervention by banks. This argument is used by some to highlight the virtues of (relationship-oriented) bank-dominated systems (e.g., Germany and Japan) visà-vis market-oriented systems. This is part of the literature on the design of financial sys­ tems (see Allen, 1993; Allen and Gale, 1995; Boot and Thakor, 1997). One objective of this literature is to evaluate the economic consequences of alternative types of financial sys­ tem architecture. What this discussion indicates is that the impact of competition on relationship banking is complex; several effects need to be disentangled. However, empirical evidence (see De­ gryse and Ongena, 2007) seems to support the Boot and Thakor (2000) prediction that the orientation of relationship banking adapts to increasing interbank competition, so higher competition does not drive out relationship lending. Despite this adaptation, there is also evidence that in recent years the geographic distance between borrowers and lenders has increased (see DeYoung, Glennon, and Nigro, 2008). The latter (p. 70) might point at an increasing availability of data and data-processing capacity, which might chal­ lenge relationship banking. New specialized lenders have arisen that seek to replace rela­ Page 7 of 38

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Commercial Banking and Shadow Banking: The Accelerating Integration of Banks and Markets and its Implications for Regulation tionship lenders and traditional credit scoring with sophisticated algorithms based on Big Data mining (data analytics). While still in its infancy, such analysis predicts creditworthi­ ness by analyzing buying habits, lifestyle choices, and all manner of opportunistic demo­ graphic correlates. One could envision similar developments enabling P2P lending as well.10

3.3 Bank Lending, Securitization, and Capital Market Funding Much of our focus in the previous section was on interbank competition. Nonetheless, banks also face competition from the capital market. The standard view is that banks and markets compete, so that growth in one is at the expense of the other (see Allen and Gale, 1995; Boot and Thakor, 1997). In this context, Deidda and Fattouh (2008) show theoreti­ cally that both bank and stock-market development have a positive effect on growth, but the growth impact of bank development is lower when there is a higher level of stockmarket development. They also present supporting empirical evidence. What this shows is that the dynamics of the interaction between banks and markets can have real effects. How banks and markets interact is therefore of great interest. In contrast to the standard view that they compete, the observations in the previous sec­ tion suggest that there are also potential complementarities between bank lending and capital market funding. We argued that prioritized bank debt may facilitate timely inter­ vention. This feature of bank lending is valuable to the firm’s bondholders as well. They might find it optimal to have bank debt take priority over their own claims, because this efficiently delegates the timely intervention task to the bank. The bondholders will obvi­ ously ask to be compensated for their subordinated status. This—ignoring the timely in­ tervention effect—is a “wash.” In other words, the priority (seniority) and subordination features can be priced. That is, as much as senior debt may appear to be “cheaper” (it is less risky), junior or subordinated debt will appear to be more expensive, and there should be no preference for bank seniority, other than through the timely bank-interven­ tion channel. Consequently, the borrower may reduce its total funding cost by accessing both the bank-credit market and the financial market.11 A theoretical (p. 71) analysis of complementarity appears in Song and Thakor (2010) who show that banks and markets exhibit three forms of interaction: competition, complementarity, and co-evolution. Another manifestation of potential complementarities between bank lending and capital market activities is the increasing importance of securitization, this being an example of the unbundling of financial services. Securitization is a process whereby assets are re­ moved from a bank’s balance sheet, so banks no longer permanently fund assets when they are securitized; instead, the investors buying asset-backed securities provide the funding. Asset-backed securities rather than deposits thus end up funding dedicated pools of bank-originated assets. More specifically, the lending function can be decom­ posed into four more primal activities: origination, funding, servicing, and risk processing (Bhattacharya and Thakor, 1993). Origination subsumes screening prospective borrowers, Page 8 of 38

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Commercial Banking and Shadow Banking: The Accelerating Integration of Banks and Markets and its Implications for Regulation and designing and pricing financial contracts. Funding relates to the provision of finan­ cial resources. Servicing involves the collection and remission of payments as well as the monitoring of credits. Risk processing alludes to hedging, diversification, and absorption of credit, interest rate, liquidity, and exchange-rate risks. Securitization decomposes the lending function such that banks no longer fully fund the assets, but continue to be in­ volved in other primal lending activities. One potential benefit of securitization is better risk sharing (see Gorton and Pennacchi, 1995 for an economic rationale for bank loan sales and securitization). The proliferation of securitization may, however, also be induced by regulatory arbitrage—for example, as a vehicle to mitigate capital regulation. And a third benefit is highlighted by Boot and Thakor (1993), who show that the pooling of as­ sets and tranching of claims in securitization achieve both a diversification of idiosyncrat­ ic information and the creation of information-sensitive claims that increase the issuer’s revenues from selling these securities. Central to the extensive academic work on securitization is the idea that it is not efficient for originators to completely offload the risks in the originated assets. The originating bank needs to maintain an economic interest in the assets in order to alleviate moral haz­ ard and induce sufficient effort on the originating bank’s part in screening and monitor­ ing. What this implies is that, even with securitization, banks do not become disengaged from the assets they originate. Banks still continue to provide the services involved in screening and monitoring borrowers, designing and pricing financial claims, and provid­ ing risk-management and loan-servicing support. As such, securitization preserves those functions that are at the core of the raison d’être for banks. This militates against the no­ tion that securitization effectively lessens the importance of banks. Boyd and Gertler (1994) have argued that the substitution from on-balance-sheet to offbalance-sheet banking induced by securitization may have falsely suggested a shrinking role for banks. Indeed, by keeping banks involved in their primal activity of (p. 72) prelending borrower screening, securitization preserves much of the banks’ value added on the asset side. Up to the 2007–9 financial crisis, securitization was rapidly gaining in importance. In fact, prior to the summer of 2007, securitization became prevalent for ever-wider types of credits, including business credits that were previously thought to be difficult to securi­ tize because of their information opaqueness. Also, a rather new market for securitization involving asset-backed commercial paper (ABCP) conduits emerged as a significant force. As the subprime crisis of 2007 has shown, these developments are not without problems. The structure of real-world securitization transactions appears to have taken a rather fragile form. In particular, it is important to note that much of the securitization leading up to the crisis involved the financing of long-term assets with short-term funding, which induced substantial liquidity risk. While this liquidity risk was sometimes mitigated by liq­ uidity guarantees (e.g., stand-by letters of credit and refinancing commitments), the un­ derwriting institutions often underestimated the risks involved and overstretched them­ selves.12 Recent events may cast doubt on the optimality of such strategies. Also, because the originating institutions appeared to have retained minimal residual risk, monitoring Page 9 of 38

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Commercial Banking and Shadow Banking: The Accelerating Integration of Banks and Markets and its Implications for Regulation incentives may have been compromised (see Mian and Sufi, 2009).13 The eagerness of banks to securitize claims—and keep the repackaging “machine” rolling—may have also adversely impacted the quality of loans that were originated through a dilution of banks’ screening incentives due to lower retained residual risks (e.g., subprime lending; see Keys et al., 2010). The 2007–9 financial crisis brought securitization almost to a grinding halt. However, the risk diversification that securitization can accomplish appears to be of more than just ephemeral importance. Thus, we expect securitization to re-emerge, albeit possibly in a form that entails lower levels of liquidity risk, as well as lesser moral hazard in screening (loan underwriting standards) and monitoring. A caveat is that some of the activity in se­ curitization might have been induced merely by capital arbitrage. With the stronger regu­ latory scrutiny following the financial crisis, we would expect such securitization to be discouraged. Another effect of the interaction between banks and markets is that as markets evolve and entice bank borrowers away, banks have an incentive to create new products and ser­ vices that combine services provided by markets with those provided by banks. This al­ lows banks to follow their customers to the market rather than losing them. There (p. 73) are numerous examples. For instance, when a borrower goes to the market to issue com­ mercial paper, its bank can provide a backup line of credit. In similar spirit, Drucker (2005) shows that junk-rated firms and companies in local lending relationships are more likely to select an integrated (universal) commercial investment bank when they expect to issue public debt in the future. This revealed preference for commercial investment bank relationships by firms that issue informationally sensitive securities suggests that there might be benefits for banks to use private information from lending in investment bank­ ing. A similar picture emerges if one looks at US banking following the 1999 Financial Services Modernization Act. It appears that information collected through the banks’ commercial lending businesses may have reduced the costs of underwriting debt and eq­ uity (see Schenone, 2004; Drucker and Puri, 2005). While this suggests a potential for val­ ue creation, an extensive amount of literature has focused on the potential conflicts of in­ terest related to banks combining lending and capital market activities; particularly, con­ flicts of interest in universal banking. Much of earlier work is motivated by the Glass– Steagall regulation in the US (see Kroszner and Rajan, 1994; Puri, 1996; Ramírez, 2002). Typical findings are reassuring, that is, conflicts were found to be limited. In more recent work, a somewhat more critical picture has emerged; the problems with securitization, as already discussed, are a good example. Moreover, as Boot and Ratnovs­ ki (2016) show, combining relationship banking with financial market-oriented transac­ tion activities (like trading) might undermine the commitment needed for relationship banking. More specifically, the ability to shift resources to trading activities within finan­ cial institutions may undermine relationship banking activities by violating (implicit) fund­ ing commitments to those borrowers. This might be particularly acute because trading activities are typically more readily scalable than relationship banking activities; that is, the latter depend on more long-term engagements leading to more cultivated relation­ Page 10 of 38

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Commercial Banking and Shadow Banking: The Accelerating Integration of Banks and Markets and its Implications for Regulation ships. This suggests that combining banking and trading activities could lead to a lack of commitment and the loss of franchise value. Consistent with this, Laeven and Levine (2007) find that banks that combine lending and non-lending activities lose value relative to engaging in these activities separately (see also Schmid and Walter, 2009). The impetus for market-based activities grows stronger as interbank competition puts pressure on profit margins from traditional banking products, and the capital market pro­ vides access to greater liquidity and lower cost of capital for the bank’s traditional bor­ rowers. As a consequence, there is a natural propensity for banks to become increasingly integrated with markets, and a sort of unprecedented “co-dependence” emerges that in­ creasingly intertwines banking and capital market risks.14 A discussion of whether this is desirable and what the regulatory implications might be is given in section 3.6.

(p. 74)

3.4 Banks, Equity, and Private Equity Firms

The emergence of non-banking financial institutions such as PE firms is considered by some to be a (further) signal for the diminishing role of banks. However, we will argue that these developments are rather complementary to the role of banks. Let us first dis­ cuss the role that PE firms play. The arguments above about the need for banks to have seniority suggest a natural eco­ nomic inhibiting of investments by banks in the equity of corporations. Equity “softens” a bank’s incentive to intervene for much the same reasons as does junior debt. So, while the emphasis of corporate finance theory on agency problems would suggest that it might be efficient for the bank to have both debt and equity claims on a corporation, this seems not to be advisable from a timely intervention point of view. This might explain why equi­ ty intermediation has largely been in the hands of PE firms and/or bulge-bracket global investment banks that typically engage less in relationship banking and focus more on transactions and the associated capital market activities. Some more observations can be made about PE firms. Their activities could be viewed as intermediation driven from the equity side. That is, PE firms attract funding from a group of investors (“partners”) and invest the funds as equity in businesses. They are extensive­ ly involved in monitoring and advising these businesses. How different is this from the role that banks play as debt intermediaries? To address this question, note first that banks do occasionally take equity positions in their role as venture capitalists, particular­ ly for later-stage financing where there is a prospect for developing a valuable relation­ ship on the lending side. Thus, banks participate in venture capital financing with higher probability if there is a greater likelihood of subsequent lucrative lending activity (Hell­ mann, Lindsey, and Puri, 2008). However, this may create a weakness in the participation decision. Bank-affiliated private equity investments, on average, do worse than non-affili­ ated investments (see Fang, Ivashina, and Lerner, 2010). Banks may also have (participa­ tions in) PE subsidiaries that operate independently from the other businesses of the bank. However, this somewhat limited role as an equity financier does not mean that it would be efficient for the bank permanently to become an integrated provider of debt and Page 11 of 38

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Commercial Banking and Shadow Banking: The Accelerating Integration of Banks and Markets and its Implications for Regulation equity finance, a “one-stop” financier of sorts. In particular, equity as a junior security may undermine a bank’s bargaining power and thus compromise its role in timely inter­ vention. Also, soft-budget constraint problems may then (re)emerge. At a more general level, one could ask whether the monitoring role of PE firms substi­ tutes for the lending-related monitoring of banks. It might. Note, however, that equity and debt are fundamentally different securities. The type of monitoring needed will differ sig­ nificantly. What will be true, however, is that the increasing involvement of PE investors induces banks to partner with these investors (often as providers of loans). In a sense, banks start building relationships with PE firms rather than the firms that the PE in­ vestors take equity positions in. This is not without risks since it may affect the (p. 75) added value of banks in timely intervention vis-à-vis the (underlying) borrower and even the banks’ incentives to be involved in this. However, to the extent that PE firms are an integral part of the capital market, this development too makes the involvement of banks in the capital market deeper and more intricate. Such complexity is further exacerbated by the emergence of other intermediaries such as hedge funds, particularly because of the growing importance of hedge funds as direct lenders. See Brophy, Ouimet, and Sialm (2009), who point out that hedge funds have emerged as “lenders of last resort,” provid­ ing finance to firms that banks do not typically lend to. This is part of the growing impor­ tance of the shadow-banking sector as a source of financing.

3.5 Role of Credit Rating Agencies Credit ratings are a fascinating part of today’s financial markets. Their importance is evi­ dent from the behavior of market participants. However, academic researchers have gen­ erally been skeptical about their incremental value, largely because of the absence of a theory of rating agencies. In the literature on financial intermediary existence, bank debt offers monitoring advantages that would not be available in the financial market. The typ­ ical argument for the lack of monitoring in the capital market is that free-rider problems among investors prevent effective monitoring. Boot, Milbourn, and Schmeits (2006) have shown that credit rating agencies (CRAs) add a monitoring-type element to the financial market, and thereby play a role as a “focal point” to resolve coordination failures among multiple dispersed investors (creditors). The CRA’s ability to resolve such coordination failure arises from the effect of its actions—the assigned rating and the “credit watch” process—on firm behavior via the conditioning of investors’ investment decisions on the assigned rating. Da Rin and Hellmann (2002) showed that banks could also resolve a mul­ tiple-equilibria problem among borrowers by helping coordinate the investment decisions of these borrowers. The role that Boot, Milbourn, and Schmeits (2006) give to CRAs has some similarity to this. This role of CRAs in resolving coordination failures in the financial market qualifies the distinction between public debt and bank financing. The mechanism is, however, less “di­ rect” than in the case of bank financing: the credit rating (and particularly the threat of a downgrade) induces good firm behavior rather than preventing bad behavior through di­ Page 12 of 38

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Commercial Banking and Shadow Banking: The Accelerating Integration of Banks and Markets and its Implications for Regulation rect intervention. Apart from bank loans, the non-bank private debt market also offers a potentially more direct alternative than credit rating agencies in the public debt market. In fact, private debtors often impose more discipline than banks and hence serve even riskier borrowers (Carey, Post, and Sharpe, 1998). Another mechanism that links banks and CRAs is the certification role of bank loans. Dat­ ta, Iskandar-Datta, and Patel (1999) show that the monitoring associated with bank loans facilitates borrowers’ access to the public debt market. This certification role of banks therefore complements what CRAs do. As rating agencies become more sophisticated and reliable, the certification role of banks diminishes in importance, causing bank borrowers to migrate to the capital market. In this sense, CRAs intensify the competition (p. 76) be­ tween banks and markets. But CRAs also pull banks into the capital market. For example, banks originate loans that they securitize, and then seek ratings for the securitized pools from CRAs. The ratings, in turn, facilitate the ability of banks to sell (securitized) assetbacked securities in the capital market. One reason why credit ratings do not precisely reflect the credit risk of the rated debt in­ strument is that ratings are “coarse” relative to underlying default probabilities—there are only a little more than twenty ratings, but default probabilities lie in a continuum. This raises the question of why such coarseness exists. Goel and Thakor (2015) provide a theory in which they rationalize coarse credit ratings in a cheap-talk framework and show that coarseness addresses a truthful reporting (by the CRA) issue when the CRA has mul­ tiple objectives (issuers vs. investors) pulling against each other. Thus, coarse ratings emerge in equilibrium even though coarseness has negative real effects.15 This largely positive interpretation of CRAs is clouded somewhat by recent negative pub­ licity. In the 2001 crisis surrounding Enron, CRAs were accused of being strategically sluggish in downgrading.16 More recently, CRAs have been blamed (in part) for the subprime crisis in which they were allegedly too lenient in rating the senior tranches in secu­ ritization transactions. Allegations have been made about conflicts of interest for CRAs, arising from the fact that structured finance is a source of ever-increasing income for CRAs, which then corrupts their incentives for accurately rating the issuers involved in structured finance (Cantor, 2004). In this context, Coffee and Sale (2008) point out that it is naïve to think that reputation-building incentives alone would keep credit rating agen­ cies in check. Of particular concern are the so-called “rating triggers.” For example, some debt con­ tracts may dictate accelerated debt repayments when the rating falls. The consequences of such accelerated debt repayments might, however, be so severe as to cause rating agencies to become reluctant to lower the ratings of those borrowers in a timely manner. Complications also arise from the role played by the so-called “monoliners.” These are in­ surers who traditionally guaranteed municipal bonds but now also guarantee the lowestrisk (best) tranches in securitization transactions. These insurers are virtually indispens­ able in the sense that the viability of many forms of securitization is predicated on this type of “reinsurance.” However, the ability of the monoliners to issue credible guarantees Page 13 of 38

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Commercial Banking and Shadow Banking: The Accelerating Integration of Banks and Markets and its Implications for Regulation (and hence their role in securitization) depends on these institutions themselves having AAA ratings. This potentially generates an indirect chain-reaction mechanism for CRAs. In rating (and monitoring) the monoliners, CRAs affect the viability of the securitization market. Thus, the impact of CRAs is both direct (rating securitization tranches) and indi­ rect (rating the monoliners). The potential failure of such monoliners (p. 77) would have a significant effect on the value of various structured finance products and induce an addi­ tional chain reaction among players active in the structured finance market, including in­ vestors. This further underscores the increasing interlinkages in the financial markets. Other concerns are related to the oligopolistic nature of the industry, and the importance that ratings have due to regulation. The latter includes the exclusivity given to a few rat­ ing agencies via the “Nationally Recognized Statistical Rating Organization” (NRSRO) classification, weakened in the 2006 Credit Rating Agency Reform Act, but also the refer­ ences to external ratings in the Basel II capital regulation framework. Under the Dodd–Frank Act 2010, the legal liability for CRAs has been elevated. Whether this will result in credit ratings that more accurately reflect credit risks is an open ques­ tion.17

3.6 Regulation and the Second Raison D’être for Banks: Liquidity Creation In section 3.2, we discussed the role of banks as information processors and delegated monitors. That information processing and monitoring referred to credit risk primarily. But banks also perform another important function, which is the provision of liquidity. The typical way this is framed is that banks invest in illiquid assets (loans) but finance themselves largely with highly liquid demand deposits, and through this intermediation process create liquidity in the economy. Liquidity is then created because depositors who invest in illiquid projects through the bank have liquid claims (demand deposits) that they would not have had if they had invested directly in those projects. The actual operations of banks, however, would have them make loans while simultaneously creating a match­ ing deposit in the borrower’s bank account, thereby creating new money (see Bank of England, 2014). This alternative framing, would still lead banks to provide liquidity to the economy.18 In the process of creating liquidity, banks expose themselves to the risk of unanticipated deposit withdrawals and become fragile. Our discussion of this issue in this section will focus on “institution-driven fragility,” manifested in the classic run on an individual bank, as well as “market-driven fragility,” which refers to risks that come primarily via the fi­ nancial market and interbank linkages, and appear to be more systemic. We will discuss how the increasing integration of banks into financial markets allows banks to (p. 78) shift some of their traditional risks to the markets, and what this implies for financial system stability and regulation. Issues related to the economics of bank regulation are covered in Bhattacharya, Boot, and Thakor (1998, 2004).

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Commercial Banking and Shadow Banking: The Accelerating Integration of Banks and Markets and its Implications for Regulation

3.6.1 Fragile Banks as Liquidity Providers In the classical interpretation, a financial crisis is directly linked to the notion of bank runs. In a fractional reserve system with long-term illiquid loans financed by (liquid) de­ mandable deposits, runs may come about due to a coordination failure among depositors (Diamond and Dybvig, 1983). Even an adequately capitalized bank could be subject to a run if the deadweight liquidation costs of assets are substantial. Regulatory intervention via lender of last resort (LOLR) support, deposit insurance, and/or suspension of convert­ ibility could all help, and perhaps even eliminate the inefficiency. In fact, such interven­ tion can be justified because of its potential to expunge the negative social externalities arising from the possible contagion effects associated with an individual bank failure. While these implications arise theoretically in a rather simple and stylized setting, many have generalized this simple setting by allowing for asymmetric information and incom­ plete contracts; see Rochet (2004) for a review. The general conclusion is that fragility is real, and information-based runs are plausible. In particular, Gorton’s (1988) empirical evidence suggests that bank runs are not sunspot phenomena (as in Diamond and Dybvig, 1983), but are triggered by adverse information about economic fundamentals. More im­ portantly, the banking crises stemming from such runs have independent negative real ef­ fects (see DellʼAriccia, Detragiache, and Rajan, 2008). Also relevant in this context is the rich body of literature that has now developed on banks and liquidity (see, e.g., Acharya and Schaefer, 2006; Acharya, Gromb, and Yorulmazer, 2007; Brunnemeier and Pedersen, 2009). Given that bank runs are triggered by adverse information that depositors have about the financial health of banks, one might think that a simple solution would be to make banks safer by, for example, imposing higher capital requirements. Calomiris and Kahn (1991) first argued that the threat of bank runs may be a valuable disciplining device to keep bank managers honest, since a greater diversion of bank resources for personal consump­ tion can increase the likelihood of a bank run. Building on this argument, Diamond and Rajan (2001) have suggested that financial fragility created by high bank leverage may play an important role in inducing banks to create liquidity, and thus a reduction in fragility through higher bank capital may lead to lower liquidity creation. Acharya and Thakor (2016) show that this link between bank leverage and liquidity creation has a dark side in that it causes higher bank leverage to generate higher systemic risk via spillover effects, namely inefficient “contagious liquidations” of healthy banks due to the observed liquidations of highly-levered failing banks. Until recently, there has been no empirical work done on this issue, in part because of a paucity of empirical measures of liquidity creation. Berger and Bouwman (2009) develop measures of liquidity creation and provide empirical evidence on the relationship between bank capital (p. 79) and liquidity creation. They show that higher capital leads to higher liquidity creation in the case of large banks (which create over 80 percent of the liquidity in the US economy), and lower liquidity cre­ ation in the case of small banks. Since capital requirements also affect the asset portfo­ lios of banks through their lending decisions (see Thakor, 1996) and these requirements may be binding for some banks, this raises issues about the interaction of credit and liq­ uidity risks that need to be explored. Mehran and Thakor (2011) show both theoretically Page 15 of 38

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Commercial Banking and Shadow Banking: The Accelerating Integration of Banks and Markets and its Implications for Regulation and empirically that bank capital and value are positively related in the cross-section, pointing to the private benefits of higher capital for banks. Admati et al. (2011) similarly argue that the commonly asserted punitive costs of bank equity do not exist in reality, and stress the virtues of having higher capital. Complicating this issue further is that the liquidity provision function of banks is also af­ fected by the financial markets. Two observations are germane in this regard. First, ac­ cess to financial markets weakens the liquidity insurance feature of demand-deposit con­ tracts. To see this, note that the root cause of the fragility in the Diamond and Dybvig (1983) world is the underlying demand-deposit contract. The rationale for this contract— as modeled by Diamond and Dybvig (1983)—is the desire for liquidity insurance on the part of risk-averse depositors with uncertainty about future liquidity needs. However, as shown by von Thadden (1998), the very presence of financial markets allows depositors to withdraw early and invest in the financial market, which puts a limit on the degree of liq­ uidity insurance. In fact, when the market investment opportunity is completely re­ versible, deposit contracts cannot provide any liquidity insurance. This is related to the earlier work of Jacklin (1987), who shows that deposit contracts have beneficial liquidity insurance features, provided that restricted trading of deposit contracts can be enforced.19 In any case, these arguments suggest that the proliferation of financial mar­ kets weakens the liquidity-provision rationale for demand deposits, which may help ex­ plain the market-based proliferation of close substitutes for deposits. A second observation has to do with whether the development of financial markets leads to a diminished role for the Central Bank in providing liquidity via its LOLR function. In the Bagehot tradition, one could ask whether the LOLR has a role to play in providing liq­ uidity to liquidity-constrained-yet-solvent institutions when capital markets and interbank markets are well developed. Goodfriend and King (1988) argue that solvent institutions then cannot be illiquid since informed parties in the repo and interbank market would step in to provide the needed liquidity. In this spirit, former European Central Bank (ECB) board member Tommaso Padoa-Schioppa suggested that the classical bank run may only happen in textbooks since the “width and depth of today’s interbank market is such that other institutions would probably replace those which withdraw their funds” (as quoted in Rochet and Vives, 2004). While these remarks correctly suggest that the development and deepening of financial markets could reduce the need for an LOLR in providing liquidity support, we (p. 80) be­ lieve that it would be hasty to conclude that there is no role for an LOLR, particularly when information asymmetries are considered. For example, Rochet and Vives (2004) show that a coordination failure in the interbank market may occur, particularly when fundamentals are weak, and that this may lead to a need for liquidity support by the LOLR for a solvent institution.20 The 2007–9 financial crisis gives ample reason to believe that coordination failures in interbank markets are real and that the role of an LOLR is still important. This discussion suggests two, somewhat tentative, conclusions. First, the development of financial markets (including interbank markets) has improved the risksharing opportunities available to banks and has probably decreased the likelihood of a Page 16 of 38

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Commercial Banking and Shadow Banking: The Accelerating Integration of Banks and Markets and its Implications for Regulation run on an individual bank. Whether the total insolvency risk of individual institutions has declined depends on the actual risk-taking and capitalization. Second, because these im­ proved risk-sharing opportunities have arisen from a greater degree of integration be­ tween banks and markets, they may also have contributed to an increase in systemic risk. In particular, financial market linkages (and focus) may have induced herding behavior (Boot, 2014). Adrian and Shin (2010) point at the effect of favorable financial market con­ ditions on leverage (increasing) and funding (becoming more fragile and short term). These effects cause stress in the financial system at large when market conditions deteri­ orate. In other words, while the likelihood of an individual bank failing due to an idiosyn­ cratic shock may have declined, there may be a concomitant increase in the probability that liquidity and solvency problems may propagate quickly through the financial system as a whole, leading to higher systemic risk. This raises thorny regulatory issues, which we turn to next.

3.6.2 Regulatory Implications The preceding discussion has focused the spotlight on one fact: banks and markets are becoming increasingly integrated. This is happening in part because greater competition is inducing banks to follow their borrowers to the capital market and offer products that combine features of bank-based and market-based financing. It is also happening because banks themselves are using the financial market increasingly for their own risk manage­ ment purposes. And the availability of market participants as purchasers of new bank products encourages financial innovations by banks. But, as Thakor (2012) shows, this can also increase the likelihood of financial crises. There is thus a multitude of factors that have contributed to an astonishingly rapid melding process.21 An important implication of this integration is that it is becoming more and more difficult to isolate banking risks from financial market risks. A financial market crisis in­ evitably cascades through the banking system, and what happens in the banking system does not take long to reverberate through the financial market. So, if the main task of bank regulators is the safety and soundness of the banking system, they must now also worry about the financial market whose participants are outside the bank regulator’s do­ main. Explicit recognition that these sorts of effects have created the specter of “endoge­ nous systemic risk” has led to the creation of the Financial Stability Oversight Council (FSOC) in the US and the European Systemic Risk Board (ESRB) in the EU as parts of the post-subprime-crisis regulatory landscape. (p. 81)

Moreover, even though the explicit insurance guarantee applies only to bank deposits, the temptation for government regulators to bail out various uninsured participants—includ­ ing investment banks and financial market investors—in the event of a crisis in the capital market seems difficult to resist on ex post efficiency grounds, particularly because of the implications for bank safety and systemic stability.22 It will be interesting to examine the connotations of this for ex ante incentives and the magnitude of the implicit “soft” safety net provided by the government. What seems safe to conjecture is that a perception of a greater regulatory concern with ex post efficiency—and hence a greater desire to inter­ Page 17 of 38

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Commercial Banking and Shadow Banking: The Accelerating Integration of Banks and Markets and its Implications for Regulation vene—has elevated the importance of moral hazard. And this has happened in an environ­ ment in which regulatory issues are becoming increasingly international, both due to the cross-border proliferation of financial institutions and the increasing integration of banks with financial markets, which are typically international in scope.23 The decentralized, mainly national structure of regulatory and supervisory arrangements in a financial world that operates across borders may give rise to potential conflicts of in­ terest between the national authorities and “outsiders.” For example, national authorities might be prone to “too-big-to-fail” (TBTF) rescues, and this worsens (p. 82) the moral haz­ ard on the part of large institutions. Yet one could argue that the moral hazard engen­ dered by TBTF policies could be attenuated somewhat by attaching to TBTF rescues spe­ cific provisions that would involve replacing management, wiping out the claims of share­ holders and uninsured debtholders, etc. This is true in theory but does not appear to hap­ pen often in practice. One reason might be the possibility of capture of local regulators and supervisors due to the closeness of their relationships to the “national flagship” insti­ tutions (Boot and Thakor, 1993). There are also issues of “too many to fail” (see Acharya and Yorulmazer, 2007) or “too interconnected to fail” (Herring, 2008), which could also in­ duce regulatory leniency toward these institutions. Alternatively, national authorities may not sufficiently internalize the disruptive consequences that a domestic bank failure could have in other countries. Efficiency might be hampered in other ways as well. For exam­ ple, the national scope of supervision may help encourage the emergence of “national champions” among regulators, who may then seek to protect institutions in their coun­ tries. More fundamentally, the decentralized structure could give rise to an uneven play­ ing field, regulatory arbitrage possibilities, and coordination failures in the resolution of financial distress in cross-border operating institutions. Casual observation would seem to suggest that integration and further coordination (if not centralization of authority) of both regulation and supervision might yield substantial efficiency gains not only for the supervisory authorities but also, and perhaps more im­ portantly, for the supervised financial institutions themselves.24

3.6.3 Reform Suggestions The struggle for better cross-border coordination in regulation and supervision should go hand in hand with more fundamental reforms in the regulatory structure. The first is that the scope of regulation and supervision needs to be clearly identified and, if possible, con­ tained. Effective supervision and regulation—given the mushrooming cross-sector and cross-border footprint of financial institutions—requires a better delineation of safety and systemic risk concerns. The cross-sector integration of financial institutions and the in­ creasingly more seamless integration of financial markets and institutions have consider­ ably broadened the scope of regulation and the potential sources of systemic risk. Another relevant question is whether market discipline could help in containing systemic risks, or whether market responses merely amplify such risks (see Flannery, 1998). Here the picture gets a bit murky. Basel II tries to encourage market discipline via its third pil­ Page 18 of 38

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Commercial Banking and Shadow Banking: The Accelerating Integration of Banks and Markets and its Implications for Regulation lar that is aimed at greater transparency. The idea is that market discipline could help su­ pervisors in safeguarding the well-being of the financial sector. This has (p. 83) merit on the face of it and has support in the literature as well. The literature has viewed market discipline working in three ways: (1) by providing regulators with market-based signals of bank risk-taking through the yields on subordinated debt issued by banks; (2) by provid­ ing banks with disincentives to take excessive risk through the upward adjustments in sub-debt yields in response to greater bank risk; and (3) by choking off the supply of subdebt when sufficiently high risk-taking by the bank is detected by the market, thereby providing additional encouragement to the bank to temper its risk-taking. Nonetheless, it has been shown both theoretically and empirically that market discipline can be effective only if the claims of uninsured investors (sub-debt and equity) are not protected via de facto ex post insurance in a government-sponsored rescue of a failing institution. For a theoretical treatment of these issues, see Decamps, Rochet, and Roger (2004), and for empirical analyses that support the risk-controlling role of market discipline, see Barth, Caprio, and Levine (2004), and Goyal (2005). However, despite all of the research support for the role of market discipline, our knowl­ edge of whether market discipline facilitates or hinders the regulatory task of maintain­ ing banking stability during a financial crisis is quite limited. In particular, when the fi­ nancial sector is severely stressed, as during the 2007–9 credit crisis, market discipline may induce herding behavior, as everybody “heads simultaneously for the exit,” and this actually could be a source of instability. This suggests that regulation and supervision in “normal times” should perhaps be distinguished from that during crisis episodes. Market discipline, although valuable in normal times, may be very distortive in times of systemic stress. This may be one reason why, during crises, regulators have been inclined to pro­ vide more or less blanket guarantees to distressed institutions, ostensibly to counter the potentially adverse effects of market discipline. To complicate matters even further, it would be dangerous to conclude that market disci­ pline, say via the use of market value accounting and other mechanisms, is something that can be relied upon in good times and eschewed in bad times. The key is to figure out the appropriate regulatory actions in good times—when banks have the flexibility to com­ ply without compromising their viability—that would enable banks to be more capable of withstanding the stresses of market discipline during bad times. In such good times, risk management by banks tends to be corrupted at the same time that market discipline is the weakest and risk is “underpriced” (see, e.g., Thakor, 2015, 2016; Boot, 2014). Market discipline may thus not work in good times, or even be counterproductive due to the “un­ derpriced” risk inviting excessive leverage and risk-taking. It will also be important to re­ member that banks cannot be completely insured from the effects of market stress during bad times (e.g., through the use of blanket guarantees for all claimants), or else the ex ante effectiveness of market discipline is lost entirely (e.g., Decamps, Rochet, and Roger, 2004).

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Commercial Banking and Shadow Banking: The Accelerating Integration of Banks and Markets and its Implications for Regulation This brings up the issue of introducing firewalls in the financial sector. For example, does a subsidiary structure reduce systemic risk concerns? We do not think that an answer is readily available. More generally, what type of constraints, if any, should be put on the corporate structure of financial institutions? Until the 2007–9 financial crisis, the general belief was that deregulation in the financial sector would continue further, (p. 84) possibly leading to even bigger and broader financial institutions. But now it is far from clear what the future will bring. Some have suggested reintroducing the Glass–Steagall Act to insu­ late local banking from the risks and fads that periodically afflict financial markets. Pro­ posals that echo the Glass–Steagall Act include the Dodd–Frank Act in the US, the Vickers Report in the UK (Vickers, 2011), and the Liikanen Report (Liikanen, 2012) in the EU. To what extent these are effective, and not overly costly, is open to debate.25 In any case, changes in the industrial structure of the financial sector might be of paramount impor­ tance for the design and effectiveness of regulation and supervision.26 A second issue has to do with the evolution of capital regulation. The introduction of Basel II rules meant that banks could fine-tune their required capital ratios based on their (certified) internal models. There are questions about whether these models induce pro­ cyclicality, and whether such model-dependency induces systemic risk by itself (e.g., insti­ tutions using the same models, and thus potentially being subject to the same shortcom­ ings). There have also been concerns about the potential adverse consequences of the discretion that Basel II provides.27 Perhaps similar concerns led the FDIC to impose a minimum leverage ratio on banks in the Basel II environment; an element that the postcrisis Basel III amendments have introduced in the Basel framework as well. The FDIC has argued that requiring a minimum level of capital—regardless of risk—is essential for timely regulatory intervention in the event of problems. Such timely intervention seems particularly important in cross-border situations, given the complexities created by bank failures when multiple countries are involved. Timely intervention could help contain con­ flicts between local authorities in such cases (see Eisenbeis and Kaufman, 2005). This is one reason why new rules are proposed—commonly referred to as Basel III—that stipu­ late higher capital requirements, and indeed also a leverage ratio, although one could jus­ tifiably argue, as in Admati et al. (2011), that the levels of even these higher require­ ments may be well short of adequate.28 A third issue is deposit insurance. The 2007–9 financial crisis has made it clear that, when a real crisis hits, national authorities effectively feel compelled to fully guaran­ tee the deposit bases of their financial institutions to eliminate the possibility of massive runs. This heavy dependence on insured deposits is an issue that needs a re-examination. Extant research (see Bhattacharya, Boot, and Thakor, 1998) has clearly shown the moral hazards that insured deposits entail. Moreover, Barth, Caprio, and Levine (2004) have shown that high levels of (de facto or de jure) deposit insurance impede the effectiveness of market discipline and increase the likelihood of a banking crisis. A question is whether strict regulatory limits should be put on the risks that institutions can expose these de­ posits to. Earlier research had at some point advocated narrow banking, which fully insu­ (p. 85)

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Commercial Banking and Shadow Banking: The Accelerating Integration of Banks and Markets and its Implications for Regulation lates insured deposits. But are there alternatives? And, more generally, can insured de­ posits be made less important as a funding vehicle for financial institutions? A fourth issue is whether regulation and supervision sufficiently address macro pruden­ tial issues, in particular systemic concerns. Despite many references to systemic risk, it appears that the majority of regulatory initiatives are focused on the well-being of individ­ ual financial institutions. That is, a micro prudential focus dominates (see Brunnemeier et al., 2009). This should be addressed to better reconcile regulation and supervision with the systemic concerns that are paramount. The fifth issue is that very little is known about the efficiency and effectiveness of various regulatory and supervisory structures. As Barth et al. (2003) put it, “there is very little empirical evidence on how, or indeed whether, the structure, scope or independence of bank supervision affects the banking industry.” Their own research suggests that the ef­ fect is at best marginal, but measurement problems are vexing. They suggest that nar­ rowing the focus on the effect that regulation has on systemic risk may help. But here, too, little is known about the regulatory structures that are most efficient in dealing with systemic risk. We need considerable additional research to sharpen our identification of the costs and benefits of different regulatory and supervisory arrangements. Given the strikingly different national supervisory arrangements that exist today, our lack of knowl­ edge on this issue is a significant barrier to progress toward a harmonized “superior” model.29 Finally, more research is needed on the role that bank culture can play in attenuating problems of excessive risk and financial fragility. Song and Thakor (forthcoming) have re­ cently provided a theory of bank culture in which culture acts as a mediating variable in bank risk-taking and may attenuate the propensity of banks to herd on excessive and cor­ related risk-taking. This theory is a start, and it complements discussions within the Fed­ eral Reserve System in the US, and in the ECB with respect to what can be done to change corporate culture in banking (Dudley, 2014). The evidence in Cohn, Fehr, and Marechal (2014) suggests that the culture in banking may encourage dishonest behavior; see also Cerqueti, Fiordelisi, and Rau (2016).30

3.7 Conclusions We have reviewed some of the literature on why banks exist, the risks they create, and how interbank competition as well as that from markets affects the economic roles served by banks as well as the attendant risks. One important development is that banks have become increasingly integrated with markets. This integration generates two effects that work in opposite directions. On the one hand, individual banks become better equipped to manage their own risks because it becomes easier and less costly to hedge these risks us­ ing the market. This could reduce the risk of an individual bank failing due to an idiosyn­ cratic shock. On the other hand, there is an increase in the probability that a shock to a small subset of banks could generate systemic effects that ripple through the financial Page 21 of 38

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Commercial Banking and Shadow Banking: The Accelerating Integration of Banks and Markets and its Implications for Regulation market, so that this banks–markets integration may be causing an elevation of systemic risk. It is easy to see that this substantially complicates the task of prudential regulation of banks and raises the specter of a widening of the “implicit” governmental safety net as ex post efficiency concerns tempt the government to bail out even uninsured players. This is no longer a mere theoretical conjecture, as demonstrated by the bailouts of investment banks and insurance companies in 2008–9. We believe that these are important issues that deserve greater theoretical and empirical attention. In particular, we need to have a better understanding of what the regulatory intervention should be in a crisis. Govern­ mental initiatives such as those witnessed in the US during the 2007–9 crisis—massive governmental injections of liquidity and capital into banks and other financial institutions without an adequate corporate control role for the government—are very costly and pos­ sibly ineffective due to daunting moral hazard and asymmetric information problems. Some key lessons might be learnt from previous financial crises—for example, the Swedish financial crisis of the 1990s (see Ingves and Lind, 1994; Aghion, Bolton, and Fries, 1999). To conclude, we believe the most important, yet only partially answered, research ques­ tions raised by our discussion are the following: • What are the implications of the ever-increasing integration of banks and markets for systemic risk and fragility? • What will FinTech developments, including P2P lending, portend for banks? (p. 87)

• What issues should we consider in the optimal design of regulation to respond

to the (until recently, at least) growing cross-border footprints of major financial insti­ tutions and the increasing integration of banks and financial markets? • What changes, if any, should be imposed on the structure of the financial services in­ dustry in general, and the banking sector in particular, to contain the “mushrooming” nature of systemic risk concerns (i.e., to contain the scope of regulation and supervi­ sion)? • What role, if any, can market discipline play in helping safeguard the stability of the financial sector? • How do banks and private equity firms (and other non-banking financial institutions) interact and what implications does this interaction have for the regulation of banks and financial markets? • What role do credit rating agencies play in financial markets, how does this affect banks, and what implications does this have for systemic risks that bank regulators care about? These questions represent a rich agenda for future research.

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Commercial Banking and Shadow Banking: The Accelerating Integration of Banks and Markets and its Implications for Regulation

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Commercial Banking and Shadow Banking: The Accelerating Integration of Banks and Markets and its Implications for Regulation Diamond, D. (1984). “Financial Intermediation and Delegated Monitoring,” Review of Economic Studies, 51, 393–414. Diamond, D. (1991). “Monitoring and Reputation: The Choice Between Bank Loans and Directly Placed Debt,” Journal of Political Economy, 99, 689–721. Diamond, D. (1993). “Seniority and Maturity of Debt Contracts,” Journal of Financial Eco­ nomics, 33, 341–68. Diamond, D. and Dybvig, P. H. (1983). “Bank Runs, Deposit Insurance and Liquidi­ ty,” Journal of Political Economy, 91, 401–19. (p. 91)

Diamond, D. and Rajan, R. G. (2001). “Liquidity Risk, Liquidity Creation and Financial Fragility: A Theory of Banking,” Journal of Political Economy, 109, 287–327. Dinç, I. S. (2000). “Bank Reputation, Bank Commitment, and the Effects of Competition in Credit Markets,” Review of Financial Studies, 13, 781–812. Donaldson, J., Piacentino, G., and Thakor, A. (2018). “Warehouse Banking,” Journal of Fi­ nancial Economics, 129(2, August), 250–67. Drucker, S. (2005). “Information Asymmetries and the Effects of Banking Mergers in Firm–Bank Relationships,” Proceedings, Federal Reserve Bank of Chicago, 140–7. Drucker, S. and Puri, M. (2005). “On the Benefits of Concurrent Lending and Underwrit­ ing,” Journal of Finance, 60, 2763–99. Dudley, W. (2014). “Enhancing Financial Stability by Improving Culture in the Financial Services Industry,” remarks at the Workshop on Reforming Culture and Behavior in the Financial Services Industry, Federal Reserve Bank of New York, October 20. Eisenbeis, R. A. and Kaufman, G. G. (2005). “Bank Crises Resolution and Foreign-Owned Banks,” Federal Reserve Bank of Atlanta Economic Review, 90, 1–18. Emter, L., Schmitz, M., and Tirpak, M. (2018). “Cross-Border Banking in the EU since the Crisis: What is Driving the Great Retrenchment?” European Central Bank, Working Paper. Fang, L., Ivashina, V., and Lerner, J. (2010). “An Unfair Advantage? Combining Banking with Private Equity Investing,” Working Paper. Farhi, E. and Tirole, J. (2017). “Shadow Banking and the Four Pillars of Traditional Finan­ cial Intermediation,” Working Paper. Flannery, M. (1998). “Using Market Information in Prudential Bank Supervision: A Re­ view of the US Empirical Evidence,” Journal of Money, Credit and Banking, 30, 273–305. Financial Stability Board (FSB) (2018). “Global Shadow Banking Monitoring Report 2017,” Financial Stability Board, March 5.

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Commercial Banking and Shadow Banking: The Accelerating Integration of Banks and Markets and its Implications for Regulation Gande, A. and Saunders, A. (2005). “Are Banks Still Special when there is a Secondary Market for Loans?” New York University, Working Paper. Goel, A. and A. V. Thakor (2015). “Information Reliability and Welfare: A Theory of Coarse Credit Ratings,” Journal of Financial Economics, 115(3), 541–57. Goodfriend, M. and King, R. (1988). “Financial Deregulation, Monetary Policy and Central Banking,” in W. Haraf and R. M. Kushmeider (eds.), Restructuring Banking and Financial Services in America, American Enterprise Institute Studies 481 (Lanham, MD: University Press of America). Gorton, G. (1988). “Banking Panics and Business Cycles,” Oxford Economic Papers, 40, 751–81. Gorton, G. and Kahn, J. A. (1993). “The Design of Bank Loan Contracts, Collateral, and Renegotiation,” National Bureau of Economic Research Working Paper No. W4273. Gorton, G. and Metrick, A. (2012). “Securitized Banking and the Run on Repo,” Journal of Financial Economics, 104, 425–51. Gorton, G. and Pennacchi, G. (1995). “Banks and Loan Sales: Marketing Nonmarketable Assets,” Journal of Monetary Economics, 35, 389–411. Goyal, V. (2005). “Market Discipline of Bank Risk: Evidence from Subordinated Debt Con­ tracts,” Journal of Financial Intermediation, 14, 318–50. Greenbaum, S. I., Thakor, A. V., and Boot, A. W. A. (2016). Contemporary Financial Inter­ mediation, 3rd edn (Cambridge, MA: Elsevier Academic Press). Group of Thirty (2009). “Financial Reform: A Framework for Financial Stability,” Report by the Working Group on Financial Reform, Washington, DC. (p. 92)

Hauswald, R. and Marquez, R. (2006). “Competition and Strategic Information Ac­

quisition in Credit Markets,” Review of Financial Studies, 19, 967–1000. Hellmann, T., Lindsey, L., and Puri, M. (2008). “Building Relationships Early: Banks in Venture Capital,” Review of Financial Studies, 21, 513–41. Hellwig, M. (1991). “Banking, Financial Intermediation and Corporate Finance,” in A. Giovanni and C. P. Mayer (eds.), European Financial Integration (New York: Cambridge University Press), 35–63. Herring, R. J. (2008). “The US Subprime Crisis: Lessons for Regulators,” Proceedings of the 44th Annual Conference on Bank Structure and Competition, Federal Reserve Bank of Chicago, 48–55. Hoshi, T., Kashyap, A., and Scharfstein, D. (1993). “The Choice between Public and Pri­ vate Debt: An Analysis of Post-Deregulation Corporate Financing in Japan,” National Bu­ reau of Economic Research Working Paper No. 4421. Page 29 of 38

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Commercial Banking and Shadow Banking: The Accelerating Integration of Banks and Markets and its Implications for Regulation Houston, J. and James, C. (1996). “Bank Information Monopolies and the Mix of Private and Public Debt Claims,” Journal of Finance, 51, 1863–89. Ingves, S. and Lind, G. (1994). “The Management of the Bank Crisis: In Retrospect,” Sverigs Riksbank Quarterly Review, 1, 5–18. Jacklin, C. J. (1987). “Demand Deposits, Trading Restrictions and Risk Sharing,” in E. Prescott and N. Wallace (eds.), Financial Intermediation and Intertemporal Trade (Minneapolis, MN: University of Minnesota Press), 26–47. James, C. (1987). “Some Evidence on the Uniqueness of Bank Loans,” Journal of Financial Economics, 19, 217–35. Kane, E. J. (1988). “How Market Forces Influence the Structure of Financial Regulation,” in W. S. Haraf and R. M. Kushmeider (eds.), Restructuring Banking and Financial Services in America (Washington, DC: American Enterprise Institute Press), 343–82. Kashyap, A., Rajan, R., and Stein, J. (2002). “Banks as Liquidity Providers: An Explanation for the Co-Existence of Lending and Deposit-Taking,” Journal of Finance, 57, 33–73. Keys, B., Mukherjee, T., Seru, A., and Vig, V. (2010). “Did Securitization Lead to Lax Screening: Evidence from Subprime Loans,” Quarterly Journal of Economics, 125, 307– 62. Kroszner, R. S. and Rajan, R. G. (1994). “Is the Glass–Steagall Act Justified? A Study of the US Experience with Universal Banking before 1933,” American Economic Review, 84, 810–32. Laeven, L. and Levine, R. (2007). “Is there a Diversification Discount in Financial Con­ glomerates?” Journal of Financial Economics, 85, 331–67. Liikanen, E. (2012). “High-level Expert Group on Reforming the Structure of the EU Banking Sector,” Final Report, Brussels, October 2. Lizzeri, A. (1999). “Information Revelation and Certification Intermediaries,” Rand Jour­ nal of Economics, 30, 214–31. Lopez-Espinosa, G., Mayordomo, S., and Moreno, A. S. A. (2017). “When does Relation­ ship Lending Start to Pay?” Journal of Financial Intermediation, 31, 16–29. Lummer, S. L. and McConnell, J. J. (1989). “Further Evidence on the Bank Lending Process and the Reaction of the Capital Market to Bank Loan Agreements,” Journal of Fi­ nancial Economics, 25, 99–122. Mayer, C. (1988). “New Issues in Corporate Finance,” European Economic Review, 32, 1167–83. Mehran, H. and Thakor, A. V. (2011). “Bank Capital and Value in the Cross-Section,” Re­ view of Financial Studies, 24(4), 1019–67. Page 30 of 38

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Commercial Banking and Shadow Banking: The Accelerating Integration of Banks and Markets and its Implications for Regulation Merton, R. and Thakor, R. (forthcoming). “Customers and Investors: A Framework for Un­ derstanding the Evolution of Financial Institutions,” Journal of Financial Intermediation. Mian, A. R. and Sufi, A. (2009). “The Consequences of Mortgage Credit Expansion: Evidence from the 2007 Mortgage Default Crisis,” Quarterly Journal of Economics, 124, 1449–96. (p. 93)

Millon, M. and Thakor, A. V. (1985). “Moral Hazard and Information Sharing: A Model of Financial Information Gathering Agencies,” Journal of Finance, 40, 1403–22. Ongena, S. and Smith, D. C. (2000). “What Determines the Number of Bank Relation­ ships? Cross-Country Evidence,” Journal of Financial Intermediation, 9, 26–56. Partnoy, F. (1999). “The Siskel and Ebert of Financial Markets: Two Thumbs Down for the Credit Rating Agencies,” Washington University Law Quarterly, 77, 619–712. Petersen, M. and Rajan, R. G. (1994). “The Benefits of Lending Relationships: Evidence from Small Business Data,” Journal of Finance, 49, 1367–400. Petersen, M. and Rajan, R. (1995). “The Effect of Credit Market Competition on Lending Relationships,” Quarterly Journal of Economics, 110, 407–43. Posen, A. S. and Hinterschweiger, M. (2009). “How Useful were Recent Financial Innova­ tions? There is Reason to be Skeptical,” Real Time Economic Issues Watch, May 7. Pozsar, Z., Adrian, T., Ashcraft, A., and Boesky, H. (2010). “Shadow Banking,” Federal Re­ serve Bank of New York, FRNBNY Staff Report No. 458. Puri, M. (1996). “Commercial Banks in Investment Banking: Conflict of Interest or Certifi­ cation Role?” Journal of Financial Economics, 40, 373–401. Puri, M., Rocholl, J., and Steffen, S. (2017). “What do a Million Observations Have to Say About Loan Default? Opening the Black Box of Relationships,” Journal of Financial Inter­ mediation, 31, 1–15. Rajan, R. G. (1992). “Insiders and Outsiders: The Choice between Informed and Arm’s Length Debt,” Journal of Finance, 47, 1367–400. Ramakrishnan, R. and Thakor, A. V. (1984). “Information Reliability and a Theory of Fi­ nancial Intermediation,” Review of Economic Studies, 51, 415–32. Ramírez, C. (2002). “Did Banks’ Security Affiliates Add Value? Evidence from the Com­ mercial Banking Industry during the 1920s,” Journal of Money, Credit and Banking, 34, 391–411. Rochet, J.-C. (2004). “Bank Runs and Financial Crises: A Discussion,” in S. Bhattacharya, A. W. A. Boot, and A. V. Thakor (eds.), Credit Intermediation and the Macro Economy (Oxford: Oxford University Press), 324–38. Page 31 of 38

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Commercial Banking and Shadow Banking: The Accelerating Integration of Banks and Markets and its Implications for Regulation Rochet, J.-C. and 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– 47. Sangiorgi, F. and Spatt, C. (2017a). “Opacity, Credit Rating Shopping, and Bias,” Manage­ ment Science, 63(12), 4016–36. Sangiorgi, F. and Spatt, C. (2017b). “The Economics of Credit Rating Agencies,” Founda­ tions and Trends in Finance, 12(1), 1–116. Sapienza, P. (2002). “The Effects of Banking Mergers on Loan Contracts,” Journal of Fi­ nance, 57, 329–67. Schenone, C. (2004). “The Effect of Banking Relationships on the Firm’s IPO Underpric­ ing,” Journal of Finance, 59, 2903–3058. Schmid, M. M. and Walter, I. (2009). “Do Financial Conglomerates Create or Destroy Eco­ nomic Value?” Journal of Financial Intermediation, 18, 193–216. Sharpe, S. A. (1990). “Asymmetric Information, Bank Lending, and Implicit Contracts: A Stylized Model of Customer Relationships,” Journal of Finance, 45, 1069–87. Shleifer, A. and Vishny, R. W. (2010). “Unstable Banking,” Journal of Financial Economics, 97, 306–18. Shockley, R. and Thakor, A. V. (1997). “Bank Loan Commitment Contracts: Data, Theory and Tests,” Journal of Money, Credit and Banking, 29, 517–34. (p. 94)

Simons, H. C. (1936). “Rules versus Authorities in Monetary Policy,” Journal of Political Economy, 44, 1–30. Song, F. and Thakor, A. V. (2007). “Relationship Banking, Fragility and the Asset-Liability Matching Problem,” Review of Financial Studies, 20, 2129–77. Song, F. and Thakor, A. V. (2010). “Financial System Architecture and the Co-evolution of Banks and Markets,” The Economic Journal, 120, 1021–255. Song, F. and Thakor, A. V. (forthcoming). “Bank Culture,” Journal of Financial Intermedia­ tion. Stein, J. C. (2002). “Information Production and Capital Allocation: Decentralized versus Hierarchical Firms,” Journal of Finance, 57, 1891–921. Strahan, P. E. (2007). “Bank Structure and Lending: What We Do and Do Not Know,” Boston College Working Paper. Thakor, A. V. (1996). “Capital Requirements, Monetary Policy and Aggregate Bank Lend­ ing: Theory and Empirical Evidence,” Journal of Finance, 51, 279–324.

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Commercial Banking and Shadow Banking: The Accelerating Integration of Banks and Markets and its Implications for Regulation Thakor, A. V. (2012). “Incentives to Innovate and Financial Crisis,” Journal of Financial Economics, 103(1), 130–48. Thakor, A. V. (2014). “Bank Capital and Financial Stability: An Economic Tradeoff or a Faustian Bargain?” Annual Review of Financial Economic, 6, 185–223. Thakor, A. V. (2015). “Lending Booms, Smart Bankers and Financial Crises,” American Economic Review, 105(5, May), 305–9. Thakor, A. V. (2016). “The Highs and the Lows: A Theory of Credit Risk Assessment and Pricing through the Business Cycle,” Journal of Financial Intermediation, 25(1), 1–29. US Senate Hearings (2002). “Rating the Raters: Enron and the Credit Rating Agencies,” Hearings before the Senate Committee on Governmental Affairs, Washington, DC. US Senate Staff Report (2002). “Financial Oversight of Enron: The SEC and Private-Sec­ tor Watchdogs,” Report of the Staff to the Senate Committee on Governmental Affairs, Washington, DC. Vickers, J. (2011). “Independent Commission on Banking,” Final Report, London, Septem­ ber 12. von Thadden, E.-L. (1998). “Intermediated versus Direct Investment: Optimal Liquidity Provision and Dynamic Incentive Compatibility,” Journal of Financial Intermediation, 7, 177–97.

Notes: (1) In its Global Shadow Banking Monitoring Report 2017, the Financial Stability Board covering twenty-eight jurisdictions with over 80 percent of world GDP, reports $45 trillion assets in shadow banks (FSB, 2018). See their “narrow” definition that confines shadow banking to activities posing financial stability risk involving a dependence on short-term funding risks and/or having bank-run-like features; it excludes assets in institutions that are not susceptible to runs like pension funds, (unlevered) closed-end funds, and insur­ ance companies. (2) In the definition of Adrian and Ashcraft (2016), shadow banking consists of financial institutions that are involved in credit, maturity, and liquidity transformation (which could create financial stability risks), but without the access to public backstops that banks have. Gorton and Metrick (2012) define the shadow-banking system as one consisting of the following key components: (i) money-market mutual funds or other institutional (mar­ ket-based) lenders who replace depositors as a primary funding source for shadow banks; (ii) securitization of bank-originated loans, which permits the creation of asset-backed se­ curities that then serve as collateral for the bank’s borrowing from mutual funds and oth­ er institutional lenders; and (iii) repurchase agreements (or Repos), which represent the financial contract used by banks to raise funding from investors.

Page 33 of 38

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Commercial Banking and Shadow Banking: The Accelerating Integration of Banks and Markets and its Implications for Regulation (3) Much of the discussion that follows focuses on bank loans vs. bond financing in the capital market, rather than equity financing in the market. In reality, we would expect the market to segment itself into some firms going for bank loans, some going for bond mar­ ket financing, and some going for equity market financing. Boot and Thakor (1997) devel­ op a theory that predicts the choice between bank loans and bond market financing. Brown, Martinson, and Petersen (2017) provide evidence that better-developed stock markets support the faster growth of high-tech industries, whereas better-developed bank-oriented credit markets foster growth in industries that rely on external financing for physical capital. (4) Empirical evidence that depository information about potential borrowers is relevant to the bank is provided by Puri, Rocholl, and Steffen (2017). That paper uses data on a million German loans to show that when a bank extends loans to those who have had a depository relationship with the bank (and continue to have it) exhibit lower default prob­ abilities than those without depository relationships with the bank, consistent with one of the predictions in Donaldson, Piacentino, and Thakor (2018). (5) Ramakrishnan and Thakor (1984) and Millon and Thakor (1985) focus on pre-contract information asymmetries to rationalize the value that financial intermediaries add rela­ tive to markets. Diamond (1984) focuses on post-contract information asymmetries to ra­ tionalize intermediation. Coval and Thakor (2005) show that financial intermediaries can provide an institutional resolution of the problem of cognitive biases at the individual in­ vestor level, acting as a “belief’s bridge” between pessimistic investors and optimistic en­ trepreneurs. James (1987), Lummer and McConnell (1989), and Gande and Saunders (2005) provide empirical evidence on the informational value of bank financing. See also the “stories” provided by Berlin (1996) supporting the special role of banks. (6) One strong implication of the Boot and Thakor (1994) theory is that the gains from re­ lationship lending will take some time to be manifested. Recent empirical evidence in support of this prediction is provided by Lopez-Espinosa, Mayordomo, and Moreno (2017) who document that the gains from relationship lending accrue only when the relationship is of a longer duration than two years. (7) Mayer (1988) and Hellwig (1991) discuss the commitment nature of bank funding. Bolton et al. (2016) discuss the implicit commitment in bank funding to local markets in times of crisis. Boot, Thakor, and Udell (1991) address the credibility of commitments. (8) Berlin and Mester (1999) provide a related, albeit different argument. Their analysis suggests that competition forces banks to pay market rates on deposits, which may im­ pede their ability to engage in the potentially value-enhancing smoothing of lending rates. (9) In related work, Hauswald and Marquez (2006) focus on a bank’s incentives to acquire borrower-specific information in order to gain market share, and Dinç (2000) examines a bank’s reputational incentives to honor commitments to finance higher-quality firms. Song and Thakor (2007) theoretically analyze the effect of competition on the mix be­ tween relationship and transaction lending, and focus on fragility issues raised by the Page 34 of 38

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Commercial Banking and Shadow Banking: The Accelerating Integration of Banks and Markets and its Implications for Regulation bank’s desire to match core deposit funding with relationship lending and purchased money funding with transaction lending. (10) See chapter 18 in Greenbaum, Thakor, and Boot (2016). (11) The complementarity between bank lending and capital market funding is further highlighted in Diamond (1991) and Hoshi, Kashyap, and Scharfstein (1993). Diamond (1991) shows that a borrower may want to borrow first from banks in order to establish sufficient credibility before accessing the capital markets. Hoshi, Kashyap, and Scharf­ stein (1993) show that bank lending exposes borrowers to monitoring, which may serve as a certification device that facilitates simultaneous capital market funding. In related theoretical work, Chemmanur and Fulghieri (1994) show that the quality of the bank is of critical importance for its certification role. This suggests a positive correlation between the value of relationship banking and the quality of the lender. See Petersen and Rajan (1994) and Houston and James (1996) for empirical evidence. (12) Most noteworthy are the bankruptcies among German Lander banks, which were in­ volved in providing liquidity guarantees. (13) Securitization is facilitated in part by credit enhancement, including partial guaran­ tees by the arranger of a securitization transaction (and/or he holds onto the most risky layer of the transaction). In the recent credit crisis, this disciplining mechanism broke down; residual risk with the arranger was minimal or framed as liquidity guarantees to off-balance-sheet vehicles without appropriately realizing the inherent risks. The mar­ ketability of securitized claims has also been facilitated by accreditation by credit rating agencies. However, the role of rating agencies has been called into question during the subprime lending crisis, see section 3.5. (14) Innovations integrating banks and markets went far beyond securitization. For exam­ ple, OTC derivatives, especially credit default swaps, showed enormous growth in the pe­ riod preceding the 2007–9 crisis, outpacing real investment by a factor of twelve (Posen and Hinterschweiger, 2009). For further insights, see also Shleifer and Vishny (2010). (15) See also Lizzeri (1999), in whose model, some pooling of credit types is induced by the profit maximization objective of the CRA. See Sangiorgi and Spatt (2017b) for an overview of the literature on credit ratings. (16) As an illustration, consider the following discussions in the US Senate: “On March 20, 2002, the Senate Committee held a hearing entitled ‘Rating the Raters: Enron and the Credit Rating Agencies’ … The hearing sought to elicit information on why the credit rat­ ing agencies continued to rate Enron a good credit risk until four days before the firm de­ clared bankruptcy…” (US Senate Hearings, 2002). Similarly, US Senate Staff Report (2002): “in the case of Enron, credit rating agencies displayed a lack of diligence in their coverage and assessment of Enron.” See also Cantor (2004) and Partnoy (1999).

Page 35 of 38

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Commercial Banking and Shadow Banking: The Accelerating Integration of Banks and Markets and its Implications for Regulation (17) The Dodd–Frank Act also repealed the exemption given to CRAs in Regulation FD that allowed firms to have undisclosed material discussions with rating agencies. The institu­ tional feature of rating shopping (i.e., firms may choose to hide ratings) is another ele­ ment in the effectiveness of CRAs. See Sangiorgi and Spatt (2017a, 2017b). (18) In this spirit, Donaldson, Piacentino, and Thakor (2018) have banks create private money by making loans that go beyond their stock of physical deposits, thereby creating “funding liquidity” and allowing the economy to invest more in real projects than its ini­ tial endowment. (19) Actually, Jacklin (1987) shows that with the “extreme” Diamond-Dybvig preferences, a dividend-paying equity contract can achieve the same allocations without the possibility of bank runs. However, for other preferences, a demand-deposit contract does better, pro­ vided that trading opportunities are limited. (20) Recent evidence provided by Berger et al. (2017) shows that when the Federal Re­ serve increased banks’ access to the discount window through its Term Auction Facility, lending by (treated) banks went up. Another line of research studies the impact of liquidi­ ty on asset pricing (e.g., Acharya and Pedersen, 2005) and the possible role of asset price bubbles as a source of fragility and contagion (see De Bandt and Hartmann, 2002; and Allen, 2005, for surveys on contagion). (21) Interestingly, the fact that this integration can increase the risk to which the bank’s depositors are exposed can induce banks to slow down the integration to enhance the val­ ue of the bank’s services to its depository customers, as shown by Merton and Thakor (forthcoming). The key is that many bank services benefit from being remote from the credit risk originating from the bank itself. This point also relates to the value of creating risk-free claims in the economy (see also Dang, Gorton, and Holmström, 2015). (22) The guarantee provided in 2008 to a collapsing Bear Stearns by the government to fa­ cilitate its sale to JPMorgan Chase is an example, as are the general measures to let in­ vestment banks qualify for a commercial banking license (and in doing so allow them ac­ cess to deposits and let them qualify for deposit insurance). Bailouts were common in the financial crisis, also in Europe. Following the crisis, attempts have been made to make, so-called, bail-ins possible; meaning that upon the rescue of a financial institution unse­ cured financiers would lose their money. (23) The importance of international coordination was already on the radar screen far be­ fore the financial crisis. The Basel (BIS) capital accords (with agreements on minimum capital requirements) could be seen as a first success story of international coordination. Typically, progress was a response to crises; for example, the first step came with the cre­ ation of the Basel Committee in 1974 following the Herstatt failure (a relatively small bank that via its international linkages nevertheless had a big effect on international fi­ nancial markets). Its first major (advisory) document followed in 1975 on host and home country supervisory responsibilities (the Basel Concordat). Several revisions followed, in­ cluding the 1992 revision that followed the 1991 failure of the Luxembourg-based Bank Page 36 of 38

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Commercial Banking and Shadow Banking: The Accelerating Integration of Banks and Markets and its Implications for Regulation Credit and Commerce International (BCCI) that pointed at an ill-defined home country definition. In 1988, the first Basel capital accord came about (Basel I). For more, see Alessi (2012). (24) A noteworthy example of cross-border coordination and centralization in supervision is the regulatory overhaul in the EU following the financial (and Euro) crisis. It has led to a common regulatory and supervisory framework, the so-called Banking Union. See chap­ ters 15 and 16 in Greenbaum, Thakor, and Boot (2016). (25) All these proposals seek to protect core banking functions against risks originating from financial markets. In the case of the Dodd–Frank Act, restrictions particularly aim at containing risks coming from private equity, hedge fund investments and derivatives. Vickers and Liikanen focus on internally separating banking operations. See BIS (2013, chapter 5) and Greenbaum, Thakor, and Boot (2016, chapter 16) for a discussion and com­ parison of the various proposals. Farhi and Tirole (2017) develop a theoretical framework for such containment. (26) Also important might be the ownership structure of financial institutions (see Berger et al., 2008). The concentration in the credit rating business and the importance of rat­ ings for structured finance (securitization) is another issue. Structural changes could be desirable here as well. (27) This concern stems from the observation that individual banks are unlikely to suffi­ ciently internalize the systemic-risk externalities of their actions. Consequently, the lati­ tude that Basel II grants in having banks use their own internal risk assessment models to determine appropriate capital levels might be troublesome. Banks may tweak these mod­ els in order to generate prescriptions to keep low levels of capital (see Behn, Haselman, and Vig (2014) for evidence on this for German banks). The follow-up with Basel III seeks to provide remedies. (28) See also Thakor (2014). Berger and Bouwman (2013) provide empirical evidence that higher capital produces greater benefits for banks during financial crises, including a higher probability of survival. This is consistent with Thakor’s (2012) theory that higher capital weakens incentives for banks to introduce financial innovations that are associat­ ed with higher probabilities of financial crises. (29) Some theoretical work suggests that competition between regulatory regimes might be helpful; see Kane (1988). This touches on a broader point: diversity in the financial sector—diversity in regulatory approaches, bank business models and ownership struc­ tures etc.—can be valuable. Too much homogeneity could invite systemic risk by itself (Boot, 2014; Butzbach, 2016; see also Berger et al., 2008). (30) We have not focused on the internal incentive structure in banks (which might be re­ lated to bank culture). As has become clear in the current crisis, internal risk manage­ ment showed substantial lapses (see Group of Thirty, 2009). Other issues abstained from include procyclicality in Basel II and IFRS accounting standards. Page 37 of 38

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Commercial Banking and Shadow Banking: The Accelerating Integration of Banks and Markets and its Implications for Regulation Arnoud W. A. Boot

Arnoud W. A. Boot is Professor of Corporate Finance and Financial Markets at the University of Amsterdam and member of the Royal Netherlands Academy of Arts and Sciences (KNAW). He is chairman of the Bank Council of the Dutch Central Bank (DNB), member of the Dutch Scientific Council for Government Policy (WRR) and chairman of the European Finance Association (EFA). He is also a research fellow at the Centre for Economic Policy Research (CEPR) in London. He was member of the Advisory Committee of the European Systemic Risk Board (ESRB), and a faculty member at the Kellogg Graduate School of Management at Northwestern University in Chicago. He has written extensively in the areas of financial institutions and corpo­ rate finance, with publications in major academic journals, such as the Journal of Fi­ nance, American Economic Review, Review of Financial Studies, and the Journal of Financial Intermediation. Anjan V. Thakor

Anjan V. Thakor holds the John E. Simon Professorship of Finance and is Director of the Olin Business School’s Ph.D program, and Director of the WFA Center for Fi­ nance and Accounting Research. He has also served as Senior Associate Dean at the Olin Business School at Washington University in St Louis. Until July 2003, he held the Edward J. Frey Professorship of Banking and Finance and was Chairman of the Finance Group (2000–3) at the University of Michigan Business School. Prior to join­ ing Michigan, he served as the NBD Professor of Finance and Chairman of the Fi­ nance Department at the School of Business at Indiana University. He has also served on the faculties of Northwestern University and UCLA as a Visiting Professor. He re­ ceived his Ph.D in Finance from Northwestern University. He is a research associate of the European Corporate Governance Institute and a Fellow of The Financial Theo­ ry Group. He has served as managing editor of Journal of Financial Intermediation from 1996–2005 and currently serves as an associate editor. He is past-President and a founder of the Financial Intermediation Research Society.

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Corporate Complexity and Systemic Risk: A Progress Report

Corporate Complexity and Systemic Risk: A Progress Report   Jacopo Carmassi and Richard J. Herring The Oxford Handbook of Banking (3rd edn) Edited by Allen N. Berger, Philip Molyneux, and John O. S. Wilson Print Publication Date: Oct 2019 Subject: Economics and Finance, Financial Economics Online Publication Date: Nov 2019 DOI: 10.1093/oxfordhb/9780198824633.013.4

Abstract and Keywords This chapter updates and extends our earlier work on the corporate complexity of Global Systemically Important Banks (G-SIBs). The first edition of this chapter, which appeared in the Oxford Handbook of Banking, first edition, was based on data in 2007, documented a notable degree of complexity among most G-SIBs, and warned complexity could pose in­ superable obstacles if an institution needed to be resolved, an issue then largely neglect­ ed. The Lehman Brothers bankruptcy highlighted these issues, stimulating ambitious ini­ tiatives to rationalize the corporate structure of G-SIBs and enhance their resolvability. The second edition, based on data through May 2013, found only mixed evidence of progress in reducing corporate complexity, and noted that some institutions had grown still larger and more complex. In the current edition, published a decade after the crisis, our measures of corporate complexity remain high. Apart from some improvements in the US disclosures, the corporate structures of G-SIBs remain quite opaque. If regulators are to achieve their goal of bolstering confidence in resolution procedures and enhancing market discipline, transparency must be enhanced. Keywords: complexity, Financial Stability Board, G-SIBs, Living Wills, resolution, systemic risk, transparency

4.1 Introduction THE first edition of this chapter, drafted in 2007–8, before the start of the Great Financial Crisis (GFC), documented the growing complexity of the corporate structure of Global Systemically Important Banks (G-SIBs)1 and analyzed the factors driving this complexity. We found that for the sixteen international banks designated as systemically important, the median number of controlled subsidiaries was 923 with a high of 2,435. Moreover, these sixteen banks had extensive cross-border involvement. The median percent of for­ eign subsidiaries was 53 percent with a high of 96 percent.

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Corporate Complexity and Systemic Risk: A Progress Report These findings and the opacity of these relationships led us to conclude that, in the event of an insolvency, international corporate complexity would defy an efficient resolution. We conjectured that if the authorities lacked confidence they would be able to resolve such an institution without potentially devastating systemic spillovers, they would feel obliged to improvise a bailout, notwithstanding any prior avowals to the contrary. This would con­ tribute to the perception that some institutions were too complex to fail, which would un­ dermine market discipline that might otherwise constrain (p. 96) risk-taking by these in­ stitutions. Before the GFC, the regulatory authorities largely neglected the issue of the corporate complexity of G-SIBs. The behavior of the authorities during the GFC was consistent with our earlier conjec­ ture. At the height of the GFC the authorities in the United States, the United Kingdom and the Eurozone had committed over $14 trillion, about one-quarter of the world GDP, to prop-up their banking systems (Haldane and Alessandri, 2009). Indeed, the one major ex­ ception to this pattern of bailouts, the bankruptcy of Lehman Brothers in September 2008, by far the smallest and one of the least complex of our initial list of systemically im­ portant international financial institutions, demonstrated that the authorities lacked the tools to implement an orderly resolution of an international financial institution with a complex, international corporate structure. The attempt to resolve Lehman Brothers with­ out the appropriate policy infrastructure did lead to spillovers that damaged much of the international financial system and contributed to the depth of the consequent recession. The issue of the complexity and opacity of the corporate structure of G-SIBs vaulted to the top of the reform agenda in the wake of the GFC. Excessive risk-taking and leverage are generally regarded as the fundamental causes of the GFC, but corporate complexity and opaque interconnections among and within institutions impeded effective oversight by the authorities ex ante and greatly complicated crisis management and resolution of insolvent institutions ex post. The authorities began to realize that massive bailouts creat­ ed expectations of still greater future bailouts that would create huge taxpayer liabilities, which could not be justified on political or economic grounds. As Thomas Huertas (2014) observed, a continuing policy of too-big- (or too-complex-) to-fail was “too expensive to continue.” The Group of 20 Heads of State (G20) meeting in September 2009 officially recognized the problem and mandated the Financial Stability Board to identify G-SIBs and ensure that each G-SIB prepared a credible recovery and resolution plan that would ensure each G-SIB could be resolved in an orderly manner without taxpayer subsidy. The second edition of this chapter, drafted in 2013, re-examined the topic of corporate complexity as these reforms were being implemented. We analyzed the reform agenda and investigated whether any discernable impact had yet been made on our measure of corporate complexity, the number of controlled subsidiaries.2 The results were decidedly mixed. Despite the disappearance of three of the institutions on our initial list of G-SIBs, the overall trend toward bigger and more complex banks had continued (often encour­ aged by publicly subsidized mergers). Although some banking groups had made (p. 97) verifiable progress in rationalizing and simplifying their corporate structures, others had

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Corporate Complexity and Systemic Risk: A Progress Report greatly increased their number of subsidiaries so that, on average, our measure of corpo­ rate complexity had not decreased since the crisis. In this third edition of the Handbook, we examine progress in the rationalization and sim­ plification of the corporate complexity of G-SIBs ten years after the GFC and nine years after the Group of Twenty (2009) announced that all “Systemically important financial firms should develop international-consistent firm-specific contingency and resolution plans.” To implement this promise, the FSB developed Key Attributes of Effective Resolu­ tion Regimes for Financial Institutions (KA) (FSB, 2011b) to be adopted by all countries that host G-SIBs. Among other measures, the KA required that G-SIBs should be required to identify essential and systematically important functions and map them into the legal entities within which they are conducted. In addition, countries were urged to establish resolution regimes that would provide for speed and transparency and as much pre­ dictability as possible for orderly resolution. The overall objective was to establish credi­ ble resolution procedures that would enhance market discipline and provide incentives for market-based solutions to deal with faltering banking groups. Although banks have been obliged to disclose massive amounts of data relevant to resolu­ tion, very little of it is made public. Analysts outside the regulatory community face sub­ stantial challenges in monitoring progress toward the achievement of the KA. The FSB has established a peer review process to monitor progress by each country, which is re­ ported annually to the G20. The implementation report for 2017 (FSB, 2017a, pp. 26–7) indicates that ten of the twenty-eight FSB jurisdictions have powers to require changes to firms’ structure and operations to improve resolvability.3 Whether the existence of such powers has resulted in a significant reduction in the number of subsidiaries controlled by G-SIBs is a key question addressed in this chapter. More broadly, we analyze why com­ plexity may jeopardize systemic stability, review the factors that have incentivized G-SIBs to adopt such complex and opaque structures, examine the broader policy agenda to en­ hance the resolvability and consider what additional measures could be taken to enhance the transparency of the corporate structure of G-SIBs.

4.2 Why the Complex, Opaque, International Corporate Structure of G-Sibs Jeopardizes Sys­ temic Stability Mervyn King (2010) observed, “[M]ost large complex financial institutions are global—at least in life if not in death.” This poses a fundamental problem to resolving a G-SIB. In the event of insolvency an integrated G-SIB’s lines of business would first need to be mapped into the legal entities that would then need to be taken through national (p. 98) bankrupt­ cy or administrative process. Prior to the post-crisis reforms, most G-SIBs were managed as integrated global entities, with complex operational and financial interrelationships and minimal regard for legal entities in which transactions were booked and operations were located. Page 3 of 66

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Corporate Complexity and Systemic Risk: A Progress Report The Lehman Brothers (LB) bankruptcy demonstrated the daunting challenges the authori­ ties faced in resolving a G-SIB that was managed as a single, integrated entity. Lehman’s total reported assets were roughly $700 billion when it applied for bankruptcy. Its corpo­ rate structure included 433 subsidiaries in twenty countries (based on Bureau Van Dijk (BvD) data; see Herring and Carmassi, 2010). Not only was this hierarchy opaque to out­ siders, but also court records show that employees were often unaware of distinctions among these legal entities or, indeed, of which legal entity employed them. These legal entities held a number of different regulatory licenses and were regulated by a variety of different national authorities including securities and banking regulators. In addition, LB participated in a number of exchanges and clearing settlement systems, each of which had procedures that must be followed to approve the continuing operations of its mem­ bers. This posed formidable coordination challenges to any effort to preserve the value of LB as a going concern. LB actively participated in global financial markets in which it was the sixth largest coun­ terparty in OTC derivatives markets and a major borrower in the repo market, which to­ taled roughly $11 trillion at the time. More than 43,000 trades were still live when Lehman failed and had to be negotiated separately with each counterparty. The bankrupt­ cy filing set-off cross default clauses in more than 900,000 contracts and triggered closeout netting by counterparties that caused downward pressure on asset prices, which ad­ versely affected the solvency of other major financial institutions. The result was 60 civil proceedings extending over three continents, which made it virtually impossible to pre­ serve whatever going concern value might have otherwise been salvaged. Because LB was managed as an integrated group with minimal regard for the legal enti­ ties, disentangling its financial obligations and operations impeded an efficient resolu­ tion. Lehman Brothers Holdings Inc. (LBHI) issued the vast majority of the unsecured debt for the group and invested most of the proceeds in its subsidiaries. This was a com­ mon approach to managing a global corporation, designed to facilitate control over global operations, while reducing funding, capital, and tax costs. LBHI, in effect, served as trea­ surer for its affiliates, running a zero-balance cash-management system. LBHI lent to its operating subsidiaries at the beginning of each day and then swept the cash back to LBHI at the end of each day to be managed overnight from LBHI headquarters in New York. The bankruptcy petition was filed in the United States before most of the subsidiaries had been funded, which tied up most of LB’s cash in US court proceedings, leaving its inter­ national subsidiaries bereft of liquidity. Lehman also centralized its information technology so that data for different products and different subsidiaries were co-mingled. This was an efficient way of running the busi­ ness as a going concern but presents an enormous problem in uncoordinated global bank­ ruptcy proceedings. LB used approximately 2,700 proprietary, third-party, and off-theshelf programs, each of which interacted with or created transactions data that LB (p. 99) stored on 26,666 servers, 20,000 of which contained accumulated emails, files, voicemail messages, instant messages, and recorded calls. The largest data centers were in New York, London, Tokyo, Hong Kong, and Mumbai, but this integrated approach fragmented Page 4 of 66

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Corporate Complexity and Systemic Risk: A Progress Report when the bankruptcy petition was filed so that individual subsidiaries lost access to infor­ mation stored in other jurisdictions. Much of this information needed to be preserved, ex­ tracted, stored, and analyzed for bankruptcy administrators to resolve each legal entity. Consequently, it was necessary to negotiate complex protocols among the various juris­ dictions in which the data resided and the jurisdictions in which the legal entity resided, before the various resolution authorities could sort out the claims of various creditors and counterparties. This breakdown in the management information systems impeded the de­ termination of what had become of the trades customers had placed with individual enti­ ties or funds advanced by creditors to individual legal entities. In addition, the LB bankruptcy revealed that most jurisdictions were totally ill-equipped to deal with the collapse of a major international institution, except through costly and disruptive liquidation proceedings. For example, the administrators in the United King­ dom found it difficult even to fund basic services such as lights and catering while they undertook investigations within the firm. As chaotic and destructive as the LB bankruptcy proved to be, the authorities realized it could have been much worse. Many G-SIBs had much larger balance sheets (measured in trillions not billions), more extensive interconnections, more complex intra-affiliate trans­ actions, more diverse lines of business, more complex organizational structures, and more extensive international involvement. Given the lack of coordination among interna­ tional resolution authorities, and the inadequacy of most resolution regimes for coping with the insolvency of a complex international financial institution, there seemed no plau­ sible way to resolve such an institution without exacerbating international financial insta­ bility. Against this background, the G20 met in 2009 to agree on plans to reform the inter­ national financial system. But before turning to a discussion of these reforms we first ex­ amine data showing the extent of complexity before the GFC and how the number of sub­ sidiaries controlled by G-SIBs has evolved over the subsequent ten years. We will then consider why G-SIBs have chosen to adopt such large and complex corporate structures.

4.3 Corporate Complexity of G-Sibs: An Update 10 Years After the Crisis The first edition of this chapter documented the corporate complexity of international sys­ temically important banks at the end of 2007, just before the GFC. The second edition of this chapter examined the evolution in the corporate complexity of G-SIBs from 2007 to 2013. Our key measure of corporate complexity is the number of “ultimately (p. 100) owned”/controlled subsidiaries in the BvD database. Ultimately owned subsidiaries are those legal entities in which the G-SIB’s ownership share is at least 50.01 percent in all the nodes of the ownership chain.4 This criterion for control is conservative because ef­ fective control can be exercised through a much smaller ownership position if the remain­ ing shares are widely dispersed among a number of shareholders. The Fed, for example, uses a threshold of 25 percent to identify controlled subsidiaries.

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Corporate Complexity and Systemic Risk: A Progress Report Despite this conservative bias, we found that most G-SIBs controlled a remarkably large number of subsidiaries in both 2007 and 2013. As of December 2007, the average num­ ber of ultimately owned subsidiaries of international, systemically important banks was 969 with considerable variation (with a difference of 2,168 controlled subsidiaries) be­ tween the most and the least complex institution. On average, the majority of these sub­ sidiaries were incorporated in foreign jurisdictions (56 percent). By number, only a small share of subsidiaries was involved in the banking (5 percent) or insurance business (2 percent), while larger shares were classified as vehicles and trusts (22 percent), other fi­ nancial firms (27 percent) and, most notably, non-financial entities (43 percent). The overall picture did not change in 2013 with a new sample consisting of the 28 institu­ tions identified as G-SIBs by the FSB in November 2012. The average number of sub­ sidiaries remained almost the same (964 in May 2013), as did the share of foreign sub­ sidiaries (60 percent in May 2013). The average size of the 28 G-SIBs increased from $1.5 trillion as of year-end 2007 to $1.6 trillion as of year-end 2012, mainly as a result of merg­ ers and acquisitions that occurred during the crisis. Thus, five years after the crisis, sys­ temically important banks had remained very complex and had grown larger. In 2009, the Group of Twenty (G20) heads of state had announced ambitious plans to en­ sure that each G-SIB could be resolved without intolerable spillovers and without govern­ ment assistance (see section 4.5 below). These reforms included initiatives to simplify and rationalize the corporate structure of G-SIBs and to map lines of business in each G-SIB into its legal entities. These measures were expected to reduce the number of controlled subsidiaries, but the reforms were quite challenging for most jurisdictions requiring fun­ damental legislative and institutional changes, which were expected to take several years to implement.5 Thus, it was premature to draw conclusions about the impact of the postcrisis reforms on our measure of corporate complexity in the second edition of this chap­ ter. A key contribution of this chapter is to provide new data on the corporate complexity of G-SIBs as of October 2018, ten years after the start of the GFC. These new data will help to shed more light on whether the post-crisis reforms have reduced our measure of corporate complexity—the number of subsidiaries controlled by G-SIBs. Table 4.1 reports information regarding the size, foreign business and total number of ul­ timately owned subsidiaries of 32 G-SIBs. This sample combines the 28 G-SIBs (p. 103) an­ alyzed in the second edition of this chapter with four additional G-SIBs included in the most recent list (FSB, 2017b). (p. 101) (p. 102) 6

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Corporate Complexity and Systemic Risk: A Progress Report Table 4.1 Size and Complexity of G-SIBs, 2018 vs. 2013 (G-SIBs Ranked by Total Assets 2017)

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Corporate Complexity and Systemic Risk: A Progress Report G-SIBs

Total as­ sets 2017 (USD mln)

Total as­ sets 2013 (USD mln)

% of for­ eign as­ sets, 2017

% of for­ eign rev­ enues/in­ come, 2017

Total sub­ sidiaries (October 2018)

Total sub­ sidiaries (May 2013)

1

ICBC

4,006,242

3,100,051

13%

11%

266

36

2

China Construc­ tion Bank

3,397,688

2,517,568

5%

4%

255

89

3

Agricul­ tural Bank of China

3,233,212

2,386,291

4%

2%

29

14

4

Bank of China

2,989,653

2,273,581

10%

7%

199

116

5

Mit­ subishi UFJ

2,890,455

2,509,791

35%

74%

236

112

6

JPMorgan Chase

2,533,600

2,415,689

24%

22%

2,703

1,095

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Corporate Complexity and Systemic Risk: A Progress Report 7

HSBC

2,521,771

2,671,318

69%

75%

1,922

1,565

8

BNP Paribas

2,350,929

2,496,891

68%

.

1,794

2,592

9

Bank of America

2,281,477

2,104,995

14%

14%

2,828

1,910

10

Crédit Agricole

2,114,568

2,328,285

17%

37%

1,469

1,255

11

Wells Far­ go

1,951,757

1,527,015

5%

1%

2,151

1,549

12

Mizuho

1,930,768

1,709,508

30%

50%

132

103

13

Sumito­ mo Mitsui

1,874,462

1,570,582

24%

30%

199

165

14

Citigroup

1,842,465

1,880,035

49%

45%

2,009

2,297

15

Deutsche Bank

1,768,645

2,222,282

71%

63%

1,499

2,124

16

Santander

1,732,154

1,538,576

67%

90%

1,024

605

17

Barclays

1,531,189

2,212,686

58%

47%

935

1,739

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Corporate Complexity and Systemic Risk: A Progress Report 18

Société Générale

1,529,260

1,674,494

27%

52%

1,016

913

19

BPCE

1,510,938

1,549,446

9%

21%

1,848

1,448

20

ING Groep

1,014,866

1,491,244

71%

59%

310

764

21

Unicredit

1,003,562

1,166,496

56%

53%

1,322

2,216

22

Royal Bank of Scotland

997,225

1,692,709

9%

34%

728

799

23

Royal Bank of Canada

944,810

822,250

47%

27%

300

305

24

UBS

939,570

1,136,685

58%

61%

357

458

25

Goldman Sachs

916,787

911,595

41%

37%

3,857

420

26

Morgan Stanley

851,733

832,666

33%

27%

3,439

1,311

27

BBVA

827,587

803,429

54%

73%

502

415

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Corporate Complexity and Systemic Risk: A Progress Report 28

Credit Suisse

816,455

979,031

70%

63%

561

242

29

Nordea

697,527

869,432

82%

79%

216

220

30

Standard Chartered

663,501

674,380

82%

97%

808

118

31

Bank of New York Mellon

371,758

374,310

30%

51%

1,231

279

32

State Street Corpora­ tion

238,496

243,028

34%

42%

293

155

Average

1,696,097

1,646,448

40%

43%

1,139

884

Median

1,631,672

1,622,538

35%

45%

872

605

Range

3,767,746

2,857,023

78%

96%

3,828

2,578

Source: BankFocus (BvD) for total assets and number of subsidiaries; annual reports, SNL and other public regula­ tory and bank reports for the share of foreign assets and foreign revenues/income. Data on subsidiaries for BCPE SA in 2018 as of May. Data on subsidiaries for Agricultural Bank of China, China Construction Bank, and Royal Bank of Canada as of July 2015 instead of May 2013.

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Corporate Complexity and Systemic Risk: A Progress Report Table 4.1 shows that the average size of G-SIBs has remained almost unchanged at $1.6 trillion. This average is mainly driven by the four Chinese G-SIBs, each of which had bal­ ance sheets well above $2 trillion already in 2013 and had become substantially larger by 2017. Excluding the Chinese G-SIBs, the average size of the remaining G-SIBs decreased slightly from $1.51 trillion (year-end 2013) to $1.45 trillion (year-end 2017). This average conceals substantial differences across banks. Some G-SIBs have downsized significantly (for example, Royal Bank of Scotland: −41 percent; Barclays: −31 percent; Deutsche Bank: −20 percent), while others have grown larger (for example, Wells Fargo: +28 per­ cent; Mitsubishi UFJ: +15 percent; Santander: +13 percent). With regard to foreign activ­ ities, on average over 40 percent of both total assets and foreign revenues/income are re­ lated to foreign business, in line with 2007 and 2013 data shown in the previous editions of this chapter.7 The right-most two columns of Table 4.1 display the number of controlled subsidiaries of G-SIBs, based on the BvD dataset, as of October 2018 and May 2013 (the point in time for the number of subsidiaries used in the second edition of this chapter).8 These data indi­ cate that our measure of corporate complexity has not decreased. On the contrary, the av­ erage has increased from 884 in 2013 to 1,139 in 2018. This result, however, is strongly influenced by large increases in the number of subsidiaries reported for most US G-SIBs, which may be attributable to a change in the sources of data used by BvD for US banks and so it may be appropriate to remove the US G-SIBs for the purpose of comparing the evolution of the subsidiaries of G-SIBs. Even without the inclusion of the BvD data for US G-SIBs, the overall number of controlled subsidiaries remains high although it decreased somewhat. Excluding US G-SIBs from both the 2013 and 2018 data, the average number of subsidiaries of the remaining G-SIBs decreased from 821 in 2013 to 766 in 2018, a 7 percent reduction. Even so, the evidence across G-SIBs remains mixed. Some banks sub­ stantially increased their number of controlled subsidiaries since 2013 (e.g., Standard Chartered +585 percent; Credit Suisse +132 percent; UFJ +111 percent; Bank of China +72 percent; Santander +69 percent), while others have sharply reduced (p. 104) their number of controlled subsidiaries (e.g., Barclays −46 percent; Unicredit −40 percent; BNP Paribas −31 percent; Deutsche Bank −29 percent). Based on BvD data for October 2018 including the eight US G-SIBs, fifteen G-SIBs had more than 1,000 controlled subsidiaries and six US G-SIBs had over 2,000 subsidiaries. The extent of cross-border complexity, as measured by the number of countries in which G-SIBs operate, remains high. As shown in Table 4.2, on average G-SIBs now control sub­ sidiaries in forty-five different countries (with 59 percent of foreign subsidiaries as mea­ sured in 2018) compared to forty-one (60 percent of foreign subsidiaries measured in 2013). Notably, however, the average proportion of subsidiaries located in off-shore finan­ cial centers (OFCs) has increased from 15 percent in 2013 to 18 percent in 2018. Twentyone G-SIBs have located more than 10 percent of their subsidiaries in OFCs, while eleven of these G-SIBs have located more than 20 percent of their subsidiaries in OFCs.

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Corporate Complexity and Systemic Risk: A Progress Report The distribution of subsidiaries across industries is broadly consistent over time. Table 4.3 shows that, by number, 5 percent subsidiaries of the 32 G-SIBs were classified as banking subsidiaries in both 2018 and 2013 and 1 percent were insurance subsidiaries in 2018 versus 2 percent in 2013. Trusts and vehicles represented 23 percent of all entities in 2018 (up from 19 percent in 2013), while other financial companies accounted for 17 percent (down from 28 percent in 2013). Non-financial subsidiaries remain the largest category, representing over half of the total number of subsidiaries in 2018 (54 percent, up from 46 percent in 2013). Again, bank-by-bank data reveal significant differences across banks. For example, Asian G-SIBs tend to have a higher share of banking sub­ sidiaries and a smaller number of total subsidiaries. For some G-SIBs the share of non-fi­ nancial subsidiaries is remarkably high with 80 percent of Unicredit’s subsidiaries classi­ fied as non-financial, the highest proportion among G-SIBs. In the following section we will also discuss, together with other factors affecting complexity, some of the potential drivers of the high share of non-financial subsidiaries of G-SIBs.

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Corporate Complexity and Systemic Risk: A Progress Report Table 4.3 Breakdown by Industry of Subsidiaries of G-SIBs, October 2018 (in bold) and May 2013

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Corporate Complexity and Systemic Risk: A Progress Report G-SIBs

Agricultural Bank of Chi­ na

% by indus­ try

Bank of America

% by indus­ try

Banks

Insurance companies

Mutual and pension funds/nomi­ nees/trusts/ trustees

Other fi­ nancial sub­ sidiaries

Non-finan­ cial sub­ sidiaries

Total

5

1

2

2

19

29

3

1

1

5

4

14

17%

3%

7%

7%

66%

100%

21%

7%

7%

36%

29%

100%

206

26

704

458

1434

2828

72

17

584

322

915

1910

7%

1%

25%

16%

51%

100%

4%

1%

31%

17%

48%

100%

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Corporate Complexity and Systemic Risk: A Progress Report Bank of Chi­ na

% by indus­ try

Bank of New York Mellon

% by indus­ try

Barclays

% by indus­ try

41

5

17

62

74

199

23

3

27

13

50

116

21%

3%

9%

31%

37%

100%

20%

3%

23%

11%

43%

100%

60

6

782

144

239

1231

17

0

120

67

75

279

5%

0.5%

64%

12%

19%

100%

6%

0%

43%

24%

27%

100%

36

5

151

237

506

935

54

16

465

380

824

1739

4%

1%

16%

25%

54%

100%

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Corporate Complexity and Systemic Risk: A Progress Report

BBVA

% by indus­ try

BNP Paribas

% by indus­ try

BPCE SA

% by indus­ try

3%

1%

27%

22%

47%

100%

21

29

238

58

156

502

36

16

59

144

160

415

4%

6%

47%

12%

31%

100%

9%

4%

14%

35%

39%

100%

114

55

187

275

1163

1794

103

68

323

760

1338

2592

6%

3%

10%

15%

65%

100%

4%

3%

12%

29%

52%

100%

101

21

198

251

1277

1848

108

56

219

556

509

1448

5%

1%

11%

14%

69%

100%

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Corporate Complexity and Systemic Risk: A Progress Report

China Con­ struction Bank

% by indus­ try

Citigroup

% by indus­ try

Crédit Agri­ cole SA

7%

4%

15%

38%

35%

100%

17

1

25

49

163

255

11

1

12

21

44

89

7%

0.4%

10%

19%

64%

100%

12%

1%

13%

24%

49%

100%

125

30

528

452

874

2009

111

41

456

650

1039

2297

6%

1%

26%

22%

44%

100%

5%

2%

20%

28%

45%

100%

94

29

252

171

923

1469

73

32

132

434

584

1255

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Corporate Complexity and Systemic Risk: A Progress Report % by indus­ try

Credit Suisse

% by indus­ try

Deutsche Bank

% by indus­ try

Goldman Sachs

6%

2%

17%

12%

63%

100%

6%

3%

11%

35%

47%

100%

34

13

144

107

263

561

30

4

89

52

67

242

6%

2%

26%

19%

47%

100%

12%

2%

37%

21%

28%

100%

78

8

348

349

716

1499

68

8

541

618

889

2124

5%

1%

23%

23%

48%

100%

3%

0.4%

25%

29%

42%

100%

18

29

1264

415

2131

3857

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Corporate Complexity and Systemic Risk: A Progress Report

% by indus­ try

HSBC

% by indus­ try

ICBC

% by indus­ try

ING Groep

15

10

74

121

200

420

0.5%

1%

33%

11%

55%

100%

4%

2%

18%

29%

48%

100%

116

20

278

343

1165

1922

89

37

309

298

832

1565

6%

1%

14%

18%

61%

100%

6%

2%

20%

19%

53%

100%

31

1

14

23

197

266

19

2

7

5

3

36

12%

0.4%

5%

9%

74%

100%

53%

6%

19%

14%

8%

100%

20

8

34

88

160

310

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Corporate Complexity and Systemic Risk: A Progress Report

% by indus­ try

JPMorgan Chase

% by indus­ try

Mitsubishi UFJ

% by indus­ try

41

43

130

253

297

764

6%

3%

11%

28%

52%

100%

5%

6%

17%

33%

39%

100%

109

5

791

361

1437

2703

54

13

305

205

518

1095

4%

0.2%

29%

13%

53%

100%

5%

1%

28%

19%

47%

100%

53

1

60

65

57

236

27

0

22

30

33

112

22%

0.4%

25%

28%

24%

100%

24%

0%

20%

27%

29%

100%

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Corporate Complexity and Systemic Risk: A Progress Report Mizuho

% by indus­ try

Morgan Stanley

% by indus­ try

Nordea

% by indus­ try

29

0

32

28

43

132

23

3

26

22

29

103

22%

0%

24%

21%

33%

100%

22%

3%

25%

21%

28%

100%

20

8

934

483

1994

3439

19

12

245

236

799

1311

1%

0.2%

27%

14%

58%

100%

1%

1%

19%

18%

61%

100%

8

7

22

26

153

216

13

5

29

117

56

220

4%

3%

10%

12%

71%

100%

6%

2%

13%

53%

25%

100%

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Corporate Complexity and Systemic Risk: A Progress Report Royal Bank of Canada

% by indus­ try

Royal Bank of Scotland

% by indus­ try

Santander

% by indus­ try

56

9

50

99

86

300

37

10

60

125

73

305

19%

3%

17%

33%

29%

100%

12%

3%

20%

41%

24%

100%

43

8

121

194

362

728

33

5

162

206

393

799

6%

1%

17%

27%

50%

100%

4%

1%

20%

26%

49%

100%

104

13

229

223

455

1024

64

13

102

197

229

605

10%

1%

22%

22%

44%

100%

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Corporate Complexity and Systemic Risk: A Progress Report

Société Générale

% by indus­ try

Standard Chartered

% by indus­ try

State Street Corporation

11%

2%

17%

33%

38%

100%

111

17

124

245

519

1016

95

20

97

405

296

913

11%

2%

12%

24%

51%

100%

10%

2%

11%

44%

32%

100%

34

5

69

78

622

808

28

2

27

41

20

118

4%

1%

9%

10%

77%

100%

24%

2%

23%

35%

17%

100%

15

1

107

70

100

293

6

1

61

45

42

155

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Corporate Complexity and Systemic Risk: A Progress Report % by indus­ try

Sumitomo Mitsui

% by indus­ try

UBS

% by indus­ try

Unicredit

5%

0.3%

37%

24%

34%

100%

4%

1%

39%

29%

27%

100%

24

0

28

36

111

199

22

0

32

51

60

165

12%

0%

14%

18%

56%

100%

13%

0%

19%

31%

36%

100%

31

4

106

54

162

357

28

4

108

152

166

458

9%

1%

30%

15%

45%

100%

6%

1%

24%

33%

36%

100%

54

4

93

111

1060

1322

57

6

193

751

1209

2216

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Corporate Complexity and Systemic Risk: A Progress Report % by indus­ try

Wells Fargo

% by indus­ try

Total

% by indus­ try

4%

0.3%

7%

8%

80%

100%

3%

0.3%

9%

34%

55%

100%

60

15

493

549

1034

2151

19

42

323

356

809

1549

3%

1%

23%

26%

48%

100%

1%

3%

21%

23%

52%

100%

1868

384

8425

6106

19655

36438

1398

491

5340

7638

12562

27429

5%

1%

23%

17%

54%

100%

5%

2%

19%

28%

46%

100%

Note: The sum of the percentages on the share of subsidiaries by industry does not always equal precisely 100% due to rounding.

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Corporate Complexity and Systemic Risk: A Progress Report Source: Bankscope (for 2013 data) and BankFocus (for 2018 data). Private equity and venture capital subsidiaries and hedge funds are included among “other financial subsidiaries.” Foundations and research institutes are includ­ ed in “Non-financial subsidiaries.” Data on subsidiaries for BCPE SA in 2018 as of May. Data on subsidiaries for Agricultural Bank of China, China Construction Bank, and Royal Bank of Canada as of July 2015 instead of May 2013.

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Corporate Complexity and Systemic Risk: A Progress Report The lack of sufficient and consistent disclosures across G-SIBs impedes deeper analysis of the evolution of corporate complexity among G-SIBs. To our knowledge, only the BvD database9 provides consistent and systematic information on the subsidiaries of all GSIBs. As highlighted in Carmassi and Herring (2015, 2016a), significant discrepancies emerge when comparing data on corporate structures across different sources. Although the Federal Reserve data available on the National Information Center (NIC) website pro­ vide granular information on the organizational structures of US banks, the lists of sub­ sidiaries do not match the lists of those reported by BvD. Reconciliation of the two sets of data is impeded by some of the opaque criteria used by the Fed in compiling its data.10

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Corporate Complexity and Systemic Risk: A Progress Report Table 4.2 Geographical Diversification of G-SIBs and Subsidiaries in OFCs, 2018 vs. 2013 (G-SIBs Ranked by Number of Countries in 2018) (p. 105)

(p. 106)

(p. 107)

(p. 108)

(p. 109)

(p. 110)

GSIBs

Num­ ber of coun­ tries (Octo­ ber 2018)

Num­ ber of coun­ tries (May 2013)

% of do­ mes­ tic sub­ sidiari es (Octo­ ber 2018)

% of for­ eign sub­ sidiari es (Octo­ ber 2018)

% of do­ mes­ tic sub­ sidiari es (May 2013)

% of for­ eign sub­ sidiari es (May 2013)

Num­ ber of sub­ sidiari es in OFCs (Octo­ ber 2018)

% of sub­ sidiari es in OFCs (Octo­ ber 2018)

% of sub­ sidiari es in OFCs (May 2013)

1

Citi­ group

85

95

58%

42%

39%

61%

354

18%

10%

2

So­ ciété Génér ale

78

74

45%

55%

47%

53%

120

12%

8%

3

BNP Pariba s

69

88

19%

81%

17%

83%

123

7%

8%

4

HSBC

68

69

14%

86%

21%

79%

524

27%

27%

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Corporate Complexity and Systemic Risk: A Progress Report 5

BPCE

68

70

71%

29%

65%

35%

97

5%

6%

6

Gold­ man Sachs

66

24

49%

51%

29%

71%

1124

29%

11%

7

Deuts che Bank

58

61

21%

79%

24%

76%

420

28%

27%

8

JP­ Mor­ gan Chase

57

57

70%

30%

45%

55%

389

14%

10%

9

Stan­ dard Char­ tered

57

32

6%

94%

42%

58%

280

35%

8%

10

Mor­ gan Stan­ ley

53

45

62%

38%

41%

59%

681

20%

20%

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Corporate Complexity and Systemic Risk: A Progress Report 11

Crédit Agri­ cole

51

59

61%

39%

55%

45%

156

11%

9%

12

Bank of Amer­ ica

48

48

81%

19%

72%

28%

223

8%

10%

13

UBS

43

45

5%

95%

17%

83%

29

8%

8%

14

Bar­ clays

42

58

35%

65%

37%

63%

176

19%

21%

15

Uni­ credit

42

67

28%

72%

41%

59%

35

3%

3%

16

Royal Bank of Scot­ land

40

36

47%

53%

40%

60%

110

15%

13%

17

San­ tander

39

37

24%

76%

25%

75%

65

6%

7%

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Corporate Complexity and Systemic Risk: A Progress Report 18

Credit Suisse

35

37

6%

94%

10%

90%

81

14%

21%

19

Wells Fargo

32

27

92%

8%

93%

7%

113

5%

4%

20

ICBC

31

16

30%

70%

44%

56%

113

42%

47%

21

ING Groep

31

44

30%

70%

32%

68%

21

7%

4%

22

BBVA

30

29

26%

74%

30%

70%

11

2%

4%

23

Bank of New York Mel­ lon

30

22

52%

48%

35%

65%

220

18%

17%

24

Su­ mito­ mo Mitsui

29

20

34%

66%

59%

41%

45

23%

18%

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Corporate Complexity and Systemic Risk: A Progress Report 25

Bank of China

28

16

45%

55%

72%

28%

100

50%

15%

26

Royal Bank of Cana­ da

27

29

19%

81%

18%

82%

52

17%

25%

27

Norde a

23

19

25%

75%

5%

95%

12

6%

4%

28

Mit­ subish i UFJ

22

21

21%

79%

46%

54%

17

7%

4%

29

Mizuh o

22

16

45%

55%

62%

38%

32

24%

7%

30

State Street Cor­ pora­ tion

21

14

46%

54%

26%

74%

84

29%

28%

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Corporate Complexity and Systemic Risk: A Progress Report 31

China Con­ struc­ tion Bank

16

12

54%

46%

42%

58%

96

38%

63%

32

Agri­ cul­ tural Bank of China

6

4

76%

24%

57%

43%

4

14%

21%

Aver­ age

45

41

41%

59%

40%

60%

196

18%

15%

Medi­ an

42

37

40%

60%

41%

60%

110

15%

10%

Range

64

91

87%

87%

88%

88%

1,113

48%

60%

Source: Authors’ calculations on Bankscope (for 2013) and BankFocus (for 2018) data. Number of countries indi­ cates the number of jurisdictions where a G-SIB has at least one ultimately owned subsidiary. The list of OFCs in­ cludes the 42 jurisdictions identified by the Financial Stability Forum in 2000 (FSF, 2000). Data on subsidiaries for BCPE SA in 2018 as of May. Data on subsidiaries for Agricultural Bank of China, China Construction Bank and Royal Bank of Canada as of July 2015 instead of May 2013.

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Corporate Complexity and Systemic Risk: A Progress Report The FED/NIC data are focused on US banks—and US activities of non-US banks. These data provide an alternative source, based on a consistent methodology, for analysis of the corporate structures of the eight US G-SIBs. This is particularly useful because some data reported by BvD for most US G-SIBs exhibit an abrupt increase which may be attributable to a change in sources of data rather than a meaningful change in the num­ ber of controlled subsidiaries. Table 4.4 reports the number of subsidiaries of the eight US G-SIBs from 2002 to 2018 (October) based on FED/NIC data. Although the average number of controlled subsidiaries remains high (1,173), it is heavily influenced by the high number of controlled subsidiaries at Goldman Sachs and Morgan Stanley. A clear re­ duction in the average number of subsidiaries is observable after it peaked in 2009 at 2,333. A particularly strong decrease in complexity occurs after 2012, with the average number of subsidiaries progressively decreasing. By October 2018, the number had fallen almost by half relative to December 2012. The Living Will process, including a focus on the rationalization of legal entities to enhance resolvability, is likely to have played a cru­ cial role in providing incentives for this reduction in the number of controlled sub­ sidiaries. (p. 111)

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Corporate Complexity and Systemic Risk: A Progress Report (p. 112)

Table 4.4 Number of Subsidiaries of US G-SIBs According to the FED/NIC Data Set, 2002–18

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Corporate Complexity and Systemic Risk: A Progress Report U S GSI Bs

O ct ob er 20 18

D ec e m be r 20 17

D ec e m be r 20 16

D ec e m be r 20 15

D ec e m be r 20 14

D ec e m be r 20 13

D ec e m be r 20 12

D ec e m be r 20 11

D ec e m be r 20 10

D ec e m be r 20 09

D ec e m be r 20 08

D ec e m be r 20 07

D ec e m be r 20 06

D ec e m be r 20 05

D ec e m be r 20 04

D ec e m be r 20 03

D ec e m be r 20 02

1

M or ga n St an le y

2, 42 9

2, 43 6

2, 76 9

2, 91 8

3, 04 8

3, 15 1

3, 33 0

3, 44 4

3, 69 3

3, 77 0

3, 50 7

.

.

.

.

.

.

2

G ol d m an Sa ch s

2, 30 8

2, 68 6

2, 82 7

2, 95 2

3, 44 3

3, 71 3

3, 85 7

3, 76 1

3, 64 0

3, 51 7

3, 34 6

.

.

.

.

.

.

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Corporate Complexity and Systemic Risk: A Progress Report 3

B an k of A m er ic a

1, 36 2

1, 37 1

1, 42 6

1, 58 4

1, 73 8

1, 81 4

2, 00 0

2, 14 0

2, 34 1

2, 78 0

1, 55 9

1, 40 5

1, 69 1

1, 54 9

1, 60 1

1, 04 8

1, 04 3

4

Ci ti gr ou p

98 1

1, 00 4

1, 06 7

1, 19 6

1, 30 4

1, 38 2

1, 73 1

1, 70 5

1, 74 7

1, 82 1

1, 86 3

1, 96 9

1, 52 8

1, 44 1

1, 49 1

1, 43 8

1, 47 6

5

JP M or ga n C ha se

92 6

95 6

1, 29 7

1, 90 0

2, 52 5

3, 66 4

3, 76 1

3, 66 7

4, 65 5

4, 26 0

4, 45 8

2, 89 2

2, 97 1

2, 97 2

2, 93 0

1, 30 2

1, 25 5

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Corporate Complexity and Systemic Risk: A Progress Report 6

B an k of N e w Yo rk M ell on

73 9

77 5

81 5

86 1

89 3

90 4

91 9

91 2

75 4

67 4

63 7

59 8

.

.

.

.

.

7

W ell s Fa rg o

44 5

56 5

75 2

1, 36 3

1, 32 7

1, 45 0

1, 45 4

1, 40 9

1, 54 3

1, 62 5

1, 71 2

61 3

61 2

67 7

67 6

66 2

63 5

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Corporate Complexity and Systemic Risk: A Progress Report 8

St at e St re et C or po ra ti on

19 7

20 3

19 5

20 8

22 6

24 1

24 7

24 8

23 8

21 5

28 7

28 3

21 5

22 7

21 4

20 4

18 2

Av er ag e

1, 17 3

1, 25 0

1, 39 4

1, 62 3

1, 81 3

2, 04 0

2, 16 2

2, 16 1

2, 32 6

2, 33 3

2, 17 1

1, 29 3

1, 40 3

1, 37 3

1, 38 2

93 1

91 8

M ed ia n

95 4

98 0

1, 18 2

1, 47 4

1, 53 3

1, 63 2

1, 86 6

1, 92 3

2, 04 4

2, 30 1

1, 78 8

1, 00 9

1, 52 8

1, 44 1

1, 49 1

1, 04 8

1, 04 3

R an ge

2, 23 2

2, 48 3

2, 63 2

2, 74 4

3, 21 7

3, 47 2

3, 61 0

3, 51 3

4, 41 7

4, 04 5

4, 17 1

2, 60 9

2, 75 6

2, 74 5

2, 71 6

1, 23 4

1, 29 4

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Corporate Complexity and Systemic Risk: A Progress Report Source: Federal Reserve/National Information Center.

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Corporate Complexity and Systemic Risk: A Progress Report Nonetheless, differences between BvD and FED/NIC data, which cannot be recon­ ciled based on publicly available information, present a substantial obstacle to drawing meaningful conclusions about trends in the number of controlled subsidiaries. Even so, no other official entity discloses data comparable in quantity and granularity to the FED. Quite possibly, internal sources maintained by non-US regulatory authorities may also dif­ fer from BvD data, but disclosure standards outside the US are so weak that the question cannot be posed. (p. 113)

4.4 What Drives the Corporate Complexity of GSibs? The banks’ decisions regarding their corporate structure are affected by external incen­ tives and constraints, such as regulation, taxation, accounting rules, and disclosure re­ quirements, but also by internal factors, as efforts to minimize asymmetric information costs and the legacy of mergers and acquisitions (M&A).11 Regulation has been an impor­ tant driver of the proliferation of subsidiaries within G-SIBs. In some countries, the pri­ mary regulator may require a G-SIB to create separate legal entities to conduct certain kinds of business. Historically, requirements for corporate separateness have been a cen­ tral feature of US bank regulation (Herring and Santomero, 1990), from the Edge Act in 1919 through the Glass–Steagall Act in 1933 to the Gramm–Leach–Bliley Act of 1999 and the Intermediate Holding Company Rule of 2014. In addition, regulatory authorities in host countries often require foreign financial institutions to form separate, locally char­ tered subsidiaries to conduct certain kinds of business. They take the view that host coun­ try authorities can supervise the safety and soundness and conduct of business more ef­ fectively and better protect financial stability within their borders. The Reserve Bank of New Zealand has been the most outspoken advocate of this approach, requiring not only that foreign-owned institutions establish a local subsidiary, but also that the subsidiary be insulated from the parent by a number of operational and financial firewalls. Taxation provides additional incentives to proliferate corporate subsidiaries, particularly in tax havens. Although tax policy is not generally considered to be part of the regulatory framework, its impact on corporate structure is profound and ubiquitous. The deductibili­ ty of interest payments, but not dividends, has led to a preference for debt finance rela­ tive to equity, as with most corporations, and has created an incentive to use affiliates to raise debt. Furthermore, institutional innovations are designed to capture the tax benefits of debt while satisfying regulatory capital requirements for equity.12 Because the authori­ ties often use the tax code to encourage particular kinds of activities, this may also pro­ vide incentives for G-SIBs to establish separate entities to obtain tax (p. 114) benefits. Banks frequently establish separate entities to qualify for tax subsidies targeted at spe­ cial activities such as real estate investment, leasing, or energy conservation. The ability to establish subsidiaries in foreign tax havens may facilitate the use of excess foreign tax credits and defer taxes on certain kinds of income more or less indefinitely. In addition, particular locations may be preferred so that a G-SIB can take advantage of special taxPage 42 of 66

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Corporate Complexity and Systemic Risk: A Progress Report sparing treaties with specific countries in which it conducts business. Moreover, the es­ tablishment of an intermediate-level holding company in such jurisdictions may reduce the cost of transferring funds from one foreign entity to another by avoiding withholding and transfer taxes. G-SIBs may also establish subsidiaries in tax havens for the benefit of foreign customers who would otherwise be subject to withholding taxes (these customers may also value the secrecy that tax havens also tend to provide). This web of tax incentives is even more complex than the morass of regulatory con­ straints, and so it is virtually impossible to measure the extent of their impact on the com­ plexity of the corporate structure of G-SIBs. The count of the number of subsidiaries in tax havens can only catch part of the magnitude of the impact. Nonetheless, as shown in Table 4.2 in the previous section, G-SIBs locate a remarkable proportion of their sub­ sidiaries in OFCs, which tend to be tax havens as well. Despite years of effort to harmonize accounting principles and practices across countries, substantial differences remain. A G-SIB may sometimes be able to exploit those differ­ ences by establishing a subsidiary in a strategic location or by creating a separate entity to escape accounting consolidation requirements or disclosure laws. Regulators rely on accounting measures to set capital and liquidity requirements and so often the underlying motive for the creation of a more elaborate legal structure is not only to achieve a more favorable accounting treatment for a particular activity or portfolio of assets, but also to lighten the burden of complying with the costs of regulation. The growth in special purpose vehicles (SPVs) before the crisis illustrates the distortions that can occur and the implications for corporate complexity. In addition to TruPS (men­ tioned in footnote 12), another example of the use of a separate entity to reduce taxes is provided by Hume (2011). He reported that one G-SIB had established a separate legal entity in the Cayman Islands to offload billions of troubled mortgage-backed securities. This new entity qualified as a separate company because the equity, equal to 3.5 percent of the assets, was placed with external investors, which qualified the new entity for offbalance-sheet treatment under accounting regulations. Nonetheless, the G-SIB guaran­ teed the external shareholders against loss and provided a loan to finance the remaining 96.5 percent of the assets. The creation of this separate legal entity (which, by design, would not be counted as a controlled subsidiary of the parent) allowed the parent to avoid establishing a loan loss reserve against the portfolio of assets—which would have been required if they had remained on the balance sheet—and an increase in regulatory capital requirements. This example illustrates the difficulty in understanding a G-SIB’s span of control solely from data about ownership shares. Although accountants and regulators have revised their rules to close such loopholes after the crisis, similar opportunities and incentives undoubtedly remain. Although external incentives are of fundamental importance, banks would have strong reasons to introduce a certain amount of legal separateness in their corporate (p. 115) structures even in the absence of regulatory requirements and tax and regulatory incen­ tives. Even if regulatory restrictions and incentives, tax distortions and accounting loop­ Page 43 of 66

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Corporate Complexity and Systemic Risk: A Progress Report holes were eliminated, G-SIBs are likely to prefer to establish a number of subsidiaries rather than conduct all of their business through a single legal entity. The corporate fi­ nance literature creates a presumption that many of these subsidiaries are established to reduce frictions in markets (both external and internal). Herring and Carmassi (2010, 2014) identified a number of ways that corporate separateness could diminish such fric­ tions including: reducing asymmetric information costs between shareholders and credi­ tors; reducing asymmetric information costs and agency problems between external shareholders and managers; mitigating customer concerns regarding potential conflicts of interest; reducing the costs of financial distress by protecting the group from a risky subsidiary and/or protecting a subsidiary from risks in the rest of the group; and the lega­ cy of mergers and acquisitions. The impact of mergers and acquisitions deserves special consideration because many GSIBs have grown through a series of substantial mergers and acquisitions, some of them exceptionally large13 (Herring and Carmassi, 2010, 2014; Carmassi and Herring, 2016a). Mergers and acquisitions are likely to have a significant impact on the complexity of the corporate structure of G-SIBs, as confirmed by the empirical analysis by Carmassi and Herring (2016a) who found a significant and persisting impact of large M&A deals on the corporate complexity of G-SIBs based on time series from 2002 to 2013. Previous studies identified a positive (but less than proportional) correlation between bank size and the number of subsidiaries (e.g., Avraham, Selvaggi, and Vickery, 2012; Cetorelli and Gold­ berg, 2014; Laeven, Ratnovski, and Tong, 2014); Carmassi and Herring (2016a) found that this correlation would lose significance when time effects are considered and that only the effect of M&A transactions would remain significant. The restructuring of corporate legal structures is likely to involve substantial transactions costs and may require considerable attention from top-level management, and so the cor­ porate structure of the acquired institution is often left largely intact. Relative to a firm of equal size that has grown organically, an acquisitive G-SIB is likely to have many more subsidiaries, if only because of the transactions costs in closing or consolidating the ac­ quired subsidiaries. In addition to the avoidance of transactions costs in consolidating the subsidiaries of the acquired firm, the surviving G-SIB may choose to retain a considerable amount of corpo­ rate separateness in the target firm with the hope that preserving the brand might help to retain the reputational capital of the target firm and to facilitate acceptance of the merger. As Dermine (2006) noted, by committing to keep a local structure and staff in place, local shareholders and the board of directors of the target may be reassured about the future of the target firm. Also, the host country regulatory authorities sometimes re­ quire that the acquiring bank maintain the target bank as a separate, locally chartered corporation. Nonetheless, even when a G-SIB wants to reduce its corporate complexity, it may take a significant amount of time to do so because of a wide range of frictions such as (p. 116) outstanding litigation involving particular subsidiaries. Moreover, rationalization of corpo­ Page 44 of 66

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Corporate Complexity and Systemic Risk: A Progress Report rate structure requires resources and management attention at a time when the main goal may be simply continuing operations and trying to meet profitability objectives. Given the low costs of creating some kinds of additional legal entities it may sometimes be easier to create a new legal entity than to identify and make use of an existing one. As a result, some of the proliferation of subsidiaries may simply be attributable to lackadaisi­ cal housekeeping of corporate structures. To the extent that increased complexity may have been the result of inadequate attention to the growing complexity of corporate structures, the Living Will process should be effective in encouraging banking groups to simplify and rationalize their corporate structures. Finally, given the challenges that a complex corporate structure poses for timely resolu­ tion, it is certainly possible that some banks find it useful to develop complex corporate structures to ensure that they are considered too complex to fail. The perception of this status might be expected to give them an advantage in funding costs. The described impediments to consolidating subsidiaries once the merger has been com­ pleted make it likely that mergers will have a lasting impact on the degree of complexity of financial institutions. In addition, and more broadly, given changes in regulations and tax policies—and the tendency to grandfather some institutions when taxes or regulations are changed—the current structures of G-SIBs must be regarded as path dependent. These structures reflect a broad range of external and internal incentives that may have changed over time (and across countries). The complicated corporate structures tend to accrue and a number of frictions may impede corporate simplification—especially in the absence of regulatory pressures to do so. As shown in section 4.3 and Table 4.3, a specific source of corporate complexity of G-SIBs is the very high number of non-financial subsidiaries. This factor was identified by Her­ ring and Carmassi (2010) and subsequently confirmed by other studies (Cetorelli and Goldberg, 2014; Herring and Carmassi, 2014; Carmassi and Herring, 2015). As discussed in Carmassi and Herring (2015), non-financial subsidiaries include a wide variety of busi­ nesses, ranging from hotels and restaurants to energy and aviation. Several rationales can be identified for the ownership by G-SIBs of such a relevant number of non-financial subsidiaries. First, a G-SIB may have acquired a non-financial corporation with several subsidiaries: for example, Bank of China acquired Singapore Aircraft Leasing Enterprise Pte. Ltd., an aircraft operating leasing company, in December 2006, and renamed it BOC Aviation Pte. Ltd., which in 2016 was renamed BOC Aviation Limited. Our list of subsidiaries of Bank of China reports 40 subsidiaries of BOC Aviation being ultimately owned subsidiaries of Bank of China. These subsidiaries account for about 20 percent of the total subsidiaries of Bank of China and are located in many different jurisdictions worldwide, including among others the US, UK, France, Ireland, Hong Kong, Cayman Islands, and Bermuda. As a fur­ ther example, in May 2017 Goldman Sachs acquired, via its Goldman Sachs Merchant Banking Division, the control of Caldic, a Dutch full-service distributor and manufacturer Page 45 of 66

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Corporate Complexity and Systemic Risk: A Progress Report for food, health and industrial markets. Our list of subsidiaries for Goldman Sachs include fifty-two Caldic subsidiaries around the globe. Other non-financial subsidiaries could be related to attempts to mitigate litigation risk. For example, when a bank forecloses on a property, say a hotel, the latter may be de­ composed into multiple separate entities (e.g., one for the garage, one for the swimming pool, etc.) to prevent a lawsuit against one entity from jeopardizing the viability of other parts of the hotel complex or creating a financial burden for the parent (Carmassi and Herring, 2015). These types of non-financial subsidiaries are unlikely to impede an order­ ly resolution, but current meager disclosures make it impossible to know. (p. 117)

Beneficial ownership may also account for many of the non-financial subsidiaries in the BvD database. This kind of subsidiary will be reported by BvD as an ultimately owned subsidiary, that is, with an ownership path of at least 50.01% in all the nodes of the own­ ership chain, even though the subsidiary is held for the benefit of a typically undisclosed client. While the G-SIB is the owner of record, it does not control such subsidiaries. Un­ fortunately, there is no systematic way to exclude these beneficially owned subsidiaries from the BvD database. Several examples of this kind of non-financial subsidiary may be found. For example, Servizio Italia Società Fiduciaria e di Servizi per Azioni is an Italian subsidiary owned by BNP Paribas. It is a fiduciary based in Rome, which owns 528 sub­ sidiaries, 511 of which conduct a wide range of non-financial businesses.14 Similarly, Uni­ credit owns a Milan-based fiduciary, Cordusio Società Fiduciaria per Azioni, which owns 388 entities, of which 374 are categorized as non-financial. Data for Standard Chartered provide yet another example: SCTS Capital Pte. Ltd, a Singapore-based subsidiary of Standard Chartered offering fiduciary services, owns 419 entities, of which 394 are clas­ sified as non-financial.15 The subsidiaries list for HSBC provides an example with an even larger number of non-financial subsidiaries: HSBC Group Nominees UK Limited is a Lon­ don-based subsidiary of HSBC, which owns 1,051 entities, 697 of which are classified as non-financial. The ownership path can be extremely intricate. For example, as many as thirteen entities are in the ownership chain between some of these subsidiaries and HSBC Holdings Plc. These anecdotes shed some light on the variety of non-financial subsidiaries of G-SIBs, but it is very difficult to track this information in a comprehensive and consistent way across G-SIBs. We lack systematic evidence about what non-financial subsidiaries do and whether they would impede an orderly resolution. Subsidiaries that represent beneficial ownership claims are probably irrelevant to an orderly resolution, but given current dis­ closure practices it is impossible to make a systematic analysis of the issue. Better trans­ parency would help identify all the entities of this type and, if convincing explanations are provided about why they are non-material in a resolution, they should be excluded in a systematic and consistent way from the analysis of the resolvability of G-SIBs.16 Finally, material entities that provide key critical non-financial services (e.g., IT and technological services) within each G-SIB represent another category of non-financial subsidiaries, which has grown as a result of regulatory pressures to ensure the provision (p. 118)

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Corporate Complexity and Systemic Risk: A Progress Report of shared services during a resolution. These entities are highly relevant from a resolu­ tion perspective, but with the exception of information included in the public sections of US Living Wills, current disclosures do not enable us to quantify their share of non-finan­ cial subsidiaries systematically. In conclusion, a large number of external and internal factors may explain the high num­ ber of controlled subsidiaries of most G-SIBs. Unfortunately, current disclosures impede a deeper analysis of the most important factors that motivate G-SIBs to form new sub­ sidiaries or continue existing subsidiaries. Undoubtedly, however, a considerable amount of this corporate complexity is attributable to regulation and taxation, policies that are generally set without regard to their impact on the opacity of corporate structures.

4.5 Policies to Enhance the Resolvability of GSibs The G20 laid out a two-pronged reform agenda. First, the G20 mandated a set of policies designed to reduce the probability that any G-SIB might become insolvent. These includ­ ed the requirement that G-SIBs maintain more and higher quality capital, increased risk weights on some positions and additional incentives to shift most derivatives trading to public exchanges, capital surcharges for G-SIBs, the introduction of a Total Loss-Absorb­ ing Capacity requirement, the establishment of a leverage ratio constraint, the introduc­ tion of liquidity requirements, heightened prudential supervision including oversight of contingent recovery plans, and the implementation of stress tests to ensure that the capi­ tal resources would be adequate even under highly stressful conditions.17 The G20 implicitly recognized that it was neither desirable, nor feasible, to set prudential standards so high that a G-SIB would never become insolvent. Thus, the second prong of the reform agenda focused on resolvability, including resolution plans, to ensure that every G-SIB would be safe to fail (Huertas, 2014). The FSB was assigned principal re­ sponsibility for developing a resolution infrastructure that would eliminate the obstacles to an orderly resolution that were evident in the collapse of LB and provide a way of en­ suring the continuity of systemically important functions, while allocating losses to share­ holders and creditors in a way that respects payment priorities in bankruptcy, without re­ liance on public resources. In response to this mandate from the G20, (p. 119) the KA were adopted in 2011 (FSB, 2011b).18 The GFC revealed that no country had established an ef­ fective resolution regime appropriate for G-SIBs and so KA set out goals that would re­ quire major reform efforts including new legislation in all jurisdictions. The KA require that each jurisdiction designate a resolution authority (or coordinated multiple resolution authorities) that should ensure the continuity of systemically impor­ tant financial services and payment, clearing and settlement functions; protect insured depositors and investors with segregated assets; respect the hierarchy of creditors;19 avoid unnecessary destruction of value; and seek to minimize resolution costs in the home and host jurisdictions. Resolution should be initiated when “a firm is no longer viable or Page 47 of 66

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Corporate Complexity and Systemic Risk: A Progress Report likely to be no longer viable, and has no reasonable prospect of becoming so.”20 The reso­ lution authority should have sweeping powers that no resolution authority had when the KA were adopted.21 These included powers to: remove and replace senior management and directors; appoint an administrator to take control and manage the firm in resolution; operate and resolve the firm, including the ability to terminate contracts, continue to as­ sign contracts, purchase or sell assets, write down debt and take other actions to restruc­ ture or wind down the firm’s operations; ensure continuity of essential services and func­ tions; override the rights of shareholders of the firm in resolution, including requirements for approval of restructuring measures; establish a temporary bridge institution to take over and continue operating critical functions and viable operations of the firm in resolu­ tion; establish a separate asset management vehicle to manage and run-down non-per­ forming loans or difficult-to-value assets; carry out bail-in of creditors of the failed institu­ tion to achieve continuity of essential functions by recapitalizing a newly established or bridge entity; temporarily stay the exercise of early termination rights that may be trig­ gered when the firm enters resolution; impose a moratorium on payments to unsecured creditors and some specified customers, and a stay on actions to attach assets, while pro­ tecting the enforcement of eligible netting and collateral agreements; and effect the clo­ sure and orderly liquidation of the whole or part of the failing firm with timely payout of insured deposits22 and prompt (for example, within seven days) access to transaction ac­ counts and to segregated client funds). Furthermore, the resolution authority should have: the authority to enter into (p. 120) agreements with resolution authorities in other jurisdictions; the obligation to take into account the impact on the group as a whole and on financial stability in other affected jurisdictions; and the obligation to make efforts to avoid actions that could reasonably be expected to trigger instability elsewhere in the group or in the financial system.23 The funding of firms in resolution received special emphasis to make clear that the public authorities should not bail out creditors as a means of resolving firms. If the authorities, nonetheless, provide temporary funding to maintain essential functions, any losses in­ curred should be recovered from shareholders and unsecured creditors or, if necessary, from the broader financial system in an ex post assessment. Any provision of temporary funds by the authorities should be subject to strict conditions that minimize moral haz­ ard. The KA acknowledged that some countries may choose to have the power to place a faltering firm under temporary public ownership and control to continue critical opera­ tions while seeking a permanent, private sector solution. But the KA caution this option should be deployed only as a last resort and any losses must be recovered from the firm’s shareholders and unsecured creditors or, if necessary, in an ex post assessment on the broader financial system. In 2015, the FSB (2015) instituted a Total Loss Absorbing Capacity (TLAC) standard to in­ crease the loss-absorbing capacity and facilitate the recapitalization of a G-SIB in resolu­ tion from its own pre-resolution capital structure. (Moreover, these additional resources may also ease the challenge of funding the group in resolution.) The TLAC standard de­

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Corporate Complexity and Systemic Risk: A Progress Report fines a minimum requirement for the instruments and liabilities that should be readily available for bail-in within a G-SIB resolution. Cross-border cooperation was notably absent in the LB resolution and so the KA placed special emphasis on the importance of building a framework to facilitate and sustain co­ operation. The KA specify that the resolution authority should be given a statutory man­ date to achieve a cooperative solution with foreign resolution authorities whenever possi­ ble. Legislation and regulation should not contain provisions that trigger automatic action in response to official intervention or the initiation of resolution proceedings in another jurisdiction, and national laws and regulations should not discriminate against creditors on the basis of their nationality, the location of their claims or the jurisdiction where the claims are payable. Nonetheless, the KA provide that jurisdictions may reserve the right to take discretionary national action to protect domestic stability if international coopera­ tion and information sharing prove inadequate. Along the same lines, the resolution au­ thority should have resolution powers over local branches of foreign firms and the capaci­ ty to use these powers to support a resolution carried out by a foreign home authority or, in exceptional cases, to take measures on its own initiative if the home jurisdiction does not take adequate account of the need to protect financial stability in the local jurisdic­ tion. The possibility that a local authority may choose to ring-fence a foreign firm’s assets to satisfy local creditors has led market participants to doubt that a cooperative (p. 121) cross-border solution will be achieved in a crisis.24 The KA stop short of prohibiting ringfencing, but attempt to discourage such behavior. This may be the best that could be achieved in the absence of any supra-national entity that could compel countries to coop­ erate, but it may not be enough to reassure markets in times of stress. In order to encourage cross-border cooperation, the KA require that home and key host authorities maintain a crisis management group (CMG) for each G-SIB with the objective of enhancing preparedness and facilitating the management and resolution of any crossborder crisis involving the G-SIB. The CMGs, which include supervisory authorities, cen­ tral banks and ministries of finance, should review, at least annually, progress in coordi­ nation and information sharing within the CMGs, recovery and resolution plans for the GSIB under institution-specific cooperation agreements and the resolvability of the G-SIB. Regular reports should be submitted to the FSB and the FSB Peer Review Council. The in­ stitution-specific cooperation agreements should: establish the objectives and processes for cooperation with the CMGs; define the roles and responsibilities of the home and host authorities pre-crisis and during a crisis; set up processes for information sharing before and during a crisis; develop processes for coordination in the development of Recovery and Resolution Plans for the G-SIB, including the parent and significant branches and subsidiaries; and set out procedures for timely information-sharing and consultation pro­ cedures between home and host countries. To boost confidence in the effectiveness of CMGs, the KA state the existence of such agreements should be made public. Jurisdic­

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Corporate Complexity and Systemic Risk: A Progress Report tions are also permitted to publish the broad structure of such agreements if all parties agree. The resolution authority, in coordination with the CMG, is responsible for making an on­ going assessment of the resolvability of each G-SIB.25 This requires an evaluation of the feasibility of resolution strategies planned for each G-SIB and their credibility in light of the likely impact on the financial system and real economy if the resolution strategy is im­ plemented. The resolution authority should assess: the extent to which critical financial services, payment, and clearing and settlement functions can be performed; the nature and extent of intra-group exposures and their impact on resolution if they need to be un­ wound; the capacity of the group to deliver sufficiently detailed, accurate and timely in­ formation to facilitate resolution;26 and the robustness of cross-border agreements within the CMG. The KA require that the resolution or supervisory authorities should have the power to improve a group’s resolvability by requiring changes in a G-SIB’s business practices, structure or organization to reduce the complexity and costliness of resolution. In particu­ lar, the authorities should evaluate whether to require a G-SIB’s functions be (p. 122) seg­ regated in legally and operationally independent entities that are shielded from problems in the rest of the group. Although the exercise of such powers may result in a reduction of the number of subsidiaries, it is also possible that a requirement to segregate functions in legally and operationally independent entities may increase the number of subsidiaries. A prime example of this approach is Great Britain, which has required its large clearing banks to ring-fence their domestic retail activities and form a separate legal entity to con­ duct all other business. The US has added to this pressure to increase the number of le­ gal entities by requiring that large foreign banks in the United States form an intermedi­ ate holding company in the US. The foregoing summary has provided only a broad-brush overview of an ambitious and complex international agenda to strengthen the infrastructure for resolving G-SIBs. An external analyst faces insuperable challenges in evaluating progress in the implementa­ tion of such a complicated set of policy reforms, yet it is essential for market participants to have confidence that these measures are being implemented and that they will make it feasible for the authorities to resolve any G-SIB without public subsidy and intolerable spillovers. If market participants lack confidence that an orderly resolution of G-SIBs is feasible, such institutions will continue to benefit from an implicit public subsidy, which provides them with an incentive to become still larger and more complex. The FSB makes regular public reports to the G20 on progress in implementing the KA. The sixth and most recent report (FSB, 2017a) concludes that only a subset of the FSB ju­ risdictions have adopted bank resolution regimes with comprehensive powers consistent with the KA.27 Fortunately this subset includes most of the jurisdictions in which G-SIBs are headquartered, but the majority of FSB jurisdictions have not yet implemented re­ forms consistent with the KA. The FSB notes particular lags in implementation of bail-in powers, powers to impose a temporary stay on the exercise of early termination rights Page 50 of 66

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Corporate Complexity and Systemic Risk: A Progress Report and powers to require changes to banks’ structures and operations to improve resolvabili­ ty. CMGs have been established for all G-SIBs, but cross-border cooperation agreements have been signed for only 70 percent of G-SIBs, and operational resolution plans have been developed for only 70 percent of G-SIBs. The report also identifies operational and financial interdependencies within G-SIBs as potential impediments to the resolvability and restructuring of a G-SIB, a problem that was clearly apparent in the LB bankruptcy. Moreover, the report notes that booking mod­ els employed by G-SIBs could hinder the separation of business lines and legal entities in a restructuring and winding-down of derivatives and trading activity during resolution, a problem which also clearly impeded the bankruptcy resolution of LB. The report (FSB, 2017a, p. 16) concludes that “The complexity and interconnectedness of G-S[IB]s pose challenges to resolvability. Despite changes to legal and operational structures in the case of some G-S[IB]s, the complexity of organizational structures and high degree of in­ ternal and external (financial and operational) interconnectedness remain important chal­ lenges to resolvability.” While the overview of progress in implementation of the resolution reforms pro­ vided by the FSB provides general insights about progress in implementing the KA, it (p. 123)

lacks sufficient detail to reassure market participants about the resolution prospects of individual G-SIBs in the event of a crisis. Unfortunately, most countries have done little or nothing to disclose information about the resolvability of individual banks. The striking exception is the United States, where G-SIBs are required to make public a section of their Living Will submissions and the authorities have posted letters to each G-SIB ex­ pressing their view on the progress—or lack of progress—the G-SIB has made in achiev­ ing resolvability. This degree of transparency far surpasses that in the rest of the world. And, although the transparency has steadily improved in the US, no other country ap­ pears to have followed the US lead. Disclosures about US-based G-SIBs enable us to draw additional insights into progress made in improving the resolvability of these banks and so this section concludes with a brief overview of the Living Will process in the United States. The Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010 (DFA) provided the resolution au­ thority in the US with the full set of powers detailed in the KA. But resolution policy has taken a distinctive pattern in the US, because the DFA requires that each G-SIB demon­ strate how it could be resolved under bankruptcy procedures without recourse to public assistance. This is a particularly tough standard because most experts agree that current bankruptcy laws are not well suited to the need for speed in resolving a G-SIB active in global financial markets. Markets tend to move at lightning speed in contrast to the usual deliberate pace of bankruptcy courts, which tend to place heavy emphasis on due process. Without measures to accelerate and simplify the bankruptcy process, most of the going concern value of a G-SIB could be lost as creditors and counterparties flee the insti­ tution in a disorderly scramble.

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Corporate Complexity and Systemic Risk: A Progress Report The House of Representatives has passed legislation to create a new chapter of the US bankruptcy code28 better suited to the speed with which a large financial institution must be resolved to minimize spillovers and loss, but the Senate has not addressed the prob­ lem and so the legislation remains in limbo as of October 2018. In the meanwhile, sub­ stantial efforts have been made to design procedures under which a G-SIB could be suc­ cessfully resolved under existing bankruptcy law.29 The success of such procedures, how­ ever, depends crucially on structuring banks so that they are resolvable under the con­ straints imposed by Congress. The Living Will process in the US has emphasized restruc­ turing banks to make bankruptcy a feasible resolution strategy. The proposal to employ current bankruptcy procedures to US G-SIBs builds on a resolu­ tion strategy developed jointly by the Federal Deposit Insurance Corporation and the Bank of England (2012) termed the Single Point of Entry (SPOE). The SPOE is designed to enable a G-SIB to be resolved without threatening financial stability and (p. 124) with­ out putting public funds at risk. It is a top-down strategy to be applied by a single resolu­ tion authority to the top of the financial group, while permitting systemically important operations to continue. In the US, the strategy would apply a single receivership to the top-level holding company, assigning losses to shareholders and unsecured creditors of the holding company, and transfer sound operating subsidiaries to a solvent bridge insti­ tution, which would restructure the operations to maintain as much going-concern value as possible for creditors. The strategy finesses the complexities of dealing with a welter of intermediate holding companies and subsidiaries by focusing the resolution process on the top-level holding company. In so doing, it neatly separates the financial problem of a non-viable bank from the much more complicated underlying problems with its business model and operations. With proper preparation, the financial problem—capitalizing a suc­ cessor bridge institution—could be achieved relatively quickly without risk to public funds by converting a sufficient amount of the unsecured debt of the non-viable holding compa­ ny into equity for the new bridge institution. The solvent successor bridge institution would then undertake the much more time-consuming process of restructuring the bank through shrinking lines of business causing distress or breaking the group into smaller entities and closing or selling certain operations. Although the SPOE was originally designed for use by the FDIC, if it should be obliged to resolve a G-SIB under Title II of the DFA, subsequent analysis has shown how the concept could be applied to a bankruptcy proceeding. The preconditions for executing an SPOE have largely determined the requirements for Living Wills prepared by US G-SIBs. These include: establishing a “clean holding company” that issues debt and equity for the group, but has no operational responsibilities; ensuring that the holding company has issued a sufficient amount of unsecured debt to enable it to recapitalize a faltering subsidiary; ne­ gotiating agreements with jurisdictions that host material entities of the G-SIB that per­ mit the US to control the resolution process so long as the interests of host-country credi­ tors are protected; rationalizing the structure of G-SIBs to ensure that critical shared ser­ vices will continue to be provided to the successor bridge entity after the bankruptcy peti­ tion is filed; and designing mechanisms to make sure the bankruptcy filing is made while Page 52 of 66

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Corporate Complexity and Systemic Risk: A Progress Report the G-SIB still has adequate capital and liquidity to fund the resolution without reliance on public funds. Under the terms of the DFA, G-SIBs are required to submit Living Wills to the Federal Re­ serve Board (Fed) and FDIC, detailing how they could be resolved through bankruptcy. These submissions are massive, sometimes involving tens of thousands of pages, but they must include a summary of the G-SIB’s resolution strategy and resolvability preparedness that is made public. The Fed and FDIC evaluate feasibility and credibility of these plans and provide feedback to each institution about measures it should take to ensure that it will be resolvable under bankruptcy. G-SIBs take this feedback quite seriously because the DFA provides the authorities with the power to take punitive measures, including re­ strictions on payouts to shareholders, restraints on growth or directives to divest lines of business, if the Fed board and the FDIC board each conclude that a G-SIB’s Living Will is not credible. Initially the feedback from the (p. 125) authorities to each individual G-SIB was strictly confidential, but in the most recent round of reviews, feedback letters have been released to the public, thus providing important, additional details about measures that each G-SIB must take to improve its resolvability. This has greatly enhanced the credibility of the process since the institution-specific comments are detailed and indicate that the authorities are examining the submissions carefully.30 In the first round of submissions, the public sections of Living Wills conveyed little new information relevant to resolvability. Terminology was not standardized, and disclosures were quite ad hoc, providing little basis for meaningful comparisons and little information that was not already publicly available. Table 4.5 summarizes some of the key features of the public sections of Living Wills released in 2017. The bottom two rows of the table pro­ vide a crude measure of how these public disclosures have expanded. The July 2012 and 2013 submissions averaged thirty-one pages. In contrast, the July 2017 submissions aver­ aged 108 pages. More importantly disclosures were much more relevant to assessing an institution’s resolvability and somewhat easier to compare, although still not standard­ ized.

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Corporate Complexity and Systemic Risk: A Progress Report (p. 127)

(p. 126)

Table 4.5 Public Sections of Resolution Plans of the 8 US G-SIBs (July 2017): Key Selected Informa­

tion Bank of America

Bank of New York Mellon

Citi­ group

Gold­ man Sachs

JPMor­ gan Chase

Morgan Stanley

State Street

Wells Fargo

List of material entities

X

X

X

X

X

X

X

X

Descrip­ tion of business of materi­ al enti­ ties

X

X

X

X

X

X

X

X

Finan­ cials of material entities

X

X

X

X

X

X

X

X

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Corporate Complexity and Systemic Risk: A Progress Report Mapping between material entities and busi­ ness lines

X–

Organiza­ tional hi­ erarchy before resolu­ tion

X–

X–

X

X (simpli­ fied)

Organiza­ tional hi­ erarchy after res­ olution

X

X (simpli­ fied)

Inter-af­ filiate ex­ posures/ funding

X (quali­ tative)

X (quali­ tative)

X–

X (quali­ tative)

X

X+

X–

X

X

X

X

X– (sim­ plified)

X

Not ma­ terial

X (quali­ tative)

X (quali­ tative)

X

X– (quali­ tative)

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Corporate Complexity and Systemic Risk: A Progress Report Critical services by legal entity

X

X+

X+

X+

X

X+

X

X+

X+

X

X

X

Material entities opera­ tional in­ tercon­ nected­ ness

X–

Participa­ tion in FMUs

X

X

X

X

X

X

X

X+

No. pages public section resolu­ tion plan 2017 (Ju­ ly)

87

121

125

116

170

108

70

66

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Corporate Complexity and Systemic Risk: A Progress Report No. pages first pub­ lic sec­ tion of resolu­ tion plan (July 2012 or 2013)

42

24

32

32

33

31

22

28

Source: Authors’ assessment of public sections of resolution plans (July 2017). An “X” indicates that information is included. An “X+” indicates that the quality of information is relatively higher when compared to peers. An “X–” in­ dicates that the quality of information is relatively lower when compared to peers. “Simplified” means that the infor­ mation on organizational hierarchy is included but is less detailed than information provided by peers. “Qualitative” means that the information provided is mostly of a qualitative nature. “FMUs” are financial market utilities, which provide the infrastructure for transferring, clearing, and settling payments, securities, and other financial transac­ tions among financial institutions.

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Corporate Complexity and Systemic Risk: A Progress Report In the 2017 round of disclosures, all eight US G-SIBs listed and described each of their material entities including relevant financial data, which was an important advance. Each G-SIB attempted to map its lines of business in to its material entities, but the approaches varied markedly across banks with some banks providing information that is difficult to assess. Attempts were made to represent inter-affiliate exposures and operational inter­ connectedness among material entities, but it was difficult to make any comparisons across G-SIBs. Some banks did an excellent job of identifying critical services provided by each material entity, but others did not provide such disclosures. Disclosure of participa­ tion in financial market utilities was relatively consistent across all eight G-SIBs. Clearly “best-practice” standards are evolving, but certainly the improvement from the first round of disclosures in 2012 and 2013 is remarkable. While these improvements in disclosure are welcome, gaps remain. It is useful to know which entities the G-SIB regards as material, but this leaves open the question of the role and importance of the majority of subsidiaries that are not designated as material. These subsidiaries should be categorized and an explanation provided about why each category is irrelevant to the resolvability of the group. In addition, the data collected by the SEC and the Fed should be reconciled and the criteria for classification should be clearly de­ fined. For example, the Fed includes entities that are “of interest” even though they are not controlled subsidiaries and no explanation is provided about why they are of interest. This lack of clarity makes it impossible for an external analyst to reconcile the Fed’s data with other publicly available sources.

4.6 Conclusions This chapter offers a progress report on the number of subsidiaries controlled by G-SIBs, ten years after the GFC. The previous two editions of this chapter had documented the corporate complexity of G-SIBs just before the GFC and five years later and showed that the number of controlled subsidiaries had not decreased despite the initiation of an ambi­ tious reform agenda designed to enhance the resolvability of G-SIBs. This chapter pro­ vides new data, showing again that, despite some simplification, our proxy for corporate complexity remains very high. Furthermore, the obstacles that such corporate complexity might pose to an orderly resolution may be underestimated because we have not been able to collect consistent data on foreign branches of G-SIBs, which may create problems in resolution. It is likely that our measure of corporate complexity has remained high because G-SIBs have compelling incentives to maintain large numbers of controlled subsidiaries. The in­ ternal and external drivers influencing the decision to form controlled subsidiaries, exam­ ined in section 4.4, have not changed. G-SIBs may still decide to create separate sub­ sidiaries to deal with asymmetric information issues; they can still be involved in large M&A with large and persisting effects on their corporate structures; they are still con­ strained by rules imposing some form of corporate separateness both domestically and in

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Corporate Complexity and Systemic Risk: A Progress Report foreign jurisdictions; and cross-jurisdictional differences in tax regimes and accounting and disclosure rules continue to motivate G-SIBs to adopt complex corporate structures. Nonetheless, some G-SIBs have made significant efforts to simplify and rationalize their corporate structures. Undoubtedly, regulatory pressure and, in some cases, market forces have played a role. Fed/NIC data show a strong reduction in the number of controlled subsidiaries for most US G-SIBs, which may well be a result of the regular Living Wills evaluations in the US. Several other G-SIBs headquartered outside the US have also re­ duced the number of their controlled subsidiaries, but this trend is not uniform across GSIBs and some G-SIBs have substantially increased their number of controlled sub­ sidiaries. Our comparison of the data on the corporate structures of US G-SIBs reported in the BvD and the Fed/NIC databases revealed troubling discrepancies which we have not been able to resolve. In part this is because the criteria and methodology for constructing these databases are particularly complex. This is surprising since it should be quite straightfor­ ward to report the number of legal entities controlled by each G-SIB. Of course, other as­ pects of complexity such as operational and financial interdependencies are much more difficult to measure in principle and we lack any consistent, systematic data to make com­ parisons across G-SIBs. These shortcomings in the data impede deeper analysis and ham­ per a better understanding of how opaque and complex corporate structures may affect the resolvability of G-SIBs and their implications for systemic risk. (p. 128) One of the ob­ jectives stated in the FSB KA was to improve transparency regarding the structure and resolvability of G-SIBs to facilitate market discipline on these institutions and eliminate any implicit too-big-to fail subsidy. It is difficult to see how this objective can be fully achieved without more systematic disclosures regarding the resolution strategies and the resolvability of G-SIBs. The US has led the way improving disclosures of the relevant data through the public sec­ tions of Living Wills and supervisory evaluations of the Living Will submissions but, as of October 2018, no other country has followed this precedent. While the US disclosures could be improved by standardizing classification criteria and reporting formats, public information relevant to evaluating the resolvability of US G-SIBs is markedly better than for any G-SIB headquartered outside the US (as this chapter was being prepared, living wills disclosure was announced also in the United Kingdom). A useful first step for improving our understanding of the aspects of corporate complexity that we have analyzed in this chapter is the establishment of a definitive database on the corporate structures of G-SIBs that applies a consistent,31 transparent methodology to all G-SIBs and is made publicly available in a format that can be easily analyzed. These data should include all key information on organizational hierarchies, the name, business, lo­ cation, financials, and intra-group connections and exposures for each subsidiary. Given the key role of the BCBS and the FSB in the identification and regulation of G-SIBs, these institutions would appear as the most natural candidates to collect, manage and post these data. Page 59 of 66

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Corporate Complexity and Systemic Risk: A Progress Report The establishment of this data set at the FSB or BCBS would also facilitate inclusion of a more direct measure of corporate complexity in the methodology for the identification of G-SIBs. The most recent revision of the G-SIB methodology (BCBS, 2018, p. 6) states “The systemic impact of a bank’s distress or failure is expected to be positively related to its overall complexity—that is, its business, structural and operational complexity.” Yet, the three proxies the current methodology employs to measure complexity—the notional val­ ue of OTC derivatives, the amount of Level 3 assets,32 and the value of the trading book and available-for-sale assets—omit any indicator of the complexity (p. 129) of corporate structure.33 This omission might not be important if corporate complexity were perfectly correlated with the complexity of a bank’s assets as reflected in its OTC derivatives, Level 3 assets and trading and available for sale book, but it is not. Carmassi and Herring (2016a) have shown that the correlation of these measures with the number of sub­ sidiaries is far from perfect. The LB bankruptcy demonstrated the crucial importance of the number and location of the group’s separate legal entities. It is surely time to address the omission of corporate complexity in the methodology for the identification of G-SIBs.

References Avraham, D., Selvaggi P., and Vickery J. I. (2012). “A Structural View of U.S. Bank Holding Companies,” Federal Reserve Bank of New York Economic Policy Review, 18(2), 65–81. Basel Committee on Banking Supervision (BCBS) (2011). “Global Systemically Important Banks: Assessment Methodology and Higher Loss Absorbency Requirement - Rules Text,” November. Basel Committee on Banking Supervision (BCBS) (2018). “Global Systemically Important Banks: Revised Assessment Methodology and the Higher Loss Absorbency Requirement,” July. Carmassi, J. and Herring, R. J. (2015). “Corporate Structures, Transparency and Resolv­ ability of Global Systemically Important Banks,” Systemic Risk Council, Washington, DC, January 27. Carmassi, J. and Herring, R. J. (2016a). “The Corporate Complexity of Global Systemically Important Banks,” Journal of Financial Services Research, 49, 175–201. Carmassi, J. and Herring, R. J. (2016b). “The Cross-Border Challenge in Resolving Global Systemically Important Banks,” in K. Scott, T. Jackson, and J. Taylor (eds.), Making Failure Feasible (Stanford, CA: Stanford University Press), 249–75. Cetorelli, N. and Goldberg, L. S. (2014). “Measures of Global Bank Complexity,” Economic Policy Review, 20(2), Special Issue on Large and Complex Banks, March 31. Dermine, J. (2006). “European Banking Integration: Don’t Put the Cart Before the Horse,” Financial Markets, Institutions & Instruments, 15, 57–106. Financial Stability Forum (2000). Press Release, May 26, 2000. Page 60 of 66

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Corporate Complexity and Systemic Risk: A Progress Report Financial Stability Board (FSB) (2011a). “Policy Measure to Address Systemically Impor­ tant Financial Institutions,” Press Release, November 4. FSB (2011b). “Key Attributes of Effective Resolution Regimes for Financial Institutions”, November 4. The version referenced in the text was updated in October 2014, and is available at: https://www.fsb.org/wp-content/uploads/r_141015.pdf FSB (2015). “Total Loss-Absorbing Capacity (TLAC) Principles and Term Sheet,” Novem­ ber, available at: https://www.fsb.org/wp-content/uploads/TLAC-Principles-andTerm-Sheet-for-publication-final.pdf FSB (2017a). “Ten Years On—Taking Stock of Post-crisis Resolution Reforms,” Sixth Re­ port on the Implementation of Resolution Reforms, July 6. FSB (2017b). “2017 List of Global Systemically Important Banks (G-SIBs),” November 21. Goodman, L., Lucas, D., and Fabozzi, F. (2007). “Financial Innovations and the Shaping of Capital Markets: The Case of CDOs,” Journal of Alternative Investments, 10(1), 62–70. (p. 130)

Haldane, A. G. and Alessandri, P. (2009). “Banking on the State,” paper based on a pre­ sentation delivered at the Federal Reserve Bank of Chicago Twelfth Annual International Banking Conference on “The International Financial Crisis: Have the Rules of Finance Changed?” Chicago, September 25. Herring, R. J. and Carmassi, J. (2010). “The Corporate Structure of International Financial Conglomerates: Complexity and its Implications for Safety & Soundness,” in A. N. Berger, P. Molyneux, and J. O. S. Wilson (eds.), Oxford Handbook of Banking (Oxford: Oxford Uni­ versity Press). Herring, R. J. and Carmassi, J. (2014). “Complexity and Systemic Risk: What’s Changed Since the Crisis?” in A. N. Berger, P. Molyneux, and J. O. S. Wilson (eds.), Oxford Hand­ book of Banking, 2nd edn (Oxford: Oxford University Press). Herring, R. J. and Santomero, A. M. (1990). “The Corporate Structure of Financial Con­ glomerates,” Journal of Financial Services Research, 4(4), December, 471–97. Huertas, T. F. (2014). Safe to Fail: How Resolution Will Revolutionise Banking (London: Palgrave Macmillan). Hume, N. (2011). “Protium’s Acid Reflux (updated),” FT Alphaville, April 28, available at: http://ftalphavilled.ft.com/2011/04/28/555611/protiums-acid-reflux/. King, M. (2010). “Banking from Bagehot to Basel, and Back Again,” Second Bagehot Lec­ ture, Buttonwood Gathering, New York City, October 25, available at: https:// www.bankofengland.co.uk/speech/2010/banking-from-bagehot-to-basel-and-backagain-speech-by-mervyn-king

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Corporate Complexity and Systemic Risk: A Progress Report Laeven, L., Ratnovski, L., and Tong, H. (2014). “Bank Size and Systemic Risk,” IMF Staff Discussion Note, SDN/14/04, May. Scott, K. E. and Taylor, J. B. (2012). “Bankruptcy Not Bailout: A Special Chapter 14”, Hoover Institution. Wharton Financial Institutions Center (2016). “Resolution of Global Systemically Impor­ tant Financial Institutions Under the Bankruptcy Code,” Briefing materials, available at: https://fic.wharton.upenn.edu/resolution-under-bankruptcy/.

Notes: (1) The Basel Committee on Banking Supervision (BCBS) published the methodology for identifying G-SIBs in July 2011 (BCBS, 2011) and the Financial Stability Board (FSB, 2011a) published the first official list of G-SIBs, initially termed Global Systemically Im­ portant Financial Institutions, in November 2011. Of necessity, the first edition of this chapter relied on a slightly different classification, Large and Complex Financial Institu­ tions (LCFIs), developed by the Bank of England and the International Monetary Fund be­ fore the G-SIB concept was introduced. Thirteen of the sixteen institutions identified as LCFIs in 2007 survived the crisis and all thirteen of these survivors were listed among the twenty-nine G-SIBs identified in 2011. For simplicity, we have dropped the LCFI terminol­ ogy and refer only to G-SIBs. (2) Admittedly, this is a very simplistic indicator of corporate complexity, but it remains the only indicator that can be measured with any degree of accuracy. We have relied on Bureau Van Dijk (BvD) data (first Bankscope, then Orbis and BankFocus), because they provide information about the full international set of G-SIBs using a clear methodology that is consistent across countries and banks. Although SEC filings and the FED/National Information Center data are available for the eight US G-SIBs, each of these sources uses a different methodology, which produces different results for the number of controlled subsidiaries. These results differ—not only from each other but also from the BvD data. See Carmassi and Herring (2015) for a detailed comparison of data and criteria across BvD, FED/NIC data and SEC filings. (3) The ten jurisdictions that have such powers are France, Germany, Hong Kong, Italy, Japan, The Netherlands, Spain, Switzerland, the United Kingdom and the United States. (4) The BvD dataset also provides the possibility of using a 25 percent threshold, but we have chosen the more conservative option. (5) For example, in 2012 banks in the US were required for the first time to file resolution plans with the regulators. In Europe, the new resolution framework, which includes reso­ lution planning, was adopted only in 2014. (6) ICBC, China Construction Bank, the Agricultural Bank of China and the Royal Bank of Canada have been added to the list, while two of the institutions designated as G-SIBs in 2012—BBVA and BPCE—were no longer classified as G-SIBs in 2017. We have retained Page 62 of 66

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Corporate Complexity and Systemic Risk: A Progress Report BBVA and BPCE in our sample to broaden our analysis of how the number of controlled subsidiaries has evolved. (7) Data on foreign revenues/income are not fully comparable across G-SIBs because, due to data availability issues, different measures had to be used for different banks (e.g., op­ erating income, income before taxation, etc.). (8) For simplicity, in the following text we will refer to 2013 and 2018 data without speci­ fying the month. Because the Agricultural Bank of China, the China Construction Bank and the Royal Bank of Canada were not classified as G-SIBS in 2012, we did not down­ load data on their corporate structures from the BvD database in May 2013 when we per­ formed our analysis for the second edition of this chapter. Unfortunately it is difficult and costly to retrieve historical BvD data and so we show only data from July 2015, which are the oldest data we have for these institutions. (9) The BvD database amalgamates earlier Bankscope data with Orbis and BankFocus da­ ta. (10) One of the criteria for the inclusion of subsidiaries in the FED/NIC lists is a definition of control under Regulation Y, which is essentially a 25 percent control. However, addi­ tional entities that meet FR Y-10/10F “reportability criteria” are included, as well as enti­ ties for which the relationship is “of interest to the Federal Reserve.” These latter two conditions make it challenging to fully understand how the FED/NIC lists are built and how they compare to the lists provided by other datasets such as BvD. The FED/NIC dataset offers, however, a key benefit relative to other sources, because it appears to be the only database that provides historical data on corporate structures (which can be downloaded at any point in time). Unfortunately, the FED/NIC dataset covers only US banks and the US operations of non-US banks and it does not report the financials of sub­ sidiaries. (11) This section is largely based on Carmassi and Herring (2016a). For a more complete discussion see chapter 4 in the second edition of this Handbook. (12) One example is the proliferation of vehicles for issuing Trust Preferred Securities (TruPS) (Goodman, Lucas, and Fabozzi, 2007). (13) The history of JPMorgan Chase provides a good example of how mergers may in­ crease corporate complexity. (14) These entities are active in a very broad range of business, including real estate, healthcare, agriculture, textiles, grocery stores, wine wholesalers, energy corporations, and jewelry stores. (15) The inclusion of this entity in the list of subsidiaries of Standard Chartered may par­ tially explain the sharp rise in Standard Chartered’s number of controlled subsidiaries from 2013 to 2018.

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Corporate Complexity and Systemic Risk: A Progress Report (16) Presumably the resolution authorities are making the appropriate adjustments in their analysis, but in the interests of transparency, and to facilitate public understanding of the resolution process, this information should be publicly disclosed. (17) See Herring and Carmassi (2014) and Carmassi and Herring (2015) for additional dis­ cussion of these initiatives and associated references. This section will focus on the sec­ ond prong of the reform agenda, that is, the measures to establish credible resolution policies. (18) The KA were adopted at a meeting of the FSB in October 2011 and endorsed by the G20 Heads of State and Government at the Cannes Summit in November 2011. The KA are intended to apply to all systemically important financial institutions, but this discus­ sion focuses only on G-SIBs, the firms which have received the most attention. (19) In practice, this means that creditors should have a right to compensation where they do not receive at least as much as they would have received in a liquidation of the firm under the applicable insolvency regime. (20) This concept is remarkably vague and probably reflects success in achieving agree­ ment through the avoidance of excessively clear language. But it may lead to markedly different points of intervention if each jurisdiction develops its own interpretation of when intervention is necessary. (21) The following selective summary of resolution powers, funding of firms in resolution, and cross-border cooperation is based on FSB (2011b, pp. 5–15). (22) Although the FDIC has long followed the practice of enabling access to insured de­ posits the next business day after intervention, for authorities in most other jurisdictions assuring access within seven days was a stretch goal. This, of course, undermines the role of deposit insurance in preventing runs. (23) Of course, this sort of consideration was notably absent in the US resolution of Lehman Brothers. (24) See Carmassi and Herring (2016b) for an extensive discussion of ring-fencing issues. (25) The KA regard a G-SIB as “resolvable” if it is feasible and credible for the resolution authorities to resolve it in a way that protects systemically important functions without severe systemic disruption and without exposing taxpayers to loss. An evaluation of the resolvability of a G-SIB is a judgment about the extent to which it can be regarded as re­ solvable. (26) Virtually no relevant information was available when LB applied for bankruptcy and so the authorities particularly emphasized this requirement. (27) This document summarizes the findings from the third Resolvability Assessment Process for G-SIBs completed in 2017. Page 64 of 66

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Corporate Complexity and Systemic Risk: A Progress Report (28) The legislation is based on a proposed Chapter 14 of the bankruptcy code specifically designed for large financial institutions. The proposal, developed by the Hoover Institu­ tion Resolution Project, is described in Scott and Taylor (2012). (29) For an overview of how this might be accomplished see Wharton Financial Institu­ tions Center (2016). (30) The credibility of the process was also enhanced when some submissions were judged “not credible” and improvements were required. In December 2016, the Fed and the FDIC imposed restrictions on the growth of international and non-bank activities of Wells Fargo, due to deficiencies on “legal entity rationalization” and “shared services.” Wells Fargo subsequently remediated these deficiencies. (31) Consistent, transparent criteria are crucial for addressing one of the major problems marring currently available data—the lack of common, clear criteria for the identification of the subsidiaries of G-SIBs. (32) “Level 3 Assets” are an accounting category of assets that must be reported at cur­ rent value, but cannot be valued at market prices determined in broad, deep financial markets or on the basis of straightforward models linked to current market prices. Level 3 Assets are distinguished from Level 1 Assets (which are valued from readily observable market prices and can thus be “marked-to-market”) and from Level 2 Assets (which are valued based on models that rely on readily observable market inputs and are thus “marked-to-matrix”). In contrast, Level 3 Assets are not actively traded, like Level 1 As­ sets, and have a more tenuous relationship to actively traded assets than Level 2 assets. The values of Level 3 Assets are estimated based on complex models that rely heavily on subjective assumptions and are described as “marked-to-model” or, more cynically, “marked-to-management.” The category typically includes distressed debt, private equity, complex, bespoke derivatives contracts and other illiquid assets. The BCBS has used Lev­ el 3 Assets as one of its proxies for complexity in the identification of G-SIBs, because these assets would be likely to impede an orderly resolution. In general, Level 3 Assets are heavily concentrated on the books of large, international banks. (33) To some extent, the indicators for cross-jurisdictional activity—cross-jurisdictional claims and cross-jurisdictional liabilities—reflect a degree of international corporate com­ plexity, but they are simply measures of financial claims and do not convey any informa­ tion about the legal entities that transact these claims, which would be the focus of a res­ olution. The number of jurisdictions where a G-SIB has subsidiaries or branches would be more relevant but it is only included as ancillary indicator.

Jacopo Carmassi

Jacopo Carmassi is a Senior Financial Stability Expert in the Financial Regulation and Policy Division, DG Macroprudential Policy and Financial Stability, at the Euro­ pean Central Bank. He is a Fellow of CASMEF, the Arcelli Center for Monetary and Financial Studies, University LUISS Guido Carli, and a Fellow of the Wharton Finan­ Page 65 of 66

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Corporate Complexity and Systemic Risk: A Progress Report cial Institutions Center, University of Pennsylvania. Previously, he worked as an econ­ omist at Assonime, the Association of Joint Stock Companies incorporated in Italy, and at the Italian Banking Association. He holds a Ph.D in Law and Economics from University LUISS Guido Carli of Rome. He is author of several publications on bank­ ing and financial regulation topics, including the 2007–9 Global Financial Crisis, bank capital rules, bank crisis resolution, deposit insurance, banking union in Eu­ rope, and the corporate complexity of Global Systemically Important Banks. Richard J. Herring

Richard J. Herring is Jacob Safra Professor of International Banking and Professor of Finance at The Wharton School, University of Pennsylvania, where he is also Director of The Wharton Financial Institutions Center. Outside the University he serves on the FDIC Systemic Risk Advisory Committee and the Systemic Risk Council. His research focuses on banking and financial market regulation and supervision.

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Corporate Governance and Culture in Banking

Corporate Governance and Culture in Banking   Jens Hagendorff The Oxford Handbook of Banking (3rd edn) Edited by Allen N. Berger, Philip Molyneux, and John O. S. Wilson Print Publication Date: Oct 2019 Subject: Economics and Finance, Financial Economics Online Publication Date: Nov 2019 DOI: 10.1093/oxfordhb/9780198824633.013.5

Abstract and Keywords Banks differ from non-financial firms. These differences affect the manner of agency con­ flicts between the various bank stakeholder groups compared with non-financial firms. However, the main corporate governance arrangements used in the banking industry to mitigate these agency conflicts are largely similar to those of non-financial firms. A case in point is executive compensation. No other major industry has less equity on the bal­ ance sheet than banking. However, executive pay in banking is linked to shareholder wealth just as in other industries thus exacerbating existing incentives for bank managers to shift risk. Further, the governance arrangements in banking make the corporate cul­ ture prevailing in banks an important subject to study. This chapter reviews the literature on corporate governance in banking with a focus on those aspects of corporate gover­ nance in which banks (should) differ from non-financial firms, that is, executive compen­ sation, the composition of the board of directors, and culture in banks. The chapter en­ courages a more profound rethink of the corporate governance of banks. Keywords: banks, corporate culture, corporate governance, diversity, executive compensation, incentive compen­ sation

5.1 Introduction CORPORATE governance deals with the ways in which outside investors and other stake­ holders, such as government and employees, exercise control over senior management and other corporate insiders in order to protect their interests. The seminal work by Jensen and Meckling (1976) describes the frictions between corporate insiders and share­ holders as well as between equity holders and external firm creditors over the desired level of firm risk. In a nutshell, since shareholders hold residual claims over a firm’s as­ sets, they have incentives to increase firm risk. While shareholders benefit from pursuing risk-increasing policies (they benefit from any upside potential in the value of their equi­ ty), external firm creditors stand to bear losses without the prospect of wealth gains from higher risk. Page 1 of 24

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Corporate Governance and Culture in Banking Banks differ from non-banking institutions in many important ways. The nature of their core activities is information-based and highly opaque, their capital structure is geared toward debt much more than any other major industry, and governments are an impor­ tant stakeholder in banks, both as regulators and as a fiscal backstop, for instance, through the lender of last resort function (Calomiris and Carlson, 2016). This suggests that the corporate governance of banks should be different from that of non-financial firms to reflect the differences between banks and non-banking firms. Perhaps surprisingly, it is not the case that bank governance is greatly different from the corporate governance arrangements of other firms. While certain aspects of bank gover­ nance are unique for banks (for instance, there are restrictions on bank ownership or bank capital structure when regulators limit leverage in some countries), most key (p. 132) aspects such as the organization of the board of directors or the way in which se­ nior executives are paid is more or less in line with that of non-financial firms. Hence, many governance devices in the banking sector mimic those of non-financial firms quite closely without taking the unique features of banks sufficiently into account. As this chap­ ter will argue, this can be problematic if, for instance, overly shareholder-focused gover­ nance is applied to a highly leveraged industry such as banking. Before the financial crisis started in 2007, research into the nature and effects of corpo­ rate governance in banks was disparate and scattered across different journals and sub­ disciplines of finance, management, and economics (see Haan and Vlahu, 2016 for an overview of these different streams of research). With some exceptions, work on the cor­ porate governance of banks rarely made it into the most prestigious academic journals, perhaps reflecting what, until recently, was a widespread view that the corporate gover­ nance of banks is a niche subject and that banks are not sufficiently different from other firms to warrant a separate investigation of their corporate governance arrangements. The result is that a coherent body of empirical findings, which advances our understand­ ing of this subject area and serves as a basis for sound policy advice, has been missing to date. However, banking is increasingly becoming an industry with corporate governance stan­ dards that differ from those in place in other industries. This demonstrates that, from a policymaking view, a new consensus has emerged that the corporate governance of bank­ ing firms deserves special and separate attention because of its importance for bank creditors, the taxpayer, and the real economy. Some examples of recent governance rules and codes targeted at the banking industry in­ clude the following. In the UK, a review conducted by Sir David Walker regarding the cor­ porate governance in UK banks and other financial institutions has made recommenda­ tions on board arrangements and the qualifications of board members as well as on the compensation arrangements of UK banks and financial firms. Partly following on from this, the 2009 UK Remuneration Code required executives of UK banks to defer a larger portion of their bonus compensation and introduced performance-vesting conditions for these bonuses. In February 2013, the UK Remuneration Code was followed by an EU-wide Page 2 of 24

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Corporate Governance and Culture in Banking bonus cap for banks that restricted the variable part of total compensation to 100 percent of the fixed component (see Kleymenova and Tuna, 2017, for an overview of the UK and EU pay regulations for banks). Similarly, the Netherlands has had a Banking Code in place since 2010 that contains guidelines on the make-up of bank boards, including the qualification and training of board members and their remuneration. Additionally, US compensation guidelines for CEOs and other senior executives at large banks come close to dictating compensation structures in banking (Board of Governors et al., 2010, p. 33). The flurry of new bank gov­ ernance rules has meant that in a number of countries, banks now have separate corpo­ rate governance codes from other industries. However, as this chapter will argue, there are reasons to rethink the corporate gover­ nance of banks more profoundly. This chapter will survey the key literature on the (p. 133) governance of banking institutions and argues that the differences between banks and non-financial firms necessitate governance arrangements that reflect these differ­ ences. Crucially, governance arrangements that do not sufficiently take the unique fea­ tures of banks into account risk exacerbating existing agency conflicts that may have con­ tributed to excessive risk-taking by banks before the global financial crisis of 2007–9. As an illustration of this, banks are highly leveraged firms. Equity funding in banking makes up the smallest proportion of the balance sheet of any major industry. However, equity holders control the key governance mechanisms of banks, such as the board of di­ rectors (shareholders enjoy the power to appoint and remove directors), and set remuner­ ation of senior management just like in any other industry where equity makes up a much more substantial proportion of funding and where equity holders jointly have greater loss exposure (more “skin in the game”). As a result, with risk-based profits going to equity holders, equity holders have strong incentives to put in place monetary risk-taking incen­ tives that lead to higher payoffs for them at the expense of debtholders (and by extension, the deposit insurer or taxpayer that acts as a fiscal backstop in the event of bank failure). The divergent interests between equity- and debtholders as regards risk is just one exam­ ple where, owing to the highly geared capital structure of banks, shareholder-oriented corporate governance leads to risky strategies that may hurt the interests of other stake­ holders in banks. Consistent with this, Beltratti and Stulz (2012) show that banks that un­ derperformed during the crisis had “better” (i.e., more shareholder-focused) corporate governance arrangements in place before the crisis. Therefore, as this chapter will argue, banks warrant separate governance arrangements that take their unique features into ac­ count over and beyond what is currently being proposed. Further, it is an increasingly widespread view that that operational and other failures in banking are not isolated events that can be attributed to a small number of people who have not been incentivized or monitored effectively (Group of Thirty, 2015). For instance, large-scale improvements in bank governance have gone hand in hand with ever more cases of misconduct and operational failures in banks (Nguyen, Hagendorff, and Eshraghi, 2015a). Therefore, standard corporate governance arrangements seem unable Page 3 of 24

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Corporate Governance and Culture in Banking to prevent operational and other bank failures. Instead, it seems probable that there are systematic issues, in some cases condoned and perhaps tacitly encouraged by the culture prevailing in some banks (Fahlenbrach, Prilmeier, and Stulz, 2012; Song and Thakor, forthcoming). Given the high leverage of banking firms and the concerns over excessive risk-taking incentives for shareholders, the culture prevailing in banks can be an impor­ tant governance device. This chapter proceeds as follows. The next section discusses the manner in which banks differ from non-financial firms and why this matters for the corporate governance of banks. The sections after that discuss the literature on the compensation of senior execu­ tives, the independence, and the composition of the board of directors, the shareholder structure, and the risk culture of banks.

5.2 Why Banks are Different and the Impli­ cations for Bank Governance (p. 134)

Banking theory explains that the nature of financial intermediation makes bank assets in­ formationally opaque and difficult to assess and monitor for outsiders and banks vulnera­ ble to runs (e.g., Diamond and Dybvig, 1983; Diamond and Rajan, 2001). While there are many factors that make banks different from non-financial firms, not all of these factors have corporate governance implications. However, two aspects that make banks special and that have implications for the corporate governance of banks are the capital struc­ ture of banks (banks are highly leveraged) and the tightly regulated nature of many of their activities. Why both of these aspects make banks different in terms of their gover­ nance is the focus of this section. One of the reasons why bank governance warrants separate analysis is that banks, by the standards of other industries, issue little equity. While equity investors are a lot less im­ portant than creditors in terms of the funding they provide to banks, equity investors still control key governance devices such as the board of directors, director appointments (and dismissals), and executive pay. Hence, it is shareholders that can put in place moni­ toring mechanisms and incentives designed to bring about shareholder-focused out­ comes. This matters because shareholders have different risk preferences (they are risk neutral) from creditors (who are risk averse) and because the negative externalities caused by bank failures mean that bank risk-taking is clearly a policy-relevant issue.

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Corporate Governance and Culture in Banking

Figure 5.1 Firm Leverage [Liabilities/ (Liabilities+Equity)], 2007.

It is important to emphasize just how unusual banks are in terms of their levels of finan­ cial leverage. Figure 5.1 illustrates that the average listed US firm in 2007 (before the cri­ sis) was funded by around 30 percent equity (relative to total assets). However, for banks it is not unusual to have a balance sheet where liabilities account for in excess of 90 per­ cent of total assets. Some large European banks entered the global financial crisis of 2007–9 with equity accounting for less than 3 percent of total assets. As Figure 5.1 shows, no other major industry has leverage ratios as high as the banking industry. The high leverage of banks has two important corporate governance implications. The first implication is that high leverage can lead to excessive risk-taking if bank sharehold­ ers become too dominant in the governance of the bank. Going back to at least Jensen and Meckling (1976), it is well known that there are conflicts between equity holders and external firm creditors over the desired level of firm risk. Since shareholders hold resid­ ual claims over a firm’s assets, they have incentives to increase firm risk. While share­ holders benefit from pursuing risk-increasing policies (they benefit from any upside po­ tential in the value of their equity), external firm creditors stand to bear losses without the prospect of wealth gains from higher risk. The second implication from high leverage is that, in the banking industry, risk-taking in­ centives linked to equity are further intensified by the presence of guarantees advanced by regulators and governments. Therefore, it is a widely held view that the financial safe­ ty net (and by extension regulators) is at least in part responsible for the high leverage of banks. The view is that regulators subsidize bank leverage and thus (p. 135) induce banks to issue larger amounts of liabilities than they otherwise would. For instance, since the prospect of large externalities caused by bank failures raises the expectation of bank bailouts, banks may increase their implicit claim on the financial safety net through high­ er risk-taking. Both explicit deposit insurance and implicit bailout guarantees shield bank creditors from market discipline and induce banks to “lever up” at low costs.

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Corporate Governance and Culture in Banking Consistent with public bank guarantees inducing higher leverage, Berger, Herring, and Szegö (1995) show drastic increases in the leverage of US banks since the mid-nine­ teenth century. The leverage increases coincide with various changes in regulation that made the financial safety net more generous. Examples are the Federal Reserve Act of 1914, which let banks obtain liquidity via discounting assets at the Federal Reserve, and the creation of deposit insurance in 1933, which guaranteed depositors’ repayments in the event of a bank failing.

5.3 Compensation in Banking Executive compensation policy may serve as a mechanism to reduce conflicts between managers and shareholders over the deployment of corporate resources and the riskiness of the firm (Jensen and Meckling, 1976). Public and academic interest in CEO (p. 136) compensation in the banking industry has increased exponentially in the aftermath of the financial crisis of 2007–8. While this is partly motivated by public outrage over the levels of CEO remuneration in an industry that has become increasingly reliant on public funds, the view that the structure of executive pay has given rise to socially harmful risk-taking by banks is gaining ground. Thus, the use of incentive pay in banking is widely believed to have motivated excessive risk-taking and to have acted as a contributory factor to the re­ cent financial crisis (e.g., Bebchuk and Spamann, 2009; Federal Reserve Bank, 2010). This section critically reviews existing empirical work on the relationship between CEO pay and bank risk-taking and argues that previous work has been too narrow in its focus on equity-linked CEO compensation (mainly share and option grants) while neglecting common forms of CEO compensation that are not equity-linked and that could make a valuable contribution to promoting more socially optimal risk-taking by banks. Research that examines non-equity components of CEO compensation, particularly pensions and other forms of deferred compensation, is still in its infancy. However, many of the findings proffered by this stream of research are consistent with the view that, where equitybased pay encourages risk-taking, non-equity-linked pay makes CEOs more risk averse (see Edmans and Liu, 2011). This section argues that it is regrettable that not more is em­ pirically known about the risk effects generated by non-equity (and essentially more debtlike) forms of compensation and calls for debt-like components of CEO compensation to be examined in greater detail.

5.3.1 Cash and Bonus Compensation Most of the extant literature largely overlooks the role of CEO cash bonuses as a risk-tak­ ing incentive. The lack of empirical work on CEO bonus plans on bank risk is unfortunate for two reasons. First, CEO cash bonuses are an important component of executive pay. CEO bonus payments make up around a third of total CEO compensation (Murphy, 2000). Second, the effect of bonus payments on managerial risk preferences is likely to differ from that exerted by option grants.

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Corporate Governance and Culture in Banking

Figure 5.2 A Typical Cash Bonus Function. Source: Adopted from Murphy (2000).

Figure 5.2 illustrates the shape of a typical bonus function. CEO cash bonuses generally become payable once an earnings-based target over a one-year period has been met. Af­ ter exceeding this threshold, the CEO payoffs from bonus plans increase in line with per­ formance until capped at a maximum payout. Therefore, for earnings performances ex­ ceeding the threshold at which bonus payments become payable, CEO bonus plans do not provide convex payoffs (Smith and Stulz, 1985) and should not promote excessive risktaking (see Noe, Rebello, and Wall, 1996; Duru, Mansi, and Reeb, 2005). This is in sharp contrast to CEO holdings of stock options. Since the payoffs from option holdings are con­ vex functions of the volatility of stock returns, options incentivize CEOs to increase the volatility of share prices by engaging in riskier activities (Guay, 1999; Rajgopal and Shevlin, 2002; Coles, Daniel, and Naveen, 2006; Hagendorff and Vallascas, 2011). Theoretical work posits that CEO cash bonuses can play an important role in miti­ gating managerial incentives to engage in risk-shifting. In a theoretical model, Smith and Stulz (1985) show that as long as cash bonuses increase linearly with corporate perfor­ mance, the payoffs linked to a bonus plan are non-convex and therefore not inherently risk-rewarding. However, when performance is below the earnings-based threshold at which bonuses become payable, bonus plans resemble a call option on the performance measure. In this case, bonus plan payoffs will be convex and offset the concavity of the CEO’s risk-averse utility function. By contrast, when performance is above the threshold at which bonuses become payable (and below the bonus cap), the slope of a bonus plan is linear with respect to performance and will not incentivize risk-averse CEOs to increase bank risk in order to secure higher bonus payments. (p. 137)

Other work suggests that, rather than having no effect on risk-taking, bonuses may lower the risk preferences of the CEO. One such argument suggests that, because bonus pay­ ments can only be received in a state of solvency, they incentivize CEOs to avoid bank­ Page 7 of 24

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Corporate Governance and Culture in Banking ruptcy (John and John, 1993). Consistent with this, Duru, Mansi, and Reeb (2005) find that earnings-based cash bonuses make managers seek stable cash flows to meet contrac­ tual debt obligations. The authors show that the costs of debt financing decrease for firms that pay higher CEO cash bonuses and contend that this reflects the lower agency costs of debt and reduced risk-shifting incentives in these firms. In spite of the arguments above, claims that cash bonuses encourage banks to en­ gage in “excessive” risk-taking continue to be made (for instance, in the Financial Stabili­ ty Board, 2009). However, the case for bonuses increasing risk tends to rest on two as­ sumptions, both of which have recently been challenged by empirical evidence. The first assumption is that cash bonus contracts do not sufficiently expose managers to downside risk and therefore reward managers for taking on more risk to achieve the performance goals underlying bonus contracts. In contrast to this, empirical studies have shown that bonus contracts tend to punish underperformance more than they reward strong perfor­ mance (Indjejikian et al., 2014). (p. 138)

The second assumption is that, by making bonus payments contingent on annual perfor­ mance targets, shareholders design bonuses to affect short-term behavior and managers pursue higher risk-taking strategies to achieve these short-term goals. While some evi­ dence exists that managers may ration productive effort in order to maximize bonus pay­ ments (Bouwens and Kroos, 2011), this does not rule out that bonuses can be designed as long-term compensation tools. In fact, Indjejikian et al. (2014) show that bonus plans pro­ vide managers with long-term incentives to exert effort. These studies document that companies consider a trade-off between bonuses and career incentives over time horizons of multiple years when devising managerial compensation packages. The narrow empirical evidence available for the banking industry reaches conflicting con­ clusions on the role of CEO bonus payments and bank risk. Harjoto and Mullineaux (2003) report a positive association between bonus payments and return volatility (risk). Balachandran, Kogut, and Harnal (2010) proffer some evidence that the sum of bonus and other cash incentives reduces the probability of bank default. Fahlenbrach and Stulz (2011) do not find that CEO cash bonus payments affected the per­ formance of US banks during the global financial crisis of 2007–9. Looking at risk, Vallas­ cas and Hagendorff (2013) show that increases in CEO cash bonuses lower the default risk of banks. They explain this finding by arguing that, because bonus payments are con­ tingent on bank solvency, they lower the risk preferences of CEOs. They then demon­ strate that the risk-reducing effect of cash bonuses disappears as banks move closer to the point of default. At the riskiest banks, the results show that bonus payments promote rather than mitigate bank risk-taking. Kleymenova and Tuna (2017) examine the influence of the UK and EU regulations that limited bonus compensation (the so-called “EU bonus cap”). They find the market reacted positively to the Remuneration Code but negatively to the EU bonus cap. This suggests equity market investors view regulating executive compensation at least in part as costly. Interestingly, the authors also show that bank compensation contracts increase in com­ Page 8 of 24

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Corporate Governance and Culture in Banking plexity after the bonus cap. The regulation of bonuses has therefore given rise to some unintended costs.

5.3.2 Equity-based Compensation Over recent decades, the use of equity-linked compensation has increased rapidly, both inside and outside the banking industry. Equity-linked CEO compensation takes the (p. 139) form of grants of the firm’s shares as well as call options on the firm’s equity. Op­ tion grants in particular make CEO wealth sensitive to risk-taking. Pay-based incentives that make compensation more sensitive to risk (vega) and pay-based incentives that make compensation more sensitive to performance (delta) are captured by a method described in Guay (1999). The measure captures the partial derivative of the value of the CEO’s portfolio of options (estimated using the dividend-adjusted Black–Sc­ holes value) or stock holdings, respectively.

(1)

(2)

where

. N´(·) and N(·) are the normal probability

density function and the cumulative normal distribution respectively. S is the closing stock price at the fiscal year end, X is the exercise price of the option, σ is the annualized standard deviation of daily stock returns, r is the risk-free rate for a maturity value equal to that of the option contract, d is the dividend yield, and T is the time to maturity of the option grant. DeYoung, Peng, and Yan (2013) show that the use of equity-linked compensation in US banking has increased so rapidly over the last decade that CEO payoffs linked to increas­ es in firm risk (vega) are higher in the banking industry than in non-financial firms. DeY­ oung, Peng, and Yan (2013) calculate that the average bank CEO saw his or her wealth in­ crease by around $300,000 in 2004 as a result of a 0.01 percent increase in stock return volatility. Previous evidence on vega and the investment decisions made by managers is equivocal. For instance, the non-financial literature finds that higher CEO vegas lead to riskier in­ vestment choices and bind corporate resources to riskier activities (Guay, 1999; Rajgopal and Shevlin, 2002; Coles, Daniel, Naveen, 2006). For the banking industry, Mehran and Rosenberg (2007) and DeYoung, Peng, and Yan (2013) show that high-vega banks engage in riskier types of activities. By contrast, Fahlenbrach and Stulz (2011) do not find that Page 9 of 24

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Corporate Governance and Culture in Banking CEO vegas explain the performance of bank stocks (i.e., previous managerial risk-taking) during the recent financial crisis. Hagendorff and Vallascas (2011) find that CEOs are re­ sponsive to the vega embedded in their compensation when engaging in acquisitions. Thus, higher pay risk sensitivity causes CEOs to engage in risk-increasing deals. As regards the levels of pay-performance sensitivity (delta), delta may exacerbate man­ agerial risk aversion (Amihud and Lev, 1981; Smith and Stulz, 1985). DeYoung, Peng, and Yan (2013) find some evidence that delta reduces the riskiness of bank activities, while Mehran and Rosenberg (2007) do not detect any robust influence of delta on bank risktaking. As regards the effect of CEO delta on the riskiness of merger decisions, Datta, Iskandar-Datta, and Raman (2001) find that higher deltas lead to acquisitions that are as­ sociated with higher increases in stock return volatility after a merger. For the banking industry, Bliss and Rosen (2001) and Minnick, Unal, and Yang (2011) show (p. 140) that high-delta banks are less likely to engage in acquisitions, which is consistent with highdelta CEOs forgoing risky investment projects such as mergers and acquisitions. Berger, Imbierowicz, and Rauch (2016) examine the role of managerial stock holdings (the primary component of delta above) and bank failures during the crisis. The results show that stock holdings of lower-level management (such as vice presidents) increase default risk while the shareholdings of CEOs and other senior executives do not affect the probability of failure. Even though the authors focus on stock holdings rather than com­ pensation, the findings raise the possibility that pay and other governance variables ought to be examined not only at the level of the board of directors but also at hierarchi­ cal levels below the board.

5.3.3 Debt-based Compensation Debt as a form of executive remuneration is widespread. It tends to take the shape of de­ ferred compensation, most notably in the form of defined benefit pensions (see Sundaram and Yermack, 2007; Wei and Yermack, 2011). These company promises of fixed sums at some future point in time are unfunded and unsecured CEO claims. In the US and many other countries, the deferred compensation claims of executives take no priority over the claims of other unsecured creditors in the event of bankruptcy, effectively turning the holders of inside debt into unsecured firm creditors. The value of deferred compensation claims by CEOs—also known as “inside debt” (Jensen and Meckling, 1976)—can make up a substantial share of a CEO’s overall remuneration. Wei and Yermack (2011) report that out of the S&P 1500 firms, more than two-thirds of CEOs hold some form of inside debt and that for those who hold inside debt, the holdings were worth an average of $5.7 million in 2006. A small number of empirical studies report evidence consistent with inside debt curbing CEO risk-taking behavior. Sundaram and Yermack (2007) find that large inside debt posi­ tions by a CEO reduce the probability of default on a firm’s debt. More recently, Wei and Yermack (2011) examine the bond and share price reaction to the disclosure of inside debt holdings in 2007 as mandated by the Security and Exchange Commission (SEC). The Page 10 of 24

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Corporate Governance and Culture in Banking authors find that large CEO pensions (as well as other forms of deferred payments to CEOs) are associated with gains for bond holders and losses for shareholders. Few studies have been conducted to examine the effects of inside debt on bank behavior. Tung and Wang (2012) show that bank CEOs with higher inside debt holdings engaged in less risk-taking before the financial crisis (as indicated by better stock market perfor­ mance during the financial crisis). Bennett, Guntay, and Unal (2015) show that larger CEO inside debt holdings before the crisis are associated with lower bank default risk during the crisis. Finally, Srivastav et al. (2018) show that acquisitions announced by CEOs with high inside debt incentives are associated with a wealth transfer from equity to debt holders. After the completion of a deal, banks where acquiring CEOs have high in­ side debt incentives display lower market measures of risk and lower loss exposures for taxpayers.

5.4 The Board of Directors and Sharehold­ er-Oriented Governance (p. 141)

In all economic sectors, the board of directors of publicly traded companies is among the most important internal control mechanisms for promoting and protecting shareholder in­ terests due to the board’s role in providing expertise and monitoring managerial discre­ tion. More specifically, boards have the authority to ratify or obstruct managerial initia­ tives, to assess the performance of top management, and to determine managerial com­ pensation packages and career paths at a particular firm. For a board to be effective in mitigating self-serving managerial behavior, its indepen­ dence from management needs to be ensured. A common assumption is that boards that are more independent (in the sense that a larger proportion of directors has no family, so­ cial, or business connections to management) are more likely to bring about shareholderoriented outcomes such as higher risk or better performance. Adams and Mehran (2003) report that US bank boards between 1986 and 1999 were both larger and more independent than those of S&P 500 manufacturing firms: the average board size was twelve for manufacturing firms and eighteen for banks. Given sharehold­ ers are risk neutral and managers are risk averse with respect to firm-specific and idio­ syncratic risk (managers’ human capital is invested in their own firm and cannot be diver­ sified), banks that are more shareholder controlled should be riskier. Powerful bank boards should therefore be associated with increased risk-taking activities, while power­ ful bank CEOs who face a less shareholder-oriented board should be associated with less risk-taking. Consistent with shareholder-aligned boards increasing risk, Pathan (2009) shows that as the boards of bank holding companies reflect shareholder interests to a larger degree (e.g., when they are smaller and more independent), bank risk-taking increases. Similarly,

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Corporate Governance and Culture in Banking Laeven and Levine (2009) show that bank risk-taking increases with the comparative power of shareholders within the corporate governance structure of a bank. Examining the global financial crisis of the 2007–9 period, the evidence is not consistent with the view that the crisis has roots in the “weak” corporate governance, if weakness is defined in terms of how aligned boards are with shareholders. Thus, Erkens, Hung, and Matos (2012) find that firms with more independent boards realized lower stock returns during the crisis period. Similarly, for an international sample of banks, Beltratti and Stulz (2012) show that banks that underperformed during the crisis had altogether more shareholder-oriented boards. Beltratti and Stulz offer an intriguing explanation for their results. The authors argue that better-governed banks outperformed before the crisis by engaging in a number of activi­ ties that at the time were value enhancing but later on turned out to be a source of under­ performance. Hence, they suggest that shareholder-focused banks suffered from “bad luck” (rather than ill-intent). Beltratti and Stulz’s (2012) study demonstrates the pitfalls of overly shareholder-oriented corporate governance. Therefore, shareholder-focused (p. 142) governance should not be viewed as a major component in the regulatory re­ sponse to the global financial crisis of 2007–9. Finally, Berger, Imbierowicz, and Rauch (2016) findings encourage future corporate gov­ ernance research to shift toward middle and higher management levels situated below the board of directors. The authors find managerial ownership can be linked to bank fail­ ures during the crisis if ownership is measured for managers (e.g., vice presidents or treasurers) but not when ownership is measured for top executives (e.g., CEO or Chief Fi­ nancial Officer).

5.5 Board Diversity: Does it Matter who Runs Banks? It is a widely accepted view that the composition of the board of directors could play a vi­ tal role in determining corporate performance (see, e.g., Hermalin and Weisbach, 2003). In the past decade, boards in and outside the banking sector have made an increasing number of appointments from a wider range of demographic, educational, and social backgrounds. Following the global financial crisis of 2007–9, the view has taken hold that the responsibility of bank boards to monitor managerial risk-taking should be improved and that board diversity can play an important part in improving board decision-making. This view has some traction with policymakers and the general public. For instance, fol­ lowing the aftermath of the global financial crisis of 2007–9, the quote that Lehman Brothers would not have collapsed if it had been “Lehman Sisters” has been attributed to European commissioner Viviane Reding and former UK minister Harriet Harman among others. This section seeks to make the case for and against board diversity based on theo­

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Corporate Governance and Culture in Banking retical grounds as well as the rather limited evidence to date that has examined the ef­ fects of more diverse bank boards in the banking industry.

5.5.1 Is There a Case for Board Diversity? The case for diversity in the boardroom essentially centers around two main types of ar­ guments: ethical and economic. Ethical arguments regard board diversity as a desirable end in itself and emphasize that it is inequitable to exclude certain groups from corporate elites on the basis of gender, race, or other non-performance-related characteristics (Singh, Vinnicombe, and Johnson, 2001). In the same vein, promoting board diversity is one means to empower constituencies of society that have historically been excluded from positions of power. Therefore, the concept of board diversity is linked to the notion of equality of representation and, ultimately, to the ideal of “fair” outcomes in society (p. 143) (Brammer, Millington, and Pavelin, 2007). It follows from this that diverse boards create legitimacy and improve a firm’s bargaining power vis-à-vis its various stakehold­ ers. As regards the economic case for board diversity, a central argument is that diversity en­ hances the functional abilities of a board, particularly its ability to engage in complex problem-solving, strategic decision-making, and management monitoring (Forbes and Milliken, 1999). Boards may be viewed as a knowledge-based asset that creates value for shareholders by linking an organization to its external environment (Pfeffer and Salancik, 1978). For example, board diversity expands the networks of existing board members and helps place firms in a network of other firms. This network may lead firms to benefit from improved access to their various external constituents (see Hillman, Cannella, and Paet­ zold, 2000). Specifically, board networks may provide access to capital, a nation’s busi­ ness elite, and—in the case of a regulated industry such as banking—industry regulators (Macey and O’Hara, 2003). As well as placing a firm within a network of external contacts, board diversity may im­ prove the internal workings of the board. Owing to their idiosyncratic experiences and values, diverse board members bring privileged economic resources to organizations that help them comprehend a firm’s dynamic industry context (Hambrick and Mason, 1984). For example, the presence of knowledge and specific skills that cater to a board’s special­ ized needs may further an organization’s understanding of its marketplace and thus im­ prove corporate performance when a board matches its diversity with that of customers or suppliers. However, calls by policymakers to appoint directors with more sector-specif­ ic knowledge run contrary to recent attempts by banks to increase the diversity of their boards. However, there may also be costs associated with board diversity. The presence of differ­ ent viewpoints on less homogeneous boards may cause coordination problems (Forbes and Milliken, 1999). Further, diversity may corrode group cohesion and lead to a board whose members are less cooperative, and experience increased emotional conflict. Con­ sistent with this, Adams and Ferreira (2009) show that female board directors engage in Page 13 of 24

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Corporate Governance and Culture in Banking more monitoring but are unable to improve performance. The authors argue that too much monitoring causes conflict and lowers overall performance.

5.5.2 Empirical Evidence on Board Diversity in Banking There is little empirical evidence as regards the effects of diversity in banking. However, the work that has been done to date is interesting because it shows that gender, educa­ tion, and director characteristics do indeed affect performance and risk-taking in the banking industry. Since the banking sector is relatively opaque, complex, and skill-inten­ sive, education and other director characteristics that may correlate with abilities could be particularly important in the banking sector. Beck, Behr, and Guettler (2013) analyze gender differences in the performance of loan of­ ficers. Consistent with the view that female loan officers make more cautious (p. 144) de­ cisions, the authors show that default rates for loans originated by female loan officers tend to be lower than for those originated by male loan officers. Berger, Kick, and Schaeck (2014) link changes in board composition to measures of bank portfolio risk. Specifically, the authors relate board-level measures of age, gender, and ed­ ucation (the latter measured by the fraction of directors on the board holding a PhD) to the proportion of risk-weighted assets on a bank’s balance sheet. The authors show that younger executive teams and teams with more females take more portfolio risks. The au­ thors show this is due to female directors being on average less experienced than male appointments and less experienced directors taking on additional risks. As regards board diversity, Hagendorff and Keasey (2012) measure the value of board di­ versity in the US banking industry. They employ a sample of bank mergers and find posi­ tive announcement returns to mergers approved by boards whose members are diverse in terms of their occupational background. By contrast, Erkens, Hung, and Matos (2012) do not find a significant relationship between the financial experience of board members and firms’ stock returns during the crisis. Nguyen, Hagendorff, and Eshraghi (2015b) examine the announcement effects of new bank director appointments and find that age, education, and prior experience of execu­ tive directors create shareholder wealth in the US banking sector. In contrast, gender, ex­ perience outside the banking sector, and a PhD degree do not have measurable market returns. In addition, the appointment of directors who hold non-executive directorships with an unaffiliated firm at the time of the appointment attracts negative returns, consis­ tent with the view that these directors are too busy to be effective monitors. In a rare glimpse at some of the more mixed results linked to board diversity, GarcíaMeca, García-Sánchez, and Martínez-Ferrero (2015) show that different measures of di­ versity produce different value effects. García-Meca et al. study the effects of diversity on boards in terms of gender and nationality in an international sample. The authors find

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Corporate Governance and Culture in Banking that while diversity in gender is associated with higher bank valuations, diversity in terms of nationality is associated with lower valuations. In summary, while the ethical arguments for board diversity appear strong, the economic case for board diversity has yet to stand on more solid empirical grounds. Therefore, more work needs to be done to establish stronger causal links between who the members of the board are and corporate outcomes such as bank risk and returns.

5.6 Culture in Banks Much of the corporate governance literature sees the role of governance as incentivizing and monitoring the behavior of individual agents. However, it is a widely held view that bank failures are not isolated events that can be attributed to a small number of individu­ als. Instead, it seems probable that there are systematic issues, in some cases condoned and perhaps tacitly encouraged by the culture prevailing in some banks. In other words, institutional culture—whether good or bad—could be contagious (Song and Thakor, forth­ coming). (p. 145)

A Group of Thirty (2015) report explains that “culture … creates a consistent

framework for behaviors and business practices.” Culture, like governance, shapes the behavior of economic agents but does so in ways that are less targeted. A bank’s culture will, therefore, affect large parts of a bank at the same time. Given the high leverage of banking firms and concerns over excessive risk-taking incentives for shareholders, a bank’s culture can be an important governance device. Studying culture is also important because of a number of high-profile misconduct cases that have put pressure on the reputation of the sector for professional and ethical con­ duct. For instance, regulators have taken record numbers of enforcement actions against banks in recent years to require them to take corrective measures against misconduct cases (see Nguyen, Hagendorff, and Eshraghi, 2015a). Among the banks engulfed in mis­ conduct cases are various high-profile institutions. For instance, JPMorgan faced several enforcement actions related to credit card fraud, money laundering, and internal account­ ing controls over the past few years. This also matters because misconduct cases are costly to bank investors with the fines imposed often outweighed by substantial reputa­ tional losses for offending banks. In many ways, the recent surge in bank misconduct cases is surprising. One explanation for misconduct holds that when a CEO has too much authority within the firm, miscon­ duct is one potential outcome. However, by most accounts, oversight of CEO decisionmaking has improved markedly in recent years. Data from Riskmetrics show that eight out of ten members of US bank boards are classified as independent in 2012, up from around half in 2000. With increasing levels of independence, one would expect bank boards to be more effective in preventing a culture that is linked to misconduct. However,

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Corporate Governance and Culture in Banking far from a declining trend, the average annual number of enforcement actions has in­ creased from 5 to 28 over the same period. The rise in bank misconduct cases under increasingly more independent boards is consis­ tent with the view that salient factors around culture are important in shaping risk-tak­ ing. However, the focus on culture (whether based on theory or empirical work) is rela­ tively new to the literature. The discussion below distinguishes between the effects of cul­ ture at an institutional level and the personally held cultural values of individuals.

5.6.1 Institutional Culture Song and Thakor (forthcoming) develop a model in which bank culture has two primary effects. Culture helps match managers to banks with similar risk attitudes, and culture is contagious. That is, a safety-oriented culture in some banks causes other banks also to adopt a more safety-oriented culture. On an empirical level, measuring bank culture and linking it to some observed outcome is challenging. However, even where culture is not the focus of existing research, the re­ sults of a number of studies already point to the existence of a persistent risk culture within some banks (e.g., Fahlenbrach, Prilmeier, and Stulz, 2012; Ellul and Yerramilli, 2013). Fahlenbrach, Prilmeier, and Stulz (2012) show that a bank’s stock return performance during the 1998 crisis predicts its stock return performance and probability of failure (p. 146) during the Great Recession. Intriguingly, this finding is independent of whether or not banks have the same CEO during both crisis periods, suggesting the presence of a risk culture that is persistent across time. Ellul and Yerramilli (2013) study the relationship between risk culture practices and tail risk for the largest 100 US banks between 1995 and 2010. They develop a risk manage­ ment culture index based on five variables related to the strength of a bank’s risk man­ agement. Their findings show that banks with higher index values in 2006 were less risky and performed better while they also had better operating and stock return performance during the financial crisis years. Further, Popadak (2014) and Fiordelisi and Ricci (2014) are part of an emerging stream of literature that attempts to quantify corporate culture outside the banking industry. Popadak uses employee reviews collected by career intelligence firms where employees self-report aspects of corporate culture, firm values, and the workplace environment. Fiordelisi and Ricci apply textual analysis to financial (10-K) filings. They adopt Cameron et al.’s (2006) four dimensions of corporate culture by measuring what the authors call the “semantic content” in financial filings. The authors identify the frequency of syn­ onyms in 10-K statements that connote collaboration, competition, control, and creation. In an application of Fiordelisi and Ricci’s (2014) framework for corporate culture to the banking industry, Nguyen, Nguyen, and Sila (2019) find that banks with a corporate cul­ Page 16 of 24

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Corporate Governance and Culture in Banking ture that emphasizes aggressive competition are associated with riskier lending prac­ tices. That is, these banks display higher loan approval rates, lower borrower quality, and fewer covenant requirements. Such banks also incur larger loan losses and make larger contributions to systemic risk. Nguyen, Nguyen, and Sila (2019) therefore provide direct empirical evidence of the importance of culture for banks’ policy choices and risk.

5.6.2 Cultural Values of Senior Managers Corporate culture matches managers to banks with similar risk attitudes (Song and Thakor, forthcoming). The values held by senior management should, therefore, be close­ ly aligned with those of the banks that managers choose to work for. In the empirical literature on personally held cultural attitudes, the general view is that cultural values are deeply rooted and slow moving. For instance, studies document that the descendants of immigrants show a degree of cultural distinctiveness over several sub­ sequent generations (e.g., Fernández, and Fogli, 2009). For instance, US immigrants’ fam­ ily living arrangements or views on the role of women in society parallel those found in the home countries of their ancestors for several generations. Nguyen, Hagendorff, and Eshraghi (2018) conduct a study that identifies the cultural val­ ues of senior managers in US banks. The authors track the family trees of US CEOs and focus on CEOs who are the children or grandchildren of immigrants. While these CEOs are exposed to the same legal, social, and institutional influences as other US-born (p. 147) CEOs, they possess a cultural heritage that is different from those of other CEOs. Specifically, the cultural preferences and beliefs of these CEOs are likely to bear the cul­ tural mark of the countries from which their parents or grandparents have emigrated. Nguyen, Hagendorff, and Eshraghi (2018) find banks led by CEOs who are second- or third-generation immigrants are associated with higher profitability compared with the average firm. This effect weakens over successive immigrant generations and cannot be detected for top executives apart from the CEO. Additional analysis attributes this effect to various cultural values that prevail in a CEO’s ancestral country of origin. Nguyen, Hagendorff, and Eshraghi (2018) trace the perfor­ mance effect linked to “immigrant CEOs” to the cultural values that prevail in the country of a CEO’s ancestors. Using a broad range of sixteen cultural values, they find that most cultural dimensions explain competitive performance. Specifically, cultural values that en­ ter their analysis significantly broadly contrast group- versus self-oriented cultures and how comfortable members of a culture are with uncertain future outcomes. When compe­ tition intensifies, bank performance is positively related to the cultural dimensions re­ straint, long-term orientation, and uncertainty avoidance. The key finding of Nguyen, Hagendorff, and Eshraghi (2018)—that personally held values are reflected in the actions and performance of banks—confirm the view that the risk cul­

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Corporate Governance and Culture in Banking ture of banks and the individuals who work for them are closely aligned (see Song and Thakor, forthcoming).

5.7 Policy Implications and Conclusions This chapter surveys the literature on the corporate governance of banking firms with a particular focus on the compensation arrangements of bank executives, the composition of the board of directors, and the risk culture in banks. One of the main conclusions of this chapter is that the unique features of banks should lead to unique governance arrangements for the banking industry. For instance, given the high leverage of banks, pay incentives should align managers more with creditors than shareholders in the bank­ ing industry compared with other sectors. However, US-based evidence suggests that, compared with CEOs in non-financial firms, CEOs in the banking industry have been more aligned with equity holders than debtholders. Equally, and as a direct result of the high leverage and the resulting importance of bank creditors in the financing of banks, creditors should be given a more prominent role in the corporate governance of banks. At present, equity holders control the key governance mechanisms of banks such as the board of directors (shareholders have the exclusive power to appoint and remove directors) and set the remuneration of senior management just like in any other industry. One possibility would be to allow for creditor representa­ tion on bank boards. The intuition behind such an initiative would be (p. 148) that, if the capital structure of banks is different from non-financial firms, the governance structure within a bank should reflect this. While creditor representation on bank boards is at odds with the principle of proportional shareholder representation on boards (“one share one vote”), it is important to bear in mind that a number of companies have long represented stakeholders other than share­ holders on the board. For instance, Germany’s Mitbestimmungsgesetz (Codetermination Act) mandates that half of the board seats at large German corporations are reserved for employee representatives. One possibility would be to allow for a sliding scale of creditor representation starting beyond a threshold level of leverage and increasing with higher leverage up to a certain point. This would ensure that creditor representation would in­ crease in line with bank leverage and give creditors the opportunity to exert more influ­ ence over governance aspects such as executive director appointments, risk manage­ ment, and remuneration policy. Overall, the evidence surveyed does not back the conclusion that the global financial cri­ sis of 2007–9 has been brought about by a lack of shareholder-oriented corporate gover­ nance and that, following this line of argument, future banking crises can be prevented by improving the influence that shareholders have on the corporate governance of banks. If anything, the literature surveyed in this chapter shows that shareholder-oriented gover­ nance leads to risky outcomes and has therefore contributed to unsustainable bank poli­ cies that played a major role in the build-up of the crisis. Page 18 of 24

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Corporate Governance and Culture in Banking This chapter also highlights two important lines for future research into the corporate governance of banks. First, future research should do more to understand the effective­ ness of individual directors and their characteristics. Empirical work has only recently be­ gun to examine issues around individual director characteristics and board heterogeneity. Some findings are consistent with the view that it matters who runs banks, but not all these findings are in line with current policy discussions around board composition. For instance, empirical support for the view that female board participation or more banking sector experience lowers risk (as is often asserted) is weak at best. Second, research into the corporate governance of banks has so far been overly focused on the board of directors. While no doubt a key governance device, there are other insti­ tutions outside the board that are important for reducing agency conflict over bank risk. For instance, studying the risk culture inside banks or studying middle- and high-ranking management instead of the board level of executives can provide useful avenues for fur­ ther research. The corporate governance of banks is an important topic both for investors and for policy­ makers. However, much of what is known about the governance of banks has relied on replicating research based on the non-financial sector without adequately taking the unique features of banks into account. However, these unique features of banks call for a more profound rethink of the corporate governance of banks, one that centers around debtholders rather than equity holders, to bring forward the literature on this topic and to base the impending regulatory changes to the banking sector on a solid empirical foot­ ing.

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Corporate Governance and Culture in Banking Diamond, D. and Dybvig, P. (1983). “Bank Runs, Deposit Insurance, and Liquidity,” Journal of Political Economy, 99, 689–721. (p. 150)

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Corporate Governance and Culture in Banking Guay, W. R. (1999). “The Sensitivity of CEO Wealth to Equity Risk: An Analysis of the Mag­ nitude and Determinants,” Journal of Financial Economics, 53, 43–71. Haan, J. De, and Vlahu, R. (2016). “Corporate Governance of Banks: A Survey,” Journal of Economic Surveys, 30, 228–77. Hagendorff, J. and Keasey, K. (2012). “The Value of Board Diversity in Banking: Evidence from the Market for Corporate Control,” The European Journal of Finance, 18, 41–58. Hagendorff, J. and Vallascas, F. (2011). “CEO Pay Incentives and Risk-Taking: Evidence from Bank Acquisitions,” Journal of Corporate Finance, 17, 1078–95. Hambrick, D. C. and Mason, P. A. (1984). “Upper Echelons: The Organization as a Reflec­ tion of its Top Managers,” Academy of Management Review, 9, 193–206. Harjoto, M. A. and Mullineaux, D. J. (2003). “CEO Compensation and the Transformation of Banking,” Journal of Financial Research, 26, 341–54. Hermalin, B. and Weisbach, M. (2003). “Boards of Directors as an Endogenously Deter­ mined Institution: A Survey of the Economic Literature,” Economic Policy Review, 9, 7– 26. Hillman, A. J., Cannella, A. A., and Paetzold, R. L. (2000). “The Resource Depen­ dence Role of Corporate Directors: Strategic Adaptation of Board Composition in Re­ (p. 151)

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Corporate Governance and Culture in Banking Minnick, K., Unal, H., and Yang, L. (2011). “Pay for Performance? CEO Compensation and Acquirer Returns in BHCs,” Review of Financial Studies, 24, 439–72. Murphy, K. J. (2000). “Performance Standards in Incentive Contracts,” Journal of Account­ ing and Economics, 30, 245–78. Nguyen, D. D., Hagendorff, J., and Eshraghi, A. (2015a). “Can Bank Boards Prevent Mis­ conduct?” Review of Finance, 20, 1–36. Nguyen, D. D., Hagendorff, J., and Eshraghi, A. (2015b). “The Value of Executive Director Heterogeneity in Banking: Evidence from Appointment Announcements,” Corporate Gov­ ernance: An International Review, 23, 112–28. Nguyen, D. D., Hagendorff, J., and Eshraghi, A. (2018). “Does a CEO’s Cultural Heritage Affect Performance Under Competitive Pressure?” Review of Financial Studies, 31, 97– 141. Nguyen, D. D., Nguyen, L., and Sila, V. (2019). “Does Corporate Culture Affect Bank RiskTaking? Evidence from Loan-Level Data,” British Journal of Management, 30(1), 106–33. Noe, T. H., Rebello, M. J., and Wall, L. D. (1996). “Managerial Rents and Regulatory Inter­ vention in Troubled Banks,” Journal of Banking & Finance, 20, 331–50. Pathan, S. (2009). “Strong Boards, CEO Power and Bank Risk-taking,” Journal of Banking & Finance, 33, 1340–50. Pfeffer, J. and Salancik, G. R. (1978). The External Control of Organizations: A Resource Dependence Perspective (New York: Harper & Row). Popadak, J. (2014). “A Corporate Culture Channel: How Increased Shareholder Gover­ nance Reduces Firm Value,” Working Paper, Duke University. Rajgopal, S. and Shevlin, T. (2002). “Empirical Evidence on the Relation Between Stock Option Compensation and Risk-taking,” Journal of Accounting and Economics, 33, 145–71. Singh, V., Vinnicombe, S., and Johnson, P. (2001). “Women Directors on Top UK Boards,” Corporate Governance: An International Review, 9, 206–16. Smith, C. W. and Stulz, R. M. (1985). “The Determinants of Firms’ Hedging Policies,” The Journal of Financial and Quantitative Analysis, 20, 391–405. Song, F. and Thakor, A. (forthcoming). “Bank Culture,” Journal of Financial Intermediation. Srivastav, A., Armitage, S., Hagendorff, J., and King, T. (2018). “Better Safe Than Sorry? CEO Inside Debt and Risk-taking in Bank Acquisitions,” Journal of Financial Stabil­ ity, 36, 208–24. (p. 152)

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Corporate Governance and Culture in Banking Sundaram, R. K. and Yermack, D. L. (2007). “Pay Me Later: Inside Debt and its Role in Managerial Compensation,” Journal of Finance, 62, 1551–88. Tung, F. and Wang, X. (2012). “Bank CEOs, Inside Debt Compensation, and the Global Fi­ nancial Crisis,” Working Paper. Vallascas, F. and Hagendorff, J. (2013). “CEO Bonus Compensation and Bank Default Risk: Evidence from the US and Europe,” Financial Markets, Institutions & Instruments, 22, 47–89. Wei, C. and Yermack, D. (2011). “Investor Reactions to CEOs’ Inside Debt Incentives,” Re­ view of Financial Studies, 24, 3813–40.

Jens Hagendorff

Jens Hagendorff is Professor of Finance at the University of Edinburgh. Professor Ha­ gendorff previously worked at Cardiff University, the Financial Stability Department of the Bank of Spain and as a lecturer at the University of Leeds. He held Visiting po­ sitions in the US, Italy, and Spain, most recently as a Visiting Fellow at The Federal Reserve Bank of Atlanta and the Bank of Spain in Madrid. He publishes and lectures on a range of topics in finance, banking, and investments, in particular the risk and return implications of corporate governance in the banking industry. His work has been published in leading international journals, including the Review of Financial Studies, Journal of Quantitative and Financial Analysis, and Review of Finance. He is one of the authors of Size, Risk and Governance in European Banking (Oxford Uni­ versity Press, 2013).

Page 24 of 24

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Private Information and Risk Management in Banking

Private Information and Risk Management in Banking   Linda Allen and Anthony Saunders The Oxford Handbook of Banking (3rd edn) Edited by Allen N. Berger, Philip Molyneux, and John O. S. Wilson Print Publication Date: Oct 2019 Subject: Economics and Finance, Financial Economics Online Publication Date: Nov 2019 DOI: 10.1093/oxfordhb/9780198824633.013.6

Abstract and Keywords In this chapter we describe the risk management challenges faced by financial institu­ tions. The very nature of the banking business requires that financial firms become ex­ perts at risk assessment in order to manage their own inventories of risk, obtained during day-to-day business transactions with bank customers. Banks are exposed to interest rate risk, currency risk, liquidity risk, credit risk, and operational risk. The first step in a risk management program is accurate risk measurement. A useful risk measurement tool is the Value at Risk (VaR) model. The 99% VaR model produces predictions such as the worse loss that may occur 1 in every 100 days (or years). In contrast, the 99% Expected Shortfall denotes the average of all losses that occur with a one percent probability. We show that the roots of the global financial crisis of 2007–8 can be found in the failure of fi­ nancial intermediaries to measure and manage risk properly. Keywords: credit risk, financial futures, financial options, forward contracts, hedging, market risk, operational risk, swaps, systemic risk

6.1 Introduction IF you open the vaults of any bank, you might think you would know what you would find there. You would be wrong. What is really there, hidden behind the stacks of currency, is the bank’s inventory of risk. The bank exists to take on the risks of its customer base. By offering its clients risk management products, the bank absorbs an inventory of risk that is contributed with each transaction. The bank prices those products by estimating its costs of managing the risks inherent in each transaction. Financial institutions are spe­ cialists in risk management. Indeed, their primary expertise stems from their ability to both measure and manage risk exposure on their own behalf and on behalf of their clients —either through the evolution of financial market products to shift risks or through the absorption of their clients’ risk into their risk inventory on their own balance sheets. Be­ cause financial institutions are risk intermediaries, they maintain an inventory of risk that must be measured carefully so as to ensure that the risk exposure does not threaten the Page 1 of 32

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Private Information and Risk Management in Banking intermediary’s solvency. Thus, accurate measurement of risk is an essential first step for proper risk management, and financial intermediaries, because of the nature of their business, tend to be leading developers of new risk measurement and risk-pricing tech­ niques. When financial institutions misprice risk, however, as was the case of subprime mortgage securities, the size of the risk inventory may overwhelm the financial system’s capacity to absorb risk, thereby resulting in global market failures such as the credit crisis of 2007. For example, banks provided equity and backup lines of credit to the Structured Invest­ ment Vehicles (SIVs) that they formed during the build-up of the subprime mortgage (p. 154) securitization bubble. The SIV is a structured operating company that invests in assets that are designed to generate higher returns than the SIV’s cost of funds. Rather than selling the asset-backed securities directly to investors in order to raise cash (as Special Purpose Vehicles (SPVs) do in standard securitizations), the SIV sells bonds or commercial paper to investors in order to raise cash. The SIV then holds the loans pur­ chased from originating banks on its own balance sheet until maturity. These loan assets held by the SIV back the debt instruments issued by the SIV to investors. Thus, in essence the SIV itself becomes an asset-backed security, and the SIV’s short-term commercial pa­ per liabilities are considered an asset-backed commercial paper. Investors buy the SIV’s liabilities (most often, asset-backed commercial paper, ABCP), providing the proceeds for the purchase of longer-term loans from originating banks. The SIV’s debt is backed by the loan portfolio held by the SIV. However, the SIV does not simply pass through the pay­ ments on the loans in its portfolio as in a traditional CMO (collateralized mortgage obliga­ tion). Indeed, investors have no direct rights to the cash flows on the underlying loans in the portfolio. They are entitled to the payments specified on the SIV’s debt instruments. The SIV’s ABCP obligations carry interest obligations that are independent of the cash flows in the underlying loan portfolio. Thus, in the traditional form of securitization, the SPV only pays out what it receives from the underlying loans in the pool of assets backing the asset-backed securities. In the newer form of securitization, the SIV is responsible for payments on its ABCP obligations, whether or not the underlying pool of assets generates sufficient cash flow to cover those costs. Of course, if the cash flow from the asset pool exceeds the cost of ABCP liabilities, then the SIV keeps the spread and makes a profit. However, if the assets in the underlying pool do not generate sufficient cash flows, the SIV is still obligated to make interest and principal payments on its debt instruments. Further, if investors become concerned about the SIV’s ability to meet their short-term ABCP obligations, they may engage in a “run,” thereby generating what has been often called “rollover risk” or more generally, liquidity risk. The SIV’s operating methodology should seem very familiar to bankers. SIVs are essen­ tially banks minus the regulations, or so-called “shadow banks.” The SIV acts in a similar way to a traditional bank—holding loan assets until maturity and issuing debt instruments (such as ABCP) to fund its asset portfolio. The major difference between an SIV and a tra­ ditional bank is that the SIV cannot issue deposits to fund its asset base (i.e., it is not technically a “bank”). However, to the extent that many of these SIVs used commercial paper and interbank loans (such as repurchase agreements)1 to finance their asset portfo­ Page 2 of 32

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Private Information and Risk Management in Banking lios, then they were subject to even more liquidity (or rollover) risk than are traditional banks. This is because in the modern world of banking, sophisticated lenders (so-called suppliers of “purchased funds”) are prone to “run” at the first sign of trouble, whereas depositors are slower to react. That is, interbank lenders and commercial paper (p. 155) buyers will withdraw funds (or refuse to renew financing) quicker than traditional “core” depositors, who may rely on their bank deposits for day-to-day business dealings or may be protected by government deposit insurance. Thus, the well-publicized problems of the UK’s Northern Rock Bank in August of 2007 were precipitated by the withdrawal of funds by interbank lenders and other purchased fund suppliers. Core depositors represented only approximately 25 percent of Northern Rock’s funded assets. The liquidity risk prob­ lem is exacerbated when the SIV relies on short-term sources of funding, such as com­ mercial paper, which must be renewed within nine months, and repurchase agreements, which must be fully backed by collateral at all points in time. Thus, if the value of the portfolio declines due to credit conditions worsening, for example, then the SIVs are forced to sell long-term, illiquid assets at fire-sale prices in order to meet the SIVs’ shortterm debt obligations. Many SIVs were sponsored and originated by banks anxious to remove the risky sub­ prime mortgages (and other obligations) from their balance sheets. The banks and bank regulators believed that these off-balance-sheet SIVs posed little risk to the bank itself. However, most of these SIVs had ABCP programs that were backed with bank lines of credit. When the ABCP market seized up during the summer of 2007, the SIVs took down their lines of credit and, all of a sudden, the risks that were believed to be off the balance sheet came back to haunt the banks. Indeed, one large bank found its assets expanded. The banks were exposed to the risks associated with the poorly underwritten subprime mortgage securities because they were forced to lend to SIVs that had no assets other than these risky securities. Bank shareholders and stakeholders suffered, top executives lost their jobs, global credit markets dried up and the SIV experiment ended—all because risk was improperly measured and priced in the mortgage securities market. Unfortunately, SIVs have recently been resurrected under a different name. In China, “wealth management products” employ a SIV-like structure, and are subject to the same risks. Acharya, Qian, and Yang (2016) document the extreme rollover risks inherent in this shadow-banking activity. Moreover, the implicit guarantees offered to investors in these SIV-like structures increase the fragility of the entire Chinese banking system. Esti­ mates of the size of this unofficial shadow-banking activity are hard to come by. The Bank of China estimated that as of 2012 there were 20,000 wealth management accounts with a total value of 12.14 RMB (Elliott and Yan, 2013). A more conservative estimate puts the aggregate value at 7.1 trillion RMB, which still represented 14 percent of China’s GDP (Xia et al., 2013). Given the contribution of SIVs to the global financial crisis of 2007–9, the continued proliferation of such risky structures in China is cause for concern. Although risk is amorphous and often changes its shape from one form to another, we can delineate several major sources of risk. The first, market risk, includes interest rate risk. Thus, if, for example, interest rates increase unexpectedly, the bank’s cost of funds may Page 3 of 32

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Private Information and Risk Management in Banking increase and the value of its longer-term assets may fall, to the detriment of both the bank’s profitability (net interest margin) and the market value of the bank’s equity. A second source of risk is credit risk. Since the most substantial asset classification on the bank’s balance sheet consists of loans (whether to businesses, residential households, or (p. 156) even sovereign governments), banks face the risk of default or deterioration in the borrower’s credit quality.2 As many of the subprime mortgages in the pools originated in 2005 and 2006 began to show delinquencies as early as one year or less after origina­ tion, there were concerns in the market about the credit risk exposure of the securities, despite their AAA and AA credit ratings. A third source of risk, described above in the context of the 2007 credit crisis, is liquidity (or rollover) risk. Banks transform short-term, liquid liabilities (such as demand deposits) into longer-term, illiquid assets (such as loans). If there is a sudden demand for liquidity, the bank will be unable to meet all withdrawal demands because of the costs of selling an illiquid portfolio at fire-sale prices. Another source of risk is operational risk. Banks undertake clearing and custodial trans­ actions on behalf of their customers. Fraud, mismanagement, computer failure, and hu­ man error can result in losses to customers, which the bank may have to reimburse in or­ der to protect its reputation. Strategic business errors cause catastrophic losses that may threaten the bank’s viability. Loss of reputation may spell the end of the firm’s indepen­ dence for a financial institution—as in the case of the venerable Barings Bank. In the con­ text of the credit crisis of 2007, HSBC absorbed $45 billion in assets from its SIVs in or­ der to protect its reputation in the market. Moreover, firms such as Citi, Merrill Lynch, UBS, Bear Stearns, etc. have all had their reputations tarnished by their participation in the subprime mortgage debacle. This brief thumbnail survey of risk exposures highlights the importance of measuring the amount of risk in the bank’s risk inventory on a continual basis. Thus, before we can even talk about risk management, we first have to discuss risk measurement. Section 6.2 of this chapter will describe commonly used models of risk measurement for banks—Value at Risk (VaR) and Expected Shortfall (ES). Only after the bank’s risk exposure is mea­ sured can we discuss how to manage that risk. It is a common perception that it was mod­ els such as VaR that led to, if not caused, the global financial crisis that began in 2007–8. Flaws in risk measurement models presumably misled banks and other financial institu­ tions, thereby reassuring them by obscuring the actual risk levels in the system. Undoubt­ edly, there are flaws in the models. However, there is evidence that banks were aware of their extreme risk exposures in 2006. For example, Goldman Sachs actively hedged its mortgage risk exposure months before the crisis broke during the summer of 2007. Most financial institutions, however, ignored the red alert future risk signals sent by their inter­ nal models in favor of the lucrative prospects immediately in front of them. Rather than the models failing the financial community, it could be said that it was the financial com­ munity that failed the models by failing to respond to signals sent by the models. Indeed,

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Private Information and Risk Management in Banking in this chapter, we will show how financial professionals blithely ignored warning signals and took actions that actually exacerbated risk exposure. What if, upon measuring the amount of risk in the bank’s risk inventory, we find that the exposure is too high from the perspective of top management’s risk tolerance? Can banks simply refuse to take on more risk? The answer is no. The business of banking (p. 157) re­ quires that banks stand ready to absorb the risks of their customers at a price. If cus­ tomers are willing to pay that price, it is bad business practice to refuse it. Customers will be forced to go elsewhere and it may be impossible to win them back. Instead, the bank should continue to take on their customers’ risk exposures—whether by making loans with credit risk, or absorbing currency risk by offering import/export firms cross-curren­ cy letters of credit, or by executing trust agreements, thereby exposing the bank to oper­ ational risk. However, once that risk is placed into inventory, the bank’s risk management team can then decide whether to hold that risk or resell it in the global marketplace. This “risk reselling” is accomplished using financial derivatives. Banks can manage their risk inventory using financial futures, forward contracts, options, and swaps. This is a much more efficient way for the bank to manage risk than disappointing long-standing cus­ tomers. Thus, risk management takes place almost exclusively using derivatives transac­ tions, rather than balance-sheet adjustments. After reviewing the risk management op­ portunities available to banks in the derivatives markets in section 6.3, it should be clear that risk measurement and management requires prodigious amounts of information. Section 6.4 discusses the exploitation of private information produced in the course of banking activity. Finally, the chapter concludes in section 6.5 with a discussion of the eco­ nomic importance of banking sector risk.

6.2 Risk Measurement Risk measurement has preoccupied financial market participants since the dawn of finan­ cial history. However, many past attempts have proven to be impractically complex. For example, upon its introduction, Harry Markowitz’s Nobel Prize-winning theory of portfo­ lio risk measurement was not adopted in practice because of its onerous data require­ ments.3 Indeed, it was Bill Sharpe who, along with others,4 made portfolio theory the standard of financial risk measurement in real world applications through the adoption of the simplifying assumption that all risk could be decomposed into two parts: systematic, market risk and the residual, company-specific or idiosyncratic risk. The resulting Capital Asset Pricing Model theorized that since only undiversifiable market risk is relevant for securities pricing, only the market risk measurement β is necessary, thereby considerably reducing the required data inputs. This model yielded a readily measurable estimate of risk that could be practically applied in a real-time market environment. The (p. 158) only problem was that β proved to have only a tenuous connection to actual security returns, thereby casting doubts on β’s designation as the true risk measure.5 With β questioned, and with asset pricing in general being at a bit of a disarray with re­ spect to whether the notion of “priced risk” is really relevant, market practitioners Page 5 of 32

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Private Information and Risk Management in Banking searched for a replacement risk measure that was both accurate and relatively inexpen­ sive to estimate. Despite the consideration of many other measures and models, Value at Risk (VaR) has been widely adopted and subject to considerable criticism. Part of the his­ torical reasons leading to the widespread adoption of VaR was the decision of JP Morgan in 1994 to create a transparent VaR measurement model, called RiskMetrics, in response to Basel’s add-on market adjustment to the 8 percent risk-based capital requirement for credit risk which fully came into effect in 1992. RiskMetrics was supported by a publicly available database containing the critical inputs required to estimate the model.6 In the past, many of the risk measurement models were private, internal models, devel­ oped in-house by financial institutions. Internal models were used for risk management in its truest sense. Indeed, the VaR tool was complementary to many other internal risk measures—such as RAROC, developed by Bankers Trust in the 1970s.7 However, market forces during the late 1990s created conditions that led to the evolution of VaR as a domi­ nant risk measurement tool for financial firms. The US financial environment during the 1990s was characterized by the de jure separa­ tion of commercial banking and investment banking that dating back to the Glass–Stea­ gall Act of 1933.8 However, these restrictions were undermined in practice by Section 20 affiliates (that permitted commercial bank holding companies to engage in investment banking activities up to certain limits), mergers between investment and commercial banks, and commercial bank sales of some “insurance” products, especially annuities. Thus, commercial banks competed with investment banks and insurance companies to of­ fer financial services to clients in an environment characterized by globalization, en­ hanced risk exposure, and rapidly evolving securities and market procedures. Concerned about the impact of the increasing risk environment on the safety and soundness of the banking system, bank regulators instituted (in 1992) risk-adjusted bank capital require­ ments that levied a capital charge for both on- and off-balance-sheet credit risk expo­ sures. Risk-adjusted capital requirements initially applied only to commercial banks, al­ though insurance companies9 and securities firms had to comply with their own reserve (p. 159)

and haircut regulations as well as with market forces that demanded capital cushions against insolvency based on economic model-based measures of exposure—so-called eco­ nomic capital. Among other shortcomings of the BIS capital requirements were their ne­ glect of diversification benefits, in measuring a bank’s risk exposure. Thus, regulatory capital requirements tended to be higher than economically necessary, thereby undermin­ ing commercial banks’ competitive position vis-à-vis largely unregulated investment banks. To compete with other financial institutions, commercial banks had the incentive to track economic capital requirements more closely, notwithstanding their need to meet regulatory capital requirements. The more competitive the commercial bank was in pro­ viding investment banking activities, for example, the greater its incentive to increase its potential profitability by increasing leverage and reducing its capital reserves.

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Private Information and Risk Management in Banking JP Morgan was one of a handful of globally diversified commercial banks that were in a special position relative to the commercial banking sector on the one hand and the invest­ ment banking sector on the other. These banks were caught in between, in a way. On the one hand, from an economic perspective, these banks could be thought of more as invest­ ment banks than as commercial banks, with large market risks due to trading activities, as well as advisory and other corporate finance activities. On the other hand, this group of globally diversified commercial banks was holding a commercial banking license, and, hence, was subject to commercial bank capital adequacy requirements. This special posi­ tion gave these banks, JP Morgan being a particular example, a strong incentive to come out with an initiative to remedy the capital adequacy problems that they faced. Specifical­ ly, the capital requirements for market risk in place were not representative of true eco­ nomic risk, due to their limited account of the diversification effect. At the same time, competing financial institutions, in particular investment banks such as Merrill Lynch, Goldman Sachs and Salomon Brothers, were not subject to bank capital adequacy re­ quirements. As such, the capital they held for market risk was determined more by eco­ nomic and investor considerations than by regulatory requirements. This allowed these institutions to bolster significantly more impressive ratios such as return on equity (ROE) and return on assets (ROA) compared with banks with a banking charter. In response to the above pressures, JP Morgan took the initiative to develop an open ar­ chitecture (rather than in-house) methodology, called RiskMetrics. RiskMetrics quickly became the industry benchmark in risk measurement. The publication of RiskMetrics was a pivotal step, moving regulators toward adopting economic capital-based models in mea­ suring a bank’s capital adequacy. Indeed, bank regulators worldwide allowed (sophisticat­ ed) commercial banks to measure their market risk exposures using internal models that were often VaR-based. The market risk amendments to the Basel accord made in-house risk measurement models a mainstay in the financial sector. Financial institutions world­ wide moved forward with this new approach and never looked back. The question that is the basis for VaR as we know it today is “how much can we lose on our trading portfolio by tomorrow’s close?” Note that this is a risk measurement, (p. 160)

not a risk management question. Also, it is not concerned with obtaining a portfolio posi­ tion to maximize the profitability of the bank’s traded portfolio subject to a risk con­ straint, or any other optimization question. Instead, this is a pure question of risk mea­ surement. VaR takes a statistical or probabilistic approach to answering Mr. Weatherstone’s question of how much could be lost on a “bad day.” That is, we define a “bad day” in a statistical sense, such that there is only an x percent probability that daily losses will exceed this amount given a distribution of all possible daily returns over some recent past period. That is, we define a “bad day” so that there is only an x percent proba­ bility of an even worse day. Moreover, VaR models can be used to estimate the expected average loss on such bad days (the expected shortfall). Implementing VaR models requires estimation of a probability distribution of returns (or losses) so that we can measure the cut-off point that designates the loss that will be ex­ ceeded with an x percent probability on any given day. The simplest forms of RiskMetrics, Page 7 of 32

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Private Information and Risk Management in Banking for example, the Rule 415 model, assume that financial securities are normally distrib­ uted. This makes estimation of VaR quite easy because all we have to do is estimate the mean and standard deviation of securities prices using historical data. Unfortunately, it is often the case that the simplicity of the VaR measures used to analyze the risk of the equi­ ty portfolio, for example, is in large part obtained with assumptions not supported by em­ pirical evidence. The most important (and problematic) of these assumptions is that daily equity returns are normally distributed, ignoring the asymmetric payoff structures of many financial instruments such as options and the “fat-tailed” risk (i.e., enhanced proba­ bilities of extreme losses) observed in the financial crisis. In general, there is a tradeoff between the accuracy of assumptions and ease of calculation, such that greater accuracy is often accompanied by greater complexity.10 This problem of complexity is exacerbated when there is a paucity of data available to be used to estimate the model’s fundamental assumptions. Market risk exposure arises from unexpected security price fluctuations, estimated using long histories of daily price fluc­ tuations. Unfortunately, measuring a loan’s credit risk exposure, for example, is far more difficult. Since loans are not always traded, and even when traded they trade infrequent­ ly, there is often no history of daily price fluctuations available to build a (loan) loss distri­ bution. Moreover, credit events such as default or rating downgrades are rare, often nonreoccurring events. Thus, we often have insufficient statistical power to estimate a daily VaR for credit risk exposure; that is, data limitations create special challenges in adapting VaR techniques to estimate credit risk exposure. However, we can use VaR techniques to estimate losses due to credit events if the time interval we consider is longer. Indeed, the convention in the new generation of credit risk models is to assume that the credit risk time horizon is one year, thereby estimating losses during the next year if it is a “bad” year, defined according to a specified VaR level; for example, a 99.5 percentile VaR (i.e., x percent equals 0.5 percent) estimates the minimum losses in the (p. 161) worst five years out of a 1,000. A VaR model, such as CreditMetrics, measures the probability that the credit rating of any given debt security will change over the course of the one year credit horizon. The tabulation of potential changes in credit ratings—known as the credit migra­ tion matrix—considers the entire range of credit events, including upgrades and down­ grades as well as actual default. Historical migrations of publicly traded debt instru­ ments, such as corporate bonds, are used to tabulate the annual probability of any given change in credit risk. These loss probabilities are then applied to specific debt instru­ ments, such as untraded loans, to calculate the loan portfolio’s VaR. Because of the problems in applying the VaR model to credit risk assessment, banks often use other credit risk measurement models. There has been widespread adoption of credit scoring models in all arenas of bank lending—mortgage lending, commercial lending, credit card and revolving debt, etc. Credit scoring models (e.g., FICO scores) apply dis­ criminant analysis to a class of borrowers by identifying certain key factors that deter­ mine the probability of default (as opposed to repayment), and combine or weight them into a quantitative score. In some cases, the score can be literally interpreted as a proba­

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Private Information and Risk Management in Banking bility of default; in others, the score can be used as a classification system: it places a po­ tential borrower into either a good or a bad group, based on a score and a cutoff point. VaR models also have the potential to measure operational risk exposure. VaR measures losses from unexpected, extreme shocks that are in the tail of the probability distribution (i.e., at the end of outcomes that are extremely unlikely to occur). Thus, the probability of a VaR-sized event (x percent) is very small (i.e., 5 percent or 1 percent or 0.5 percent). However, when these improbable events occur, they are catastrophic for the firm and typ­ ically result in insolvency. Indeed, Allen and Bali (2007) find that operational risk events are likely to be the cause of large unexpected catastrophic losses. They use a comprehen­ sive approach to measuring operational risk that includes reputational risk and strategic business risk and shows that approximately 18 percent of financial institutions’ returns represent compensation for operational risk. Finally, it should be noted that because of the fat-tailed risks (in violation of assumptions of normality) with observed returns falling in the range of between six to nine standard deviations from the mean, the Basel III regulations adopted in 2012 have incorporated the expected shortfall as the appropriate measure of market risk for capital require­ ments. Conceptually, the bank looks at the worst daily returns earned on an asset over the previous 100 days, and the worst daily returns in the 100 days prior (101 to 200 days before the present) and the worst daily returns in the 100 days prior (201 to 300 days be­ fore the present). A simple measure of the expected shortfall is simply the average of these three worst returns. For example, if the worst daily return in the past 100 days was –3 percent; and the prior 100 days’ worst return was –3 percent; and the prior 100 days’ worst return was –6 percent, then the expected shortfall would average these three re­ turns for a value of –4 percent. Often, because of the fatness of tails in the return distrib­ ution, the losses associated with this expected shortfall measure will be greater than the losses associated with the 99 percent VaR. In the illustration, therefore, the loss of –4 per­ cent from the expected shortfall exceeds the VaR loss of –3 percent. Thus, the (p. 162) ex­ pected shortfall is a more conservative measure of bank risk than VaR under the normal probability distribution assumption.

6.3 Risk Management Suppose that the VaR or expected shortfall model implemented by the bank provides a measure of risk exposure that is enormous—even in excess of the bank’s capital position. What can be done? The first thing is not to panic. The second is to fire up the derivatives traders. The bank can manage its risk position by trading in derivatives markets. If the initial risk inventory is too high, the bank can undertake hedging transactions to reduce its risk exposure without turning away profitable and long-standing customers. On the other hand, if the initial risk inventory is too low, and therefore not profitable enough, the bank can undertake speculative transactions to increase its risk exposure. Derivatives markets are the thermostat used by the bank to control its risk temperature.

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Private Information and Risk Management in Banking Warren Buffett has termed derivatives “financial weapons of mass destruction.”11 He has decried the “daisy chain of risk” that is facilitated by derivatives that require little pay­ ment up front, but can represent large and uncertain obligations in the future. This point of view has led some to call for a ban on certain derivatives, although Warren Buffett ad­ mits that “the derivatives genie is out of the bottle, and these instruments will almost cer­ tainly multiply in variety and number until some event makes their toxicity clear.” Howev­ er, the fundamental question is whether derivatives are the cause of this “toxic” behavior, or merely the vehicle for excessive risk-taking. If it is the latter, there will always be fi­ nancial players who exploit the system for personal gain, whether or not they have deriv­ atives to accomplish their nefarious goals. In either extreme, pure hedging or pure speculating, the derivatives transaction is tied to, indeed motivated by, another transaction, or series of transactions that constitute the un­ derlying cash position. The Commodity Futures Trading Commission (CFTC) estimates that up to 85 percent of all futures trades are explicitly linked to other transactions. If the cash flows on the derivatives transaction are opposite to those of the underlying cash po­ sition, we consider the derivatives trade to be a hedge. If, on the other hand, the cash flows move in the same direction, we consider the derivatives trade to be speculative. The cash flows on derivatives are determined by fluctuations in interest rates, exchange rates, equity prices, default probabilities, etc. That is, derivatives can be used to manage all types of risk exposure.12 Suppose, for example, the bank has an underlying cash position that is exposed to inter­ est rate increases. This is a very common position for a bank as a result of the process of “borrowing short to lend long.” Thus, the bank’s assets have a longer maturity (duration) than the bank’s liabilities, leading to a positive duration gap. Under these (p. 163) circum­ stances, the underlying cash position (the bank’s portfolio) will decline in value and prof­ itability will fall if interest rates go up. To hedge that risk, the bank can undertake a de­ rivatives position that generates positive (offsetting) cash flows when interest rates go up —that is, a short position. Short positions can be implemented by selling interest rate fu­ tures or forwards, buying put options on interest rate sensitive instruments and/or buying fixed-for-floating swaps. We examine each of these markets briefly.

6.3.1 Financial Futures and Forwards The concept of a forward contract originated in sixteenth-century Japan when landowners raised money by selling rice in advance of delivery to rice merchants. A more formal, ex­ change-based contract, the precursor to the modern futures contract, originated in the US Midwest during the early nineteenth century. In 1848, some eighty-two merchants met above a flour store on Chicago’s South Water Street and formed the Chicago Board of Trade (CBOT). Today, merged with the Chicago Mercantile Exchange (CME), the CBOT trades millions of futures contracts, as well as options and swaps. Financial futures or forwards are obligations to make (sell) or take (buy) delivery of some underlying financial asset at a predetermined price (i.e., futures or forward price) on a Page 10 of 32

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Private Information and Risk Management in Banking specified delivery date. The counterparty that buys the contract agrees to buy the under­ lying financial asset and holds a long position. The counterparty that sells the contract is obligated to sell the underlying financial asset and holds a short position. The long posi­ tion gains if the price upon delivery date is higher than the predetermined price, whereas the short position gains if the price declines below the predetermined price. Typically, there is no actual delivery of the underlying financial asset in financial futures/forward contracts (in contrast to commodity futures/forwards). Instead of physical delivery, the contracts are usually cash settled, with the losing party paying the winning party for the difference between the spot price upon delivery minus the predetermined futures/for­ ward price. For example, if the bank has a positive duration gap and wants to hedge its exposure to rising interest rates, it may take a short position in an interest rate futures contract, such as the US Treasury bills futures contract or the 3-month Eurodollar futures contract.13 If interest rates go up, the price of the contract falls and the short (selling) counterparty gains. For each basis point increase in interest rates, the Treasury bill and Eurodollar fu­ tures contracts gain $25 per $1 million face value. This cash inflow would offset some (or all) of the losses on the underlying cash position emanating from the bank’s positive dura­ tion gap.14 (p. 164)

Banks can hedge interest rate risk, currency risk, equity price risk, commodity

risk, credit risk and operational risk using futures and forward contracts. The methodolo­ gy is the same as illustrated above; that is, short futures/forwards positions hedge under­ lying cash exposures to price declines and long futures/forwards positions hedge underly­ ing cash exposures to price increases. The only difference is the identity of the reference security. Thus, when hedging currency risk, the reference security’s value must fluctuate with shifts in foreign exchange rates. When hedging credit risk, the derivative’s underly­ ing security fluctuates with shifts in default risk.

6.3.2 Financial Options Financial futures and forwards are useful tools to protect an underlying cash position from losses due to risk exposure. However, because of their symmetric cash flow payout, they also protect an underlying cash position from gains. That is, when the positive dura­ tion gap bank puts on a short futures position, and interest rates decline rather than in­ crease, the bank’s portfolio will make money, but the hedge will lose money. Thus, there was a demand for a hedging instrument that would protect against losses, but not against gains—that is, an insurance policy against losses. This insurance policy is an options con­ tract. An options contract is a derivative that gives the holder the right, not the obligation, to buy (call option) or sell (put option) an underlying reference financial asset at a predeter­ mined price (the exercise or strike price) for a time period up until the specified expira­ tion date.15 The buyer (holder) of the option retains the right to exercise the option if it is worthwhile. That is, if the holder has a call option, they will benefit when prices increase Page 11 of 32

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Private Information and Risk Management in Banking above the exercise price. If prices do not exceed the exercise price at expiration date, the option expires worthless. Thus, if the bank wants to use an option to hedge its exposure to rising interest rates, it would purchase a put option on an interest rate sensitive instru­ ment (such as a Eurodollar futures contract),16 which would generate positive cash flows if interest rates increase (and prices fall), thereby offsetting the bank’s loss due to its un­ derlying cash position with a positive duration gap. If, however, interest rates decline, the positive duration gap bank generates positive cash flows and the option hedge expires worthless, thereby allowing the bank to keep its gains. The exception to this is that the options buyer must pay an upfront cost—the pre­ mium—which is non-refundable to the buyer if the option expires worthless.17 Options premiums are quite substantial. Therefore, we have seen the development of compound options positions, such as straddles, collars, butterflies, etc. that were originated in order to reduce the upfront premium cost of options trades. As market participants experiment­ ed with these “lower cost options hedges,” however, they found that they were viable products in their own right. Therefore, today, collars are sold as stand-alone risk manage­ ment products to the customers of financial institutions. Alternatively, they can be pack­ aged with other financial products, as in adjustable-rate mortgages that contain collars. (p. 165)

6.3.3 Swaps It did not take long for financial market professionals to see the extension to fixed-forfloating rate swaps (to hedge interest rate risk) and credit default swaps (to hedge credit risk exposure). A swap is essentially a portfolio of forward contracts with predetermined payment dates, called reset dates, and predetermined prices. In a fixed-for-floating rate swap, for example, the buyer of the swap exchanges floating rate payments (say, tied to LIBOR) for fixed rate payments. If interest rates increase, the swap buyer gains because, instead of paying the higher LIBOR payments, the swap buyer pays the lower, predeter­ mined fixed rate. Thus, the positive duration gap bank can purchase fixed-for-floating rate swaps in order to hedge its exposure against increasing interest rates. Upon reset dates (which can occur monthly, quarterly, semi-annually, annually) for the life of the swap (which can last for up to five or ten years), the swap intermediary calculates the payments required, nets them out and supervises the transfer of the net cash flow (the difference between the fixed and floating rate as of the reset date) between the coun­ terparties. Thus, if interest rates have increased, the swap seller pays the swap buyer an amount equal to the difference between the fixed rate minus the floating rate times the notional value of the swap, and vice versa if interest rates have declined. The swap inter­ mediary also acts as the guarantor to insure that each swap counterparty meets its oblig­ ations. In exchange for setting up the transaction, monitoring its cash flows and guaran­ teeing the counterparty credit risk, the swap intermediary receives a fee that is paid on each reset date. The dominant credit derivative to date has been the credit default swap (CDS). Credit de­ fault swaps (CDS) are essentially insurance policies on the face value (notional value) of Page 12 of 32

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Private Information and Risk Management in Banking corporate debt (bonds or loans) such that the CDS buyer pays a premium in exchange for protection against loss from credit events (e.g., default) on the underlying (reference) (p. 166) debt instrument.18 That is, in the event of default, the CDS seller must pay the CDS buyer either some cash amount or transfer physical securities, depending upon the method of settlement. CDS are customizable, over-the-counter (OTC) contracts, although standardization enhances the tradability (liquidity) of the contract.19 Thus, five-year CDS contracts are most prevalent, although 1-, 3-, 7- and 10-year contracts are also traded.20 In contrast to actual insurance policies, there is no requirement that the CDS buyer actu­ ally own the underlying reference securities, and therefore the notional value of CDS con­ tracts has at times exceeded the total value of the outstanding debt instruments.21 For ex­ ample, Helwege et al. (2009) report that the number of General Motors outstanding debt was $20 billion less than the $65 billion CDS notional value outstanding. As of the end of 2006, the Bank of England estimated total global corporate debt instruments (bonds plus loans) outstanding at $17.1 trillion. In contrast, the BIS reported that single name CDS outstanding during the first half of 2007 had a total notional value exceeding $20 trillion.22 This had implications both for settlement of the CDS contract and systemic risk exposure. The credit derivatives market has grown from its roots as an ad hoc attempt by banks to transfer their risk exposure.23 As of December 2016, OTC derivatives’ notional value totaled $483 trillion, a decline from $553 trillion as of June 2016. Out of this, CDS represented a notional value of $9.9 trillion as of year-end 2016, substantially reduced (p. 167)

from pre-crisis levels exceeding $40 trillion. The gross market replacement value amount­ ed to $292 billion as of December 2016. Historically, the OTC derivatives markets have been dominated by dealers who limit the flow of information to buy-side investors by requiring trade-by-trade bilateral negotiation and preventing the release of real-time quote and trade information. Prompted by regula­ tors and litigation, centralized trading via electronic exchanges has spread throughout fi­ nancial markets, thereby slowly moving OTC derivatives have slowly moved toward a more transparent centralized system. Indeed, the use of a centralized clearing system for derivatives trading gets favorable treatment under Basel III capital requirements. Anoth­ er critical component of this transition has been the development of a centralized clear­ ing counterparty that acts as a clearinghouse on all trades. Thus, the decline in OTC de­ rivatives activity was concentrated in the segment that is not centrally cleared as a result of high margin requirements. In contrast, the share of centrally cleared CDS increased to 44 percent as of December 2016. In OTC interest rate derivatives markets, 76 percent were booked against centralized counterparties, with 92 percent of forward rate agree­ ments and 81 percent of interest rate swaps as of December 2016. Thus, the OTC deriva­ tives markets are in transition as they move slowly toward a more transparent trading mechanism. Any perceived impediment to centralized clearing as a result of confidential information requirements is negated by the development of multi-name and index contracts. For ex­ Page 13 of 32

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Private Information and Risk Management in Banking ample, in September 2003, the Dow Jones CDX (DJ CDX) North American Investment Grade Index was introduced. In November 2004, Markit initiated a credit index data ser­ vice, which included the DJ CDX (which also includes indexes covering emerging market credit derivatives) and the International Index Company’s (IIC) iTraxx (which covers the EU, Japan, and non-Japan Asia). Both sets of indexes are made up of 125 of the most liq­ uid, investment-grade credits in the form of CDS. For example, the DJ CDX consists of a basket of 125 CDS contracts on US firms with liquid, investment grade corporate debt. The identity of the components in the index changes every six months—every March and September for the DJ CDX. Companies may be dropped from the index if they are down­ graded or become illiquid. For example, Ford and General Motors were dropped from the DJ CDX in September 2005 when their debt fell below investment grade. The index is equally weighted, and so each CDS component makes up 0.8 percent of the index value. Using indexed CDS to hedge credit risk may be less expensive because of the liquidity of these instruments, although it does expose the hedger to basis risk.24 Synthetic collateral­ ized debt obligations (CDO) are comprised of (p. 168) tranches of indexed CDS. Thus, CDS are used as building blocks in financial securities design as well as risk management.25 Similar to options, but different from non-credit-related swaps, the risks on a credit swap are not symmetrical. That is, the protection buyer receives a payment upon the occur­ rence of a credit event trigger, but the swap “expires worthless” if no trigger occurs.26 In that event, the protection seller keeps the periodic premiums paid for the swap, similar to the convex cash flows that characterize options. Thus, the protection buyer transfers the credit risk to the protection seller in exchange for a premium. The size of the premium, known as the swap spread, is the internal rate of return that equates the periodic premi­ um payments to the expected payments in the event of a credit event trigger. The spread is quoted per annum, but paid quarterly throughout the year.27 Although the credit protection buyer hedges exposure to default risk, there is still coun­ terparty credit risk in the event that the seller fails to perform their obligations under the terms of the contract (as was the concern in September 2008 with regard to AIG, an ac­ tive CDS seller).28 A pure credit default swap is similar to buying credit insurance and/or a multiperiod credit option. The growth in trading of these credit derivatives has facilitat­ ed a net overall transfer of credit risk from banks to non-banks, principally insurance companies. Banks, securities firms, and corporations are net buyers of credit protection, whereas insurance companies, hedge funds, mutual funds, and pension funds are net sell­ ers. Insurance companies view credit derivatives as an insurance product, in which their relatively high credit ratings can be used to insure the buyers of credit protection (e.g., banks) against risk exposure to their loan customers. Credit derivatives such as CDS al­ low a bank to alter the risk-return tradeoff of a loan portfolio without having to sell or re­ move loans from the balance sheet. Apart from avoiding an adverse customer relationship effect, the use of credit derivatives (rather than loan sales or other portfolio methods for reducing the bank’s credit risk exposure) may allow a bank to avoid adverse timing of tax payments, as well as liquidity problems related to buying back a similar loan at a later date if risk-return considerations so dictate. Thus, for customer relationship, tax, transac­ tion cost, and liquidity reasons, a bank may prefer the credit derivative (p. 169) solution to Page 14 of 32

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Private Information and Risk Management in Banking loan portfolio optimization rather than the more direct (loan trading) portfolio manage­ ment solution.

6.4 Private Information Within Large Complex Banking Organizations Information is at the heart of finance and economics. This is particularly true for financial institutions that specialize in risk measurement and management. The business of finan­ cial intermediation involves the gathering of information that is aggregated and mobi­ lized to allocate capital on behalf of customers who range from businesses to govern­ ments to households. Bank screening and monitoring activity in the course of a lending relationship involves the production of private information about the bank’s customers. Although the bank’s monopoly power over its own information set may lead to conflicts of interest and abuse (e.g., via front-running of customer orders, manipulative and decep­ tive structured financial transactions, and insider trading), one cannot abolish these infor­ mation monopolies that are fundamental by-products of all intermediation activity. To do so would eliminate any value in the intermediation function as the information and skill set of each financial institution is its fundamental value-creating resource, thereby im­ pairing the bank’s ability to measure and manage risk. Thus, each financial intermediary is endowed with a unique information set comprised of the sum of information obtained from each of the bank’s individual interactions with its customers. The value of this infor­ mation hinges on two basic characteristics: the information’s exclusivity and reusability. That is, monopoly rents are higher, the more exclusive or the fewer the number of com­ peting banks possessing the information set (see Petersen and Rajan, 1994; Bolton and Scharfstein, 1996; Hubbard, Kumar, and Palia, 2002). Alternatively, information is more valuable the more reusable and generally applicable the information for financial market transactions (e.g., Holmstrom and Tirole (1997) model synergies between monitored bank debt and arms-length debt issuance). Informationally intensive relationship banking benefits both borrower and lender. Repeat­ ed borrowing from the same relationship bank reduces borrowing costs, thereby benefit­ ing borrowers (see Bharath et al., 2011). Further, utilizing a relationship bank as advisor increases the price paid to the target firm in an acquisition (see Allen et al., 2004). In ad­ dition, deposit-taking provides important information that can be used by the relationship bank to monitor and advise customers (see Mester, Nakamura, and Renault, 2007). Stock­ holders also benefit from the approval of bank loans as shown by positive stock price re­ actions (see Li and Ongena, 2014). Finally, and perhaps most importantly, relationship banks themselves also benefit from the ongoing, informationally intensive interaction with their customers. Banks are more likely to win additional business (lending or other services) from past borrowers (see Bharath et al., 2007) as a result of their information advantage.

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Private Information and Risk Management in Banking There is a natural tension between informational exclusivity and reusability since the reuse of private information undermines the information’s exclusivity. Reusing its pri­ vate information in many different markets and activities would most intensively generate returns from the bank’s information set. However, the more actively the lender reuses its private information in trading the borrowing company’s securities, the greater the dissi­ pation in the bank’s information monopoly. Trading may reveal the lender’s private infor­ mation and impact securities prices, thereby signaling the information content to compet­ ing financial institutions and undermining its exclusivity (e.g., Leland and Pyle, 1977; James, 1987; Lummer and McConnell, 1989). Moreover, the borrower may develop less costly alternatives to bank debt as the firm’s equity and publicly traded debt markets (e.g., bonds) become more liquid. Thus, the bank faces a tradeoff between trading returns from the reuse of information against the economic rents from maintaining private con­ trol of the information (i.e., restricting activity via bank hoarding of information), thereby endogenizing the bank’s solution to the classic hold-up problem (Rajan, 1992). This may be manifest in a tradeoff between bank returns on lending and investment returns on publicly traded equity and debt securities. (p. 170)

Indeed, informed equity market traders preserve their comparative advantage from pri­ vate information by obscuring their information from non-informed traders via stealth and gradual trading strategies (e.g., see Kyle, 1989; Boulatov, Hendershott, and Livdan, 2013; Dong and Massa, 2013; Kyle, Obizhaeva, and Wang, 2014; Foucault, Hombert, and Rosu, 2016). Similarly, it is reasonable to expect that relationship banks would judiciously trade on their private information in ways similar to equity market traders so as to pro­ tect their informational advantage. The potential loss from the dissemination of private information is even more severe for bank lenders than for equity market traders since the dissipation of the relationship bank’s informational advantage may jeopardize the bank’s monopoly loan rents, as well as erode potential equity trading gains. However, there is an amount of academic literature that suggests that relationship banks aggressively utilize private information from new lending in order to manage equity port­ folios in affiliated mutual funds (see Massa and Rehman, 2008; Dass and Massa, 2011). This literature is limited to the US case in which US banks utilize private information gen­ erated in the course of new lending to US borrowing firms in order to earn positive ab­ normal returns on their affiliated equity mutual funds by increasing their equity holdings. Allen et al. (2017) show that this result does not apply in the cross-border international context. In contrast to domestic US studies, they find that mutual funds affiliated with US lending banks have lower equity holdings in non-US borrowing firms during the quarter of new loan initiation, as compared to non-lending or non-affiliated mutual funds. Further, Allen et al. (2017) show that banks focus on lending to non-US repeat borrowers with lower levels of equity investment by affiliated mutual funds, consistent with Phelan (2017) who shows that correlated lending increases loan payoffs. Similarly, Dang et al. (2017) show that opaque banks limit their trading in financial markets in order to prevent the dissemination of secret information about bank borrowers, thereby maintaining the bank’s monopoly rents on lending. Indeed, Allen et al. (2017) find that loan rates increase as bank mutual fund equity holdings decrease, illustrating (p. 171) the benefit to the lend­ Page 16 of 32

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Private Information and Risk Management in Banking ing bank from the strategic use of their private information. That is, as banks reduce their equity investment in borrowing firms, they reap the benefits of higher loan rates. This result is consistent with other studies that show how banks exploit credit-con­ strained borrowers. For example, Santos and Winton (2008) find that bank-dependent firms pay higher interest rates than firms with access to public debt and equity markets. Hale and Santos (2009) show that banks reduce loan rates after their relationship bor­ rower issues publicly traded bonds, thereby breaking the relationship bank’s monopoly. They find that both the granting of a credit rating and a bond IPO undermines the bank’s lending monopoly by providing public information about a firm’s creditworthiness and providing access to debt markets other than bank loans. Thus, banks are forced to reduce interest rates as their informational rents are reduced. Schenone (2010) also finds that dissemination of private information in the course of an IPO reduces loan spreads. To pre­ vent this, banks may voluntarily limit their trading on private information obtained from relationship borrowers. Thus, insider trading restrictions may actually exacerbate infor­ mational frictions and exploitation of credit-constrained borrowers in opaque markets. Failure to utilize private loan information in equity market trading activity is more pro­ nounced for borrowing firms located in emerging nations. Since emerging equity markets tend to be less developed and thinly traded, any attempt to utilize the bank’s private in­ formation in equity investing would be quickly detected, thereby raising equity prices and eroding the potential returns to equity market trading as the informational advantage is dissipated. Indeed, Nguyen and Rugman (2015) show that over 90 percent of financing in British subsidiaries located in Southeast Asia come from internal sources in order to cir­ cumvent the thinly traded, inefficient local equity markets. Moreover, monopoly loan rents tend to be higher in emerging countries because of information asymmetries and in­ stitutional frictions. Thus, the lending bank has more to lose in the context of emerging markets as a result of the loss of its monopoly rents if private information seeps out via equity market trading. Therefore, during the quarter of new loan initiation by non-US firms, Allen et al. (2017) find that mutual funds affiliated with lending banks reduce equi­ ty market turnover in borrowing firms, particularly if they are located in emerging na­ tions. Since lending bank trading in equity markets improves liquidity and reduces equity market spreads (see Allen et al., 2012), reductions in equity turnover by lending banks re­ duces equity market liquidity, thereby acting as the mechanism to raise the cost of equity to non-US borrowing firms. That is, the withdrawal of informed traders such as lending banks from equity markets impairs price discovery and raises the illiquidity premium em­ bedded in borrowing firms’ equity prices. Thus, reductions in international equity turnover make non-US borrowing firms dependent on bank loans rather than equity as sources of financing. Phelan (2017) shows that bank investment in correlated loans acts as a monitoring com­ mitment mechanism that enables banks to earn monopoly rents. By knowing each project’s returns, the bank obtains information about the state of all correlated project re­ turns. Thus, correlations across loans provide the bank with additional private (p. 172) in­ formation about aggregate states of the world and their impact on the bank’s investment Page 17 of 32

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Private Information and Risk Management in Banking portfolio. In the presence of costly enforcement (as in Krasa and Villamil, 2000), this pri­ vate information makes it more likely that the bank will diligently enforce ex post pay­ ment obligations via monitoring of borrowers. For example, information obtained from a diversified portfolio of correlated loans enables the bank to better distinguish between borrower distress and strategic default. The ability of the bank to keep this information secret is critical, as shown in Dang et al. (2017). Thus, although information obtained in the course of relationship lending may be valuable in directing equity market trading, opaque banks may prevent that information from reaching financial markets by restrict­ ing their trading activity. The optimal exploitation of information gathered over different subsidiaries of large, farflung financial intermediaries operating across financial markets has been understudied in the academic literature. Kahn and Winton (2004) describe complex subsidiary struc­ tures as a centralized response to risk, shifting moral hazard concerns within financial in­ termediaries. That is, a decentralized subsidiary structure can be an optimal response to intra-firm managerial agency problems, thereby increasing the entire firm’s enterprise value. Brown and Wu (2016) find evidence of learning within fund families. Chuprinin, Massa, and Schumacher (2015) find that international mutual funds managed by in-house managers outperform funds that outsource the portfolio management function, thereby demonstrating within-firm benefits. Massa and Zhang (2015) find that banks use private information obtained from foreign lending to respond to global liquidity shocks, thereby reducing returns. Hao and Yan (2012) and Golez and Marin (2015) find that bank-affiliat­ ed mutual funds hold disproportionately large amounts of the parent bank’s IPO or SEO, thereby underwriting the parent bank’s equity. Ferreira, Matos, and Pires (2016) conjec­ ture that the poor performance of bank-affiliated mutual funds emanates from the lending bank’s implicit support of the stock price of the bank’s borrowing firm (which restricts in­ vesting opportunities, thereby reducing equity returns), in order to increase the likeli­ hood of repeat lending business. However, Allen et al. (2017) show that bank-affiliated mutual funds reduce their equity holdings at the time of syndicated bank loan initiations. There may be a spectrum of possible equilibrium outcomes ranging from full exploitation of lending information in all possible trading venues (thereby, stressing the reusability of lending information in equity investing) all the way to complete embargoing of all private lending information (to maximize monopoly rents). Further academic research into the role of private information in bank management is needed to formalize the nature of this continuum of equilibria. The optimal utilization of the relationship bank’s private information set is particularly relevant in the wake of the global financial crisis of 2007–8. The contagious spread of dis­ tress across large financial institutions has since generated calls to break up these behe­ moths into manageable pieces so as to limit systemic risk. However, this policy may gen­ erate other risks to the financial system as a result of the loss of private information pro­ duced by multifaceted banks. A careful analysis of this public policy issue brings us to the last source of risk in this chapter: systemic risk.

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Private Information and Risk Management in Banking

6.5 Why Do We Care About Risk In The Banking Sector? (p. 173)

Until this point, we have focused on the risks inherent within individual financial firms that impact the bank’s shareholders and other stakeholders. However, we have not con­ sidered the risk that financial institutions impose on the economic system at large. That is, we have neglected systemic risk. Viewing the economic wreckage in the aftermath of the financial debacle that began in 2007, it is almost self-evident that systemic risk is im­ portant. For this reason, bank regulators have focused in recent years on ways to mea­ sure systemic risk. Focus has been on correlations among pairs of financial firms to deter­ mine the most interconnected banks, since these “systemically important” banks can set off a chain reaction of financial contagion when they become distressed. These “microlevel” systemic risk measurements measure the contribution of each bank to overall sys­ temic risk. There have been many proposed micro-level estimates of systemic risk that can accomplish this.29 In this chapter, we briefly describe two measures: Adrian and Brunnermeier’s (2016) CoVaR, and the Systemic Expected Shortfall (SES) or SRISK of Acharya et al. (2017) and Brownlees and Engle (2017). Adrian and Brunnermeier’s (2016) delta CoVaR measures the marginal contribution of an individual bank i to overall systemic risk at time period t. Delta CoVaR is defined as the difference between the VaR of the financial system conditional on the distress of bank i minus the VaR of the banking system conditional on bank i’s median financial condition. That is, CoVaRit measures the impact on the VaR of the entire financial system of an event at bank i, whereas Delta CoVaRit measures the difference between CoVaR if bank i is in distress compared to non-distress (median) conditions at bank i. Thus, CoVaRit measures the expected impact of individual bank i on the system-wide value at risk, whereas Delta CoVaRit measures bank i’s marginal contribution to system-level risk in the event of dis­ tress. In contrast, Acharya et al. (2017) focus on the expected shortfall rather than value at risk in their derivation of a micro-level systemic risk measure. They develop a constrained op­ timization model to determine the impact of overall system-wide aggregate declines on each bank’s risk exposure. They advocate setting a tax that charges banks ex ante for both their institutional risk-taking and their contribution to potential systemic risk exter­ nalities. This specification must incorporate a measure of the probability of a systemic cri­ sis so as to differentiate between macroeconomic downturns and individual (p. 174) bank distress. To do this, they specify that a crisis occurs when aggregate bank capital falls be­ low a fixed percentage (z) of aggregate banking assets, where z is often set to equal the 8 percent capital requirement. To empirically define a systemic crisis, Brownlees and Engle (2017) specify a market decline of 10 percent or more within a month. This would cause aggregate capital levels to fall below the threshold z percent of aggregate banking assets. Both the SES and SRISK measures are computed as each bank’s expected undercapital­ ization in the event of a systemic crisis.30

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Private Information and Risk Management in Banking Micro-level measures of systemic risk concentrate on the contribution of each bank to overall undercapitalization in the banking system. However, systemic risk is important be­ cause of the external effects on macroeconomic activity as the impact of each bank’s risktaking spills over past the bank itself to the broader economy. Brownlees and Engle (2017) show that aggregate SRISK forecasts declines in unemployment and industrial production up to twelve months in advance of declines. Allen, Bali, and Tang (2012) develop a macrolevel index of systemic risk that predicts future real economic downturns six to eight months in advance. The index (denoted CATFIN) measures the aggregate level of sys­ temic risk in the entire financial sector (rather than an individual bank’s systemic risk ex­ posure), and is calculated using a cross-sectional analysis of equity returns of financial firms in the US, Europe, and Asia. A macro-level measure of systemic risk complements micro-level systemic risk measures focusing on direct interbank connections, because systemic risk can emerge through gen­ eral economic factors that cause financial markets to freeze up and/or banks to substan­ tially reduce the supply of credit. Kashyap, Berner, and Goodhart (2011) and Korinek (2011) describe financial amplification effects resulting from fire sales of financial assets by individual banks, which trigger the catastrophic declines in asset prices and reduced liquidity that accompany a systemic crisis. These effects transcend pairwise interconnec­ tions between banks (particularly if many bank portfolios are overly invested in assets ex­ posed to rollover risk; see Acharya, Gale, and Yorulmazer, 2011). Indeed, Bekaert et al. (2011) show that international contagion during the 2007–8 crisis did not spread through direct trade and financial linkages, but rather through a generalized “wake-up call” that “provides new information that may prompt investors to reassess the vulnerability of oth­ er market segments or countries, which spreads the crisis across markets and borders.” More generally, financial institutions are “special” since when they are in distress, banks tend to cut back on all of their activities, including lending to their customers (see Ivashina and Scharfstein, 2010 for evidence of this in 2008). Rejected business borrow­ ers, in turn, reduce their investment activity and hiring, thereby negatively impacting em­ ployment and expenditure on a macroeconomic level. If there is only a limited number of troubled banks at any one point in time, competitor banks may overcome the (p. 175) in­ formation destruction inherent in these disruptions in bank–customer relationships, and meet the demands of customers formerly served by a distressed bank. However, as more banks enter into crisis, these spillover effects become substantial and competitor banks are unable to prevent macroeconomic contagion (e.g., Jermann and Quadrini (2009) link reductions in credit availability to macroeconomic downturns). This chain reaction of sys­ temic effects extends beyond the web of individual interbank relationships and impacts the entire macroeconomic system. Further, systemic risk could conceivably bubble up from widespread catastrophic risk among smaller, less directly interrelated banks with common risk factors. Indeed, Kashyap and Stein (2000) find that aggregate declines in loan supply are driven by small­ er banks (in the bottom 95th percent of the size distribution) that are liquidity con­ strained. Thus, focus on the largest financial firms omits an important potential source of Page 20 of 32

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Private Information and Risk Management in Banking systemic risk.31 Banks, large and small, tend to take on excessive risk since they do not consider the external costs of their risk-taking on non-financial firms and on society at large. That is, financial contagion is spread through risk and illiquidity in the financial sector (Longstaff, 2010), as liquidity constrained banks transmit financial shocks to the real economy (Duchin, Ozbas, and Sensoy, 2010), thereby creating systemic risk (e.g., through bank transmission of fluctuations in investor sentiment as in Shleifer and Vishny, 2010). Indeed, it is because of the risk of macroeconomic contagion that regulators and governments are so concerned about systemic risk. Thus, regulators require a systemic risk measure that determines the macroeconomic implications of aggregate risk-taking in the financial system. Bank regulators around the world have responded to concerns about systemic risk by im­ posing higher capital requirements on systemically important banks (classified as GSIBs). As a result of their impact on macroeconomic conditions and global financial mar­ kets, G-SIBs are subjected to more stringent requirements on higher capital buffers, total loss absorbing capacity (such as bail-in bonds and contingent capital instruments de­ signed to automatically convert debt into equity),32 resolvability plans in the event of in­ solvency, and higher supervisory expectations. The Financial Stability Board and the Basel Committee on Banking Supervision publish a list of G-SIBs every November. Table 6.1 presents the list as of November 2016, comprised exclusively of large banks. Howev­ er, Allen, Bali, and Tang (2012) demonstrate that systemic risk originates at small and medium-sized banks as well as the largest banks. Thus, regulations limited (p. 176) to the largest thirty banks in the world will not mitigate the systemic risk inherent in other insti­ tutions.

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Private Information and Risk Management in Banking Table 6.1 List of G-SIBs, November 2017 Bucket*

G-SIBs in alphabetical order within each bucket

5 (3.5%)

(Empty)

4 (2.5%)

JP Morgan Chase

3 (2.0%)

Bank of America Citigroup Deutsche Bank HSBC

2 (1.5%)

Bank of China Barclays BNP Paribas China Construction Bank Goldman Sachs Industrial and Commercial Bank of China Limited Mitsubishi UFJ FG Wells Fargo

1 (1.0%)

Agricultural Bank of China Bank of New York Mellon Credit Suisse Groupe Crédit Agricole ING Bank Mizuho FG Morgan Stanley Nordea Royal Bank of Canada Royal Bank of Scotland Santander Société Générale Standard Chartered State Street Sumitomo Mitsui FG UBS Unicredit Group

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Private Information and Risk Management in Banking Note: The bucket* approach is defined in Table 2 of the Basel Commit­ tee document Global systemically important banks: updated assess­ ment methodology and the higher loss absorbency requirement, July 2013. The numbers in parentheses are the required level of additional common equity loss absorbency as a percentage of risk-weighted as­ sets that each G-SIB will be required to hold in 2019. Source: Financial Stability Board, press release, November 21, 2017. The crisis of 2007–8 demonstrates that we still have a lot to learn about risk measure­ ment and risk management. However, no system will be effective if financial institutions ignore the warning signals flashed by their risk measurement models in their rush to join in the latest market frenzy—whether it is subprime mortgage-backed securities, (p. 177) high tech, international government securities, or whatever will be the next mania. Risk measurement and management requires a steady eye and a firm hand as well as effective quantitative and analytical tools. Indeed, macroeconomic conditions around the world will be improved if the banking sector controls its systemic risk.

References Acharya, V., Gale, D., and Yorulmazer, T. (2011). “Rollover Risk and Market Freezes,” Jour­ nal of Finance, 66, 1177–209. Acharya, V., Pedersen, L., Philippon, T., and Richardson, M. (2017). “Measuring Systemic Risk,” The Review of Financial Studies, 30(1), 2–47. Acharya, V., Qian, J., and Yang, Z. (2016). “In the Shadow of Banks: Wealth Management Products and Issuing Banks’ Risk in China,” Working Paper, November 5. Adrian, T. and Brunnermeier, M. K. (2016). “CoVaR,” American Economic Review, 106(7), 1705–41. Allen, L. (1997). Capital Markets and Institutions: A Global View (New York: John Wiley and Sons). Allen, L. and Bali, T. (2007). “Cyclicality in Catastrophic and Operational Risk Measures,” Journal of Banking and Finance, 31(4), 1191–235. Allen, L. and Tang, Y. (2016). “What’s the Contingency? A Proposal for Bank Contingent Capital Triggered by Systemic Risk,” Journal of Financial Stability, 26, 1–14. Allen, L., Bali, T., and Tang, Y. (2012). “Does Systemic Risk in the Financial Sector Predict Future Economic Downturns?” Review of Financial Studies, 25(10), 3000–36. Allen, L., Boudoukh, J., and Saunders, A. (2004). Understanding Market, Credit and Oper­ ational Risk: The Value at Risk Approach (Oxford: Blackwell Publishing).

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Private Information and Risk Management in Banking Allen, L., Chakraborty, S., Hazarika, S., and Su, D. (2017). “The Role of Information from International Bank Lending in Mutual Fund Equity Investing,” Working Paper. Allen, L., Jagtiani, J., Peristiani, S., and Saunders, A. (2004). “The Role of Bank Advisors in Mergers and Acquisitions,” Journal of Money, Credit and Banking, 36(2), 197–224. Bekaert, G., Ehrmann, M., Fratzscher, M., and Mehl, A. (2011). “Global Crises and Equity Market Contagion,” Columbia University, Working Paper. Berkshire Hathaway Annual Report (2002). SEC Edgar online database. Bharath, S., Dahiya, S., Saunders, A., and Srinivasan, A. (2007). “So What Do I Get? The Bank’s View of Lending Relationships,” Journal of Financial Economics, 85, 368–419. Bharath, S., Dahiya, S., Saunders, A., and Srinivasan, A. (2011). “Lending Relationships and Loan Contract Terms,” Review of Financial Studies, 24(4, April), 1141–203. Bolton, P. and Scharfstein, D. (1996). “Optimal Debt Structure and the Number of Credi­ tors,” Journal of Political Economy, 104(1), 1–25. Boulatov, A., Hendershott, T., and Livdan, D. (2013). “Informed Trading and Portfolio Re­ turns,” Review of Economic Studies, 80(1), 35–72. Brown, D. and Wu, Y. (2016). “Mutual Fund Flows and Cross-Fund Learning Within Fami­ lies,” Journal of Finance, LXXI(1, February), 383–424. Brownlees, C. and Engle, R. (2017). “SRISK: A Conditional Capital Shortfall Measure of Systemic Risk,” The Review of Financial Studies, 30(1), 48–79. Chan-Lau, J. (2009). “Regulatory Capital Charges for Too-Connected-To-Fail Institutions: A Practical Proposal,” IMF Working Paper, November. Chuprinin, O., Massa, M., and Schumacher, D. (2015). “Outsourcing in the Inter­ national Mutual Fund Industry: An Equilibrium View,” Journal of Finance, October, (p. 178)

LXX(5), 2275–308. Dang, T. V., Gorton, G., Holmstrom, B., and Ordonez, G. (2017). “Banks as Secret Keep­ ers,” American Economic Review, 107(4), 1005–29. Dass, N. and Massa, M. (2011). “The Impact of a Strong Bank–Firm Relationship on the Borrowing Firm,” Review of Financial Studies, 24(4), 1204–60. Dong, X. and Massa, M. (2013). “Excess Autocorrelation and Mutual Fund Performance,” January. Douglas, G. W. (1969). “Risk in Equity Markets: An Empirical Appraisal of Market Effi­ ciency,” Yale Economic Essays, IX, Spring.

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Private Information and Risk Management in Banking Duchin, R., Ozbas, O., and Sensoy, B. A. (2010). “Costly External Finance, Corporate In­ vestment and the Subprime Mortgage Credit Crisis,” Journal of Financial Economics, 97, 418–35. Elliott, D. and Yan, K. (2013). “The Chinese Financial System: An Introduction and Overview,” Brookings Institute Monograph Series No. 6, July. Espinosa-Vega, M. A., Kahn, C. M., and Sole, J. (2010). “Systemic Risk and the Redesign of Financial Regulation,” IMF Global Financial Stability Report, Chapter 2, April. Fama, E. F. and French, K. R. (1992). “The Cross-Section of Expected Stock Returns,” Journal of Finance, 47(June), 427–65. Ferreira, M., Matos, P., and Pires, P. (2016). “Asset Management Within Commercial Bank­ ing Groups: International Evidence,” Working Paper, February. Foucault, T., Hombert, J., and Rosu, I. (2016). “News Trading and Speed,” Journal of Fi­ nance, LXXI(1, February), 335–81. Giglio, S., Kelly, B., and Pruitt, S. (2016). “Systemic Risk and the Macroeconomy: An Em­ pirical Evaluation,” Journal of Financial Economics, 119(3), 457–71. Golez, B. and Marin, J. (2015). “Price Support by Bank-Affiliated Mutual Funds,” Journal of Financial Economics, 115, 614–38. Gray, D. and Jobst, A. A. (2009). “New Directions in Financial Sector and Sovereign Risk Management,” Journal of Investment Management, 8, 22–38. Hale, G. and Santos, J. (2009). “Do Banks Price Their Information Monopoly?” Journal of Financial Economics, 93, 185–206. Hao, Q. and Yan, X. (2012). “The Performance of Investment Bank-Affiliated Mutual Funds: Conflicts of Interest or Informational Advantage?” Journal of Financial and Quanti­ tative Analysis, 47(June), 537–65. Helwege, J., Maurer, S., Sarkar, A., and Wang, Y. (2009). “Credit Default Swap Auctions,” Federal Reserve Bank of New York Staff Report No. 372, May. Holmstrom, B. and Tirole, J. (1997). “Financial Intermediation, Loanable Funds, and the Real Sector,” Quarterly Journal of Economics, 112(3), 663–91. Hubbard, R. G., Kumar, K., and Palia, D. (2002). “Are There Bank Effects in the Borrow­ ers’ Cost of Funds? Evidence from a Matched Sample of Banks and Borrowers,” Journal of Business, 75(4, October), 559–81. Hull, J. and White, A. (2001). “Valuing Credit Default Swaps II: Modeling Default Correla­ tions,” Journal of Derivatives, 8(3, Spring), 12–21.

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Private Information and Risk Management in Banking Ivashina, V. and Scharfstein, D. (2010). “Bank Lending During the Financial Crisis of 2008,” Journal of Financial Economics, 97, 319–38. James, C. (1987). “Some Evidence on the Uniqueness of Bank Loans,” Journal of Financial Economics, 19, 217–35. Jermann, U. and Quadrini, V. (2009). “Macroeconomic Effects of Financial Shocks,” NBER Working Paper Series No. 15338. (p. 179)

Kahn, C. and Winton, A. (2004). “Moral Hazard and Optimal Subsidiary Structure for Fi­ nancial Institutions,” Journal of Finance, 59, 2531–75. Kashyap, A. K. and Stein, J. C. (2000). “What a Million Observations on Banks Say About the Transmission of Monetary Policy?” American Economic Review, 90, 407–28. Kashyap, A. K., Berner, R. B., and Goodhart, C. A. (2011). “The Macroprudential Toolkit,” IMF Economic Review, 59. Kelly, B. (2011). “Tail Risk and Asset Prices,” Working Paper, University of Chicago. Korinek, A. (2011). “Systemic Risk-taking: Amplification Effects, Externalities, and Regu­ latory Responses,” European Central Bank Working Paper Series, No. 1345. Krasa, S. and Villamil, A. (2000). “Optimal Contracts when Enforcement is a Decision Variable,” Econometrica, 57, 197–221. Kyle, S. A. (1989). “Informed Speculation with Imperfect Competition,” Review of Eco­ nomic Studies, 56, 317–56. Kyle, S. A., Obizhaeva, A., and Wang, Y. (2014). “Smooth Trading with Overconfidence and Market Power,” October 30. Leland, H. and Pyle, D. (1977). “Informational Asymmetries, Financial Structure, and Fi­ nancial Intermediation,” Journal of Finance, 32, 371–87. Li, C. and Ongena, S. (2015). “Bank Loan Announcements and Borrower Stock Returns Before and During the Financial Crisis,” Journal of Financial Stability, 21(December), 1– 12. Longstaff, F. A. (2010). “The Subprime Credit Crisis and Contagion in Financial Markets,” Journal of Financial Economics, 97, 436–50. Lummer, S. L. and McConnell, J. J. (1989). “Further Evidence on the Bank Lending Process and the Capital-Market Response to Bank Loan Agreements,” Journal of Financial Economics, 15, 31–60. Markowitz, H. (1952). “Portfolio Selection,” Journal of Finance, 7, 77–91.

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Private Information and Risk Management in Banking Massa, M. and Rehman, Z. (2008). “Information Flows Within Financial Conglomerates: Evidence from the Bank–Mutual Fund Relation,” Journal of Financial Economics, 89, 288– 306. Massa, M. and Zhang, L. (2015). “Fire Sales and Information Advantage: When Informed Investor Help,” Working Paper, March. Mengle, D. (2007). “Credit Derivatives: An Overview,” Federal Reserve Bank of Atlanta Economic Review, Fourth Quarter, 92(4), 1–24. Mester, L., Nakamura, L., and Renault, M. (2007). “Transaction Accounts and Loan Moni­ toring,” Review of Financial Studies, 20(3), 529–56. Mina, J. and Xiao, J. Y. (2001). Return to RiskMetrics: The Evolution of a Standard (New York: RiskMetrics). Mossin, J. (1968). “Optimal Multiperiod Portfolio Policies,” Journal of Business, 41, 215– 29. Nguyen, Q. and Rugman, A. (2015). “Internal Equity Financing and the Performance of Multinational Subsidiaries in Emerging Economies,” Journal of International Business Studies, 46, 468–90. Petersen, M. and Rajan, R. (1994). “The Benefits of Lending Relationships: Evidence from Small Business Data,” Journal of Finance, 49, 3–37. Phelan, G. (2017). “Correlated Default and Financial Intermediation,” Journal of Finance, LXXII(3, June), 1253–84. (p. 180)

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Private Information and Risk Management in Banking Shleifer, A. and Vishny, R. W. (2010). “Unstable Banking,” Journal of Financial Economics, 97, 306–18. Smithson, C. (2003). Credit Portfolio Management (Hoboken, NJ: John Wiley & Sons). Tarashev, N., Borio, C., and Tsatsaronis, K. (2009). “The Systemic Importance of Financial Institutions,” BIS Quarterly Review, September, 75–87. Wallace, A. (1980). “Is Beta Dead?” Institutional Investor, 14(July), 22–30. Xia, L., Schwarz, S., and Herrero, A. (2013). “Banking Watch: An Update on China’s Shad­ ow Banking Activity,” BBVA, March 8.

Notes: (1) A repurchase agreement allows a bank to borrow against collateral (securities) trans­ ferred to a counterparty. This transaction is typically reversed within a short time period —from a week to three months. Moreover, the collateral is marked-to-market on a daily basis. (2) For example, in July 1998, Russia defaulted on its debt, followed by Argentina in 2001. (3) Modern portfolio theory is based on Markowitz’s insight that diversification can re­ duce, but not generally eliminate, risk, thereby necessitating a risk-reward guide to port­ folio selection. To estimate the efficient investment frontier in a mean-variance world re­ quires data on expected returns, standard deviations of returns and correlations between returns for every possible pair of financial securities. On the occasion of the fiftieth an­ niversary of the publication of the seminal Markowitz (1952) paper, Rubinstein (2002) of­ fers an interesting discussion of the development of modern portfolio theory by Markowitz and others. (4) For example, Sharpe’s (1963) paper was followed by Mossin (1968). (5) Dissatisfaction with the β measure began as early as Douglas (1969), with mounting doubts leading to Roll’s (1977) paper. The practitioner world closely followed the academ­ ic debate with articles such as Wallace’s (1980). Beta’s death knell was sounded by Fama and French’s (1992) paper that found that after controlling for firm size and the marketto-book ratio, the firm’s β had no statistically significant power to explain returns on the firm’s equity. (6) In their introduction, Mina and Xiao (2001) stress that RiskMetrics is not strictly a VaR model, although it can be used to estimate a VaR model. RiskMetrics’ critical role in the dissemination of VaR among financial market practitioners stems in large part from the availability of real time data on financial market fluctuations provided freely in the public domain. Recognizing that value added, RiskMetrics has currently formed a separate data service, DataMetrics which covers almost 100,000 data series.

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Private Information and Risk Management in Banking (7) RAROC (risk-adjusted return on capital) models are risk-sensitive measures of eco­ nomic performance that can be used to allocate risk capital within the firm. See chapter 11 of Saunders and Allen (2010). (8) The Gramm–Leach–Bliley Act of 1999 permitted the creation of financial service hold­ ing companies that could include commercial banking, investment banking, and insur­ ance subsidiaries under a single corporate umbrella, thereby effectively repealing the Glass–Steagall Act. (9) Insurance regulators in the US adopted their own risk-based capital requirements for life and property-casualty insurers in the mid-to-late 1990s. (10) For specific methodologies used to estimate VaR models, see Allen, Boudoukh, and Saunders (2004). (11) Warren Buffett’s quotes have been taken from the 2002 Berkshire Hathaway annual report. (12) However, under Dodd–Frank Act regulations passed in 2010 in the US, banks cannot engage in speculative trades as specified by the Volcker Rule subsection of the Act. (13) The Eurodollar CD is not related to the currency named the euro. Eurodollar CDs re­ fer to US dollar-denominated deposits held by banks outside of the US or in international banking facilities within the US. LIBOR (the London Interbank Offered Rate) is the offer rate on interbank loans of Eurodollar deposits. See chapter 12, Allen (1997). (14) If all of the losses are hedged, we consider that a “perfect” or “naïve” hedge. In prac­ tice, we do not observe such hedges because (1) they are difficult to get exactly right and (2) they are undesirable since while a “perfect” futures/forward hedge eliminates all pos­ sibility of loss, it also eliminates all possibility of gain. (15) An American option can be exercised at any time up until expiration date, whereas a European option cannot be exercised prior to expiration date. Unless there are interim cash flows (such as dividend payments), it would not be desirable to exercise an Ameri­ can option prior to expiration since the option is worth more alive than dead because of its time value. Therefore, in practical terms, there is no difference between American and European options on financial securities with no interim cash flows (e.g., zero coupon bonds). (16) In general, financial options on futures contracts tend to be more liquid than financial options on cash instruments. Thus, for example, we see more activity in the market for US Treasury bill futures options than in the market for US Treasury bill (cash) options. (17) In contrast, futures contracts require an upfront margin (paid to the exchange’s clearing corporation, which acts as third party guarantor) which is a good faith deposit and is refunded to the contract holders (both buyer and seller) upon fulfillment of their obligations under the futures contract. Because forward markets are limited to financial Page 29 of 32

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Private Information and Risk Management in Banking intermediaries with reputations to uphold, there is no margin or third-party guarantor in the forward market. (18) The credit event can be specified as default, failure to pay, restructuring, etc. Howev­ er, the use of restructuring as a credit event is ambiguous when the reference security is a loan, since loan restructuring is a fairly common occurrence that may be triggered by something other than the borrower’s financial distress. Thus, restructuring is known as a “soft” credit event. Repudiation or moratorium is used as a credit event for credit deriva­ tives based on government obligations. (19) There have been several proposals to move credit derivatives trading to organized ex­ changes. It is unclear whether the benefits of exchange trading (enhanced transparency and liquidity) will be offset by the costs of basis risk and lack of customization as the stan­ dardized contracts diverge from the underlying risks to be hedged. (20) The increased presence of hedge funds led to an agreement that enhanced the liquid­ ity of the CDS market in 2006. Liquidating a CDS position typically required either offset­ ting transactions or an agreement by both counterparties to terminate (tear up) the trans­ action. However, hedge funds preferred to transfer their shares via assignment—a process known as novation. However, there were problems in coordinating novation agreements and getting confirmation. In September 2006, the ISDA Novation Protocol was announced to standardize novation procedures requiring parties to obtain prior con­ sent, which could be communicated electronically. The results were to dramatically re­ duce confirmation backlogs. (21) In contrast to the notional value of OTC derivatives in mid-2008 of $680 trillion, as of December 2016, the total value was only $483 trillion. This may be related to Dodd–Frank Act regulations restricting bank proprietary trading activity. (22) Single name CDS specify a single reference security. In contrast, multi-name CDS ref­ erence more than one name, as in a portfolio or basket CDS or CDS index, such as the Dow Jones CDX. Baskets are credit derivatives based on a small portfolio of loans or bonds, such that all assets included in the underlying pool are individually listed. In con­ trast, the contents of larger portfolios are described by their characteristics. A basket credit default swap, also known as a first-to-default swap, is structured like a regular CDS, but the reference security consists of several securities. The first reference entity to default triggers a default payment of the par value minus the recovery value and then all payments end. As of the first half of 2007, there was an additional $20 trillion notional value in multi-name CDS. (23) See Smithson (2003) and Mengle (2007) for a discussion of the stages of development of the market for credit derivatives. The standardized contracts, terms and dispute reso­ lution provided by the International Swap and Derivatives Association (ISDA) played a role in that evolution.

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Private Information and Risk Management in Banking (24) Basis risk results when the fluctuations in the value of the reference security underly­ ing the derivative do not move in lock step with the hedge position. For example, there is basis risk if indexed CDS is used to hedge a portfolio of loans to firms that are not identi­ cal to the 125 firms in the index. (25) The most popular CDS indexes consist of 125 corporate entities. Multi-name, or bas­ ket CDS contain more than one reference security, most commonly between three and ten. The most common form of multi-name CDS is the first-to-default CDS, which compen­ sates the protection buyer for losses on the first default among the basket of reference entities, after which the swap automatically terminates. Tranched synthetic CDOs com­ prised of indexed CDS also prioritize credit protection, but are more flexible than first-todefault swaps. (26) In contrast, an interest rate swap (fixed for floating rate swap) will entail symmetric payments such that the swap buyer (the fixed rate leg of the swap) earns positive cash flows when interest rates increase and the swap seller (the floating rate leg) earns posi­ tive cash flows when interest rates decrease. (27) OTC CDS have standardized spread payment dates on March 20, June 20, September 20 and December 20. The spread is constant for the life of the swap, with the exception of a constant maturity CDS in which the spread is reset periodically to the market rate for newly issued CDS. (28) Swap spreads incorporate counterparty credit risk. For example, Hull and White (2001) find a range of around 50 basis points when they simulate the impact of counter­ party credit risk exposure. (29) Micro-level systemic risk proposals include Marginal Expected Shortfall (MES) (see Acharya et al., 2017); CoVaR (Adrian and Brunnermeier, 2016); conditional tail risk (CTR) (Kelly, 2011); co-risk (Chan-Lau, 2009); a contingent claims approach (Gray and Jobst, 2009); Shapely values (Tarashev, Borio, and Tsatsaronis, 2009); and the IMF risk budget­ ing and standardized approaches (Espinosa-Vega, Kahn, and Sole, 2010). See Giglio, Kelly, and Pruitt (2016) for an excellent comparison of various systemic risk measures. (30) Although both measures estimate the conditional capital shortfall of financial firms, the computation of SES and SRISK differs. The computation of SES requires the realiza­ tion of a systemic crisis, whereas SRISK is predictive in that it utilizes a GARCH-DCC model to forecast catastrophic events. See Brownlees and Engle (2017). (31) In May 2018, Dodd–Frank regulations were amended to define systemically important financial institutions (SIFIs) as those with assets above $250 billion, up from the former threshold of $50 billion. Systemic capital add-ons and other regulatory interventions are imposed exclusively upon SIFIs. However, this regulatory approach has no preventative mechanisms against future systemic crises that may emanate from smaller institutions (as shown in Allen, Bali, and Tang, 2012).

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Private Information and Risk Management in Banking (32) Bail-in bonds such as CoCos (contingent convertible bonds) are designed to convert debt into equity when a trigger of bank insolvency or systemic risk is breached. However, current CoCos specify a trigger that would not have been breached by any of the banks during the 2007–8 crisis. Allen and Tang (2016) propose a CoCo trigger that would have automatically recapitalized both Bear Stearns and Lehman during November 2007.

Linda Allen

Linda Allen holds the William F. Aldinger Chair in Banking and Finance at Baruch College, City University of New York. Her broad areas of research are risk measure­ ment and management, focusing on systemic risk, credit risk, and operational risk; the evolution of financial markets and bank regulation; and the organization of finan­ cial institutions. Her latest book Credit Risk Measurement In and Out of Crisis: New Approaches to Value at Risk and Other Paradigms, 3rd edition (Wiley, 2010), co-au­ thored with Anthony Saunders, describes the global financial crisis that began in 2007, as well as deconstructs credit risk measurement models commonly used by bankers and other finance professionals. She is also the author of Capital Markets and Institutions: A Global View (Wiley, 1997) and co-author of Understanding Mar­ ket, Credit and Operational Risk (Blackwell, 2004). She is an associate editor of many finance journals, and has published extensively in top academic journals in finance and economics. Along with her consulting in securities litigation, she has lectured and advised all over the world on topics of risk measurement and management, bank­ ing trends, and financial market development. Anthony Saunders

Anthony Saunders is the John M. Schiff Professor of Finance and former Chair of the Department of Finance at the Stern School of Business at New York University. He received his Ph.D from the London School of Economics, and has taught at NYU since 1978. He has served as Visiting Professor all over the world including INSEAD, the Stockholm School of Economics, and the University of Melbourne. He has held positions on the Board of Academic Consultants of the Federal Reserve Board of Gov­ ernors as well as the Council of Research Advisors at the Federal National Mortgage Association. He is Editor of Financial Markets, Instruments and Institutions. His re­ search has been published in all the major banking and finance journals.

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Creation and Regulation of Bank Liquidity

Creation and Regulation of Bank Liquidity   Christa H. S. Bouwman The Oxford Handbook of Banking (3rd edn) Edited by Allen N. Berger, Philip Molyneux, and John O. S. Wilson Print Publication Date: Oct 2019 Subject: Economics and Finance, Financial Economics Online Publication Date: Nov 2019 DOI: 10.1093/oxfordhb/9780198824633.013.7

Abstract and Keywords Liquidity creation is a core function of banks and an important economic service to the economy. This chapter discusses two distinct notions of bank liquidity creation developed in the theoretical literature—funding liquidity creation and improved risk sharing for riskaverse depositors. It also examines the empirical literature on bank liquidity creation. The focus is on the economics of bank liquidity creation, both in the traditional relationship banking context and in the shadow-banking context. This chapter discusses related pru­ dential regulation issues, pertaining mainly to capital requirements and liquidity require­ ments, as well. It provides a historical overview, starting in the early 1800s and ending with Basel III and the Dodd–Frank Act. It identifies open research questions regarding both capital requirements and liquidity requirements. Keywords: banking, capital, capital requirements, liquidity, liquidity creation, liquidity requirements, regulation, relationship banking, shadow banking

7.1 Introduction THIS chapter examines key issues related to “liquidity creation” by banks, including pru­ dential regulation. The questions addressed are: How do banks create liquidity and how does this improve welfare? What risks does liquidity creation generate for banks? How do banks cope with these risks in the traditional originate-to-hold (OTH) model and in the originate-to-distribute (OTD) model that is closely linked to the shadow-banking system? Does managing these risks call for regulation in the form of capital requirements and reg­ ulatory reserve/liquidity requirements? “Liquidity creation” is a commonly used term but it has come to have at least two distinct connotations in the theoretical literature. One refers to the different liquidities on the as­ set and liability sides of the bank’s balance sheet. Banks typically make illiquid loans fi­ nanced largely with liquid deposits that give depositors the ability to withdraw funds at par value at a moment’s notice. In this view, exemplified in the papers of Bryant (1980) and Diamond and Dybvig (1983), liquidity creation is synonymous with banks providing Page 1 of 58

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Creation and Regulation of Bank Liquidity depositors with improved risk sharing when they are subject to shocks.1 (p. 182) Another view of liquidity creation is that it is funding liquidity creation. That is, banks are able to expand investments in real projects in the economy that, in the aggregate, exceed the en­ tire initial endowment of the economy. This view, in which bank liquidity creation is linked to banks creating private money, is presented in the theory of “warehouse banking” de­ veloped by Donaldson, Piacentino, and Thakor (2018). These theories of liquidity creation deal with what banks do on the balance sheet. Of course, banks also create liquidity through their off-balance-sheet activities, like loan commitments and similar claims to liquid funds (e.g., Boot, Greenbaum, and Thakor, 1993; Holmstrom and Tirole, 1998; Kashyap, Rajan, and Stein, 2002; Thakor, 2005). Apart from extensive theoretical literature on bank liquidity creation, there is now emerg­ ing literature on its empirical measurement (e.g., Berger and Bouwman, 2009, 2016). Bank liquidity creation is important for the macroeconomy (e.g., Bernanke, 1983; Dell’Ariccia, Detragiache, and Rajan, 2008; Berger and Bouwman, 2016; Berger and Se­ dunov, 2017). However, the creation of liquidity exposes the bank to a variety of risks, in­ cluding liquidity risk. This risk can be mitigated to some extent by holding liquid assets like cash.2 This is the most basic rationale for liquidity requirements that mandate that banks hold a minimum level of liquid assets. But cash-asset reserves are not sufficient if depositors withdraw simply because they are afraid that the bank will shut down due to a deposit run by others. They will also be useless if the withdrawal decisions of depositors are not due to coordination failures but due to depositors’ concerns about the solvency of the bank, as the empirical evidence suggests is typically the case (see Gorton, 1988; Boyson, Helwege, and Jindra, 2014; Perignon, Thesmar, and Vuillemey, 2018). A regulato­ ry safety net (including deposit insurance and the discount window) can deal with such fears, but its existence gives rise to moral hazard: it gives the bank incentives to be over­ leveraged and increase asset risk at the expense of the deposit insurer (Merton, 1977). This can increase the risk of future asset-value impairment, and if the safety nets are less than complete, the risk of bank failures can perversely increase due to these safety nets (e.g., Thakor, 2014, 2015). To improve the bank’s asset portfolio choices and risk manage­ ment, regulatory monitoring and capital requirements can be used. This suggests that both liquidity requirements and capital requirements can potentially be useful as part of the regulation of banks’ liquidity creation. Before the subprime lend­ ing crisis, regulation was largely microprudential (ensuring the safety and soundness of individual banks) and focused on capital requirements. The same holds for the theories and empirical work. After the subprime lending crisis, macroprudential regulation (ensur­ ing the safety and soundness of the financial system) became important and introduced liquidity requirements as one of its tools. Theoretical and empirical work on liquidity re­ quirements is nascent, as is work that tries to combine capital and liquidity (p. 183) re­ quirements. This chapter discusses the past, present, and future of both capital and liq­ uidity regulation, implementation issues, and how they should be regulated.

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Creation and Regulation of Bank Liquidity To properly understand the roles of capital and liquidity requirements in influencing bank liquidity creation, we also take a closer look at the economics of traditional banking (which focuses on relationship lending and the originate-to-hold model) and its evolution to modern-day banking, characterized by a mix of the originate-to-hold and the originateto-distribute models, and a rapid growth of the shadow-banking system. We describe this system and how it interacts with traditional banking in its liquidity creation role. One could argue that the absence of bank runs in US commercial banking indicates the effectiveness of the regulatory safety net and the possible redundancy of liquidity require­ ments. But the rapid drying up of liquidity in the shadow-banking system during the re­ cent subprime lending crisis suggests that regulators need to look beyond the traditional boundaries of deposit-based banking when thinking about capital and liquidity require­ ments. Basel III requires banks to operate with more and higher-quality capital, and intro­ duces liquidity ratios. We discuss these new standards, how they are adopted in the US and Europe, and how they may affect liquidity creation. We also turn to the possible theo­ retical linkages between liquidity requirements and capital requirements, how one should think about these requirements for both traditional deposit-funded banks and for shadow banks, and identify open research questions.

7.2 Banks as Liquidity Creators 7.2.1 Theories Standard textbooks on financial intermediation (e.g., Freixas and Rochet, 2008; Green­ baum, Thakor, and Boot, 2015) explain that banks are institutions that make loans funded by a combination of deposits from the public and equity supplied by the banks’ sharehold­ ers. More formally, banks engage in “liquidity creation,” which is a form of “qualitative asset transformation.” To understand liquidity creation, picture a firm in need of long-term financing in a world without banks. In such a world, savers would directly finance the funding needs of the firm, and would have an illiquid claim against the firm. In contrast, in a world with banks, it is the bank that provides the long-term loan to the firm, and the bank is able to offer savers demand deposits.3 So it is the bank that holds the illiquid claim against the (p. 184) firm and savers end up with a liquid claim against the bank. Because of this difference in liquidity between what banks do with their money (their assets) and the way they finance their activities (their liabilities), banks are said to create liquidity. Inherent in the liquidity creation in these models is maturity transformation (see Bhattacharya and Thakor, 1993; Hellwig, 1994). Formal models of banks as liquidity creators in this sense were developed by Bryant (1980) and Diamond and Dybvig (1983). In those models, depositors can suffer interim liquidity shocks, so being able to hold liquid (demand) deposit claims improves welfare.

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Creation and Regulation of Bank Liquidity In Diamond and Dybvig (1983), this liquidity creation exposes banks to withdrawal risk.4 Fear that other depositors may rush in to withdraw their deposits prematurely, even though they may not have liquidity needs, can cause all depositors to withdraw, precipi­ tating a bank run as one of two possible equilibria.5,6 It is impossible for the bank to “pro­ vision” for such an event, short of practicing 100 percent reserve banking, that is, keep­ ing all deposits as cash in vault. But such an institution would be merely a safe-deposit box, rather than a bank that creates liquidity. Diamond and Dybvig (1983) argue that fed­ eral deposit insurance can eliminate bank runs, thereby ridding banks of the prospect of the large-scale deposit withdrawals that characterize such runs.7 But of course, the intent of deposit insurance is to help banks deal with panic runs, not substitute for the liquidity banks need to keep on hand to meet day-to-day routine deposit withdrawals. Thus, even with deposit insurance, banks need to worry about having enough liquidity on hand to meet the normal liquidity needs of depositors. Because the level of even routine withdrawals on any given day is stochastic, the liquidity reserves a bank keeps may either be too high or too low in light of the realized level of withdrawals. Moreover, absent panic runs and financial crises, the daily with­ drawal levels across banks will not be perfectly correlated, suggesting gains from diversi­ (p. 185)

fication. To take advantage of these diversification gains, an interbank market in trading cash reserves emerged, called the federal funds market. The federal funds rate is the rate at which banks borrow and lend on an overnight basis in this market in the US.8 Banks with excess reserves are lenders and those with reserve deficiencies are borrowers.9 In addition to the fed funds market, banks can also avail of short-term borrowing at the discount window to meet their short-term liquidity needs. The Federal Reserve’s willing­ ness, in its role as Lender of Last Resort (LOLR), to provide banks with discount window access is an important potential source of liquidity for banks. Banks face costs in accessing the federal funds market and in borrowing at the discount window. Eligible collateral must be posted and accessing the discount window may be as­ sociated with a stigma: such borrowing may be perceived as a sign of weakness and may make banks reluctant to obtain funds.10,11 Banks thus have an incentive to keep cash on hand to deal with the liquidity risk that is an unavoidable companion to the bank’s basic economic function of being a liquidity creator. In the funding liquidity creation theory of Donaldson, Piacentino, and Thakor (2018), banks have a technological advantage in storage or safekeeping (for example, due to economies of scale in safeguarding), so they receive deposits from individuals who wish to take advantage of the more efficient safekeeping provided by the bank. These banks al­ so make loans, but do not limit themselves to only lending out their deposits, as in the usual banking models. Rather, they write “fake warehouse receipts”—which are indistin­ guishable from authentic warehouse receipts given to depositors as proof of their de­ posits—and also lend these out. This means that if all of the economy’s endowment is (p. 186) deposited in banks, the total lending by banks exceeds this total initial endow­ ment of the economy. Every fake warehouse receipt represents a depository obligation of Page 4 of 58

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Creation and Regulation of Bank Liquidity the bank (on the liability side of its balance sheet), and when it is loaned out it is also a corresponding asset entry. Thus, loans create deposits in their model. But, unlike authen­ tic deposits, the fake receipts are not backed by tangible collateral (e.g., gold or fiat mon­ ey). The amount of funding liquidity created equals the total lending by the bank (both fake and authentic receipts) minus the total initial deposits, that is, liquidity creation equals the volume of fake receipts issued. These fake receipts essentially function as pri­ vate money. In their model, there is no uncertainty and the number of fake receipts is constrained by an incentive compatibility constraint that ensures that the bank does not create excess liquidity. However, it is easy to imagine that if there is an uncertain interim withdrawal need for depositors, then the bank in this model would face withdrawal risk because of deposits that are withdrawable on demand. While Donaldson, Piacentino, and Thakor (2018) cast their model in the context of an­ cient commodity warehouses that evolved into modern-day banks, their notion of fake re­ ceipts and private money creation as being central to bank liquidity creation are even more relevant today than historically. Most of the money in a modern economy is actually not fiat money, but rather what Donaldson, Piacentino, and Thakor call “fake receipts.” For example, in Switzerland, the total amount of money in circulation is 645 billion Swiss francs, of which only 85 billion Swiss francs is fiat money (notes and coins), with the rest being fake receipts. That is, over 90 percent of the money in Switzerland is fake receipts issued by banks (Wall Street Journal, 2018). We can compare these two views of liquidity creation. In Diamond and Dybvig (1983), the aggregate amount of investment in real projects in the economy is exactly the same with banks as it is without. This is because all of the initial endowment of the economy (and no more) is invested in real projects, whether there are banks or not. If there are interim withdrawals, projects can be liquidated to recover the initial investment and pay off de­ positors.12 Hence, there is no funding liquidity creation in the model. The welfare contri­ bution of banks comes from improved consumption insurance for risk-averse depositors. In contrast, in the Donaldson, Piacentino, and Thakor (2018) model, there is no risk aver­ sion, so consumption insurance plays no role, and the welfare contribution of banks comes from funding liquidity creation and the expansion of aggregate investment in real projects. Another important difference is that there is no bank capital in Diamond and Dy­ bvig (1983), so one cannot examine how bank capital affects bank liquidity creation. By contrast, in Donaldson, Piacentino, and Thakor (2018), bank liquidity creation increases with bank capital up to a point, and then the relationship flattens out. One takeaway from these papers is that loans and deposits are intertwined when it comes to liquidity creation. In both, the bank cannot create liquidity without both loans (p. 187) and deposits. In Diamond and Dybvig (1983), deposits create loans, whereas in Donald­ son, Piacentino, and Thakor (2018), loans create deposits, and deposits also create loans. This is consistent with the notion in Mester, Nakamura, and Renault (2007) that banks use information on deposit flows in making loans.13

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Creation and Regulation of Bank Liquidity While the financing of banks through liquid demand deposits leads to withdrawal risk for banks, it also provides an opportunity for banks to provide liquidity to borrowers off the balance sheet. The link between deposit-taking and loan commitments was first formal­ ized by Kashyap, Rajan, and Stein (2002),14 who argued that banks face a demand for liq­ uidity from their depositors as well as from customers who purchase loan commitments that can be exercised in the future, thereby obligating the bank to lend when customers exercise these commitments. This means that a pool of liquid assets that the bank keeps on hand can serve two purposes—meeting the liquidity needs of borrowers as well as those of depositors. There are diversification benefits associated with this costly holding of liquidity if the liquidity needs of borrowers and depositors are not perfectly correlated.15 This is a novel twist on the point made above that deposits and loans are in­ tertwined in the sense that in Kashyap, Rajan, and Stein (2002), it is loan commitments and deposits that are intertwined. The fact that banks make loan commitments is related to the seminal contributions of Dia­ mond (1984) and Ramakrishnan and Thakor (1984), which provided the microfoundations of banks as specialists in screening credit information and monitoring borrowers.16 Thus, banks as primary lenders make commitments to lend in the future. Such commitments create liquidity as they provide borrowers (partial) insurance against being rationed in the spot credit market (James, 1981; Blackwell and Santomero, 1982; (p. 188) Morgan, 1994; Thakor, 2005), so that a commitment can give a borrower access to future liquidity even when it is unavailable in the spot credit market.17 Boot, Greenbaum, and Thakor (1993) show that loan commitments improve welfare ex ante, even though they represent only “illusory promises” in that the bank may choose not to honor its commitment when the borrower attempts a takedown. They model the bank’s choice as a tradeoff between reputational and financial capital. When the bank honors a loan commitment, it provides liquidity for the borrower but uses up its financial capital. When it does not honor a commitment (it invokes the “material adverse change” or MAC clause), it “liquefies” its illiquid reputation capital and preserves its financial cap­ ital. In Thakor (2005), a bank’s reputational concerns induce it to under-invoke the MAC clause during booms, resulting in over-lending (and excessive liquidity creation).

7.2.2 Empirical Evidence Comprehensive empirical measures of liquidity creation were non-existent until recently. To measure the output of the banking sector, studies typically focused on total assets, to­ tal lending, or different types of lending. Taking a cue from the theories, Berger and Bouwman (2009) develop several measures of liquidity creation.18 Using data on banks in the US, they show that large banks (assets over $1 billion) create over 80 percent of the banking sector’s liquidity despite accounting for only a small percent of all banks. They also document that banks create almost half of their liquidity off the balance sheet through loan commitments and similar claims to liquid funds. While many banks create positive liquidity, some create negative liquidity—these banks are liquidity absorbers.

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Creation and Regulation of Bank Liquidity Most of the empirical studies in this area examine the relationship between capital and liquidity creation (see “Key Issue #1: Effect of Higher Capital Requirements on Bank Out­ put” in this chapter for a discussion of those papers). Notable exceptions include: Berger and Bouwman (2017), who study the effect of monetary policy on liquidity creation and also show that excessive liquidity creation helps to predict crises; and Jiang, Levine, and Lin (2019), who examine the relation between competition and liquidity creation. More recently, Bai, Krishnamurthy, and Weymuller (2018) develop a liquidity mismatch index (LMI), which measures the mismatch between the market liquidity of an institution’s as­ sets and the funding liquidity of its (on- and off-balance-sheet) liabilities. The LMI aims to identify the bank’s exposure to liquidity risk, in contrast to Berger and Bouwman’s (2009) measure, which focuses on bank liquidity creation. Liquidity creation obviously exposes the bank to liquidity risk, so these measures are related, but they are measuring different things. LMI works well as a measure of liquidity risk; it uses time-varying weights that in­ corporate market conditions and repo haircuts. In contrast, (p. 189) Berger and Bouwman’s (2009) measures work well as measures of bank liquidity creation, and their preferred measure appropriately uses fixed weights. Berger et al. (2018) develop a measure of bank “liquidity hoarding,” which attempts to measure the amount of liquidity stockpiled by the bank, liquidity that could perhaps be productively deployed in lending. This is different from measuring either liquidity cre­ ation or liquidity risk exposure of the bank. Liquidity hoarding is higher when banks hold more liquid assets, fewer illiquid assets, and fewer off-balance-sheet loan commitments. Empirical studies on the use of loan commitments generally focus on corporate cus­ tomers and document that over 80 percent of commercial and industrial lending is in the form of drawdowns under commitments. Melnik and Plaut (1986), Shockley and Thakor (1997), and Sufi (2009) provide detailed descriptions of loan commitment contracts and their specific features. Berger and Udell (1992) and Morgan (1994) document that credit lines reduce the risk of credit rationing during downturns. Consistent with this, Ivashina and Scharfstein (2010) show that after Lehman collapsed during the subprime lending crisis, there was a “run” by borrowers who drew down their loan commitments. There is also evidence, however, that banks renegotiated the terms for credit lines in their own fa­ vor during the crisis (Campello et al., 2011).

7.2.3 The Need for Regulation Given the demand for liquidity by both its (on- and off-balance-sheet) borrowers and de­ positors, the bank will trade off the costs and benefits of keeping liquidity on hand in de­ ciding how much cash and other liquid assets to hold. However, just as deposit insurance lessens the bank’s need to worry about events that might induce depositors to run the bank, the discount window can cause banks to keep too low a level of liquidity to meet routine withdrawal risk. Why keep cash and other liquid assets lying around earning little or nothing if you know you can borrow at the discount window at a cost lower than the re­ turn you would earn by investing the cash?19

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Creation and Regulation of Bank Liquidity Of course, the central bank can eliminate this moral hazard by removing the deposit in­ surance and discount window safety nets. But this entails social costs because it could re­ sult in disruptive banking panics.20 Moreover, it might even disrupt the bank’s relation­ ship loans if core deposits are withdrawn in large amounts, and this can add to the wel­ fare losses (Song and Thakor, 2007). Rather than throwing out the baby with the bathwa­ ter, the central bank can deal with the moral hazard created by these back-stop liquidity safety nets by imposing a minimum cash-asset reserve. We now discuss these cash reserve requirements. Since the focus of regulators later shifted to capital requirements, we then examine the Basel I and Basel II capital re­ quirements. It is only after the subprime lending crisis of 2007–9 that regulators as part of Basel III imposed both capital and liquidity requirements, so it is only toward the end of this chapter that we return to liquidity requirements. (p. 190)

7.2.4 Cash Reserve Requirements Feinman (1993) documents that cash reserve requirements have been imposed in the US as early as 1820, when commercial banks were state-chartered and did not have large amounts of deposits. However, they did issue bank notes which were often used as a medium of exchange. This initially only happened locally because it was challenging to gauge the solvency of far-away banks. To facilitate their usage over greater distances, banks voluntarily agreed to accept each other’s notes, provided that the issuing bank kept enough liquid funds at the redeeming bank as backing. A few states subsequently mandated that banks hold reserves against their notes and deposits. Reserve requirements were launched nationally in 1863 with the passage of the National Bank Act, which enabled banks with national charters to issue national bank notes and re­ quired them to hold a 25 percent reserve against notes and deposits.21 In 1864, this was reduced to 15 percent for banks located outside the largest cities. In 1874, reserve re­ quirements on bank notes were replaced with a required redemption fund: banks were required to hold 5 percent of the value of the notes as a deposit with the Treasury (Champ, 2010).22 Reserve requirements did stay in place for deposits, which replaced bank notes as the preferred medium of exchange. Various bank runs and panics in the late nineteenth and early twentieth centuries demon­ strated that reserve requirements could not safeguard the convertibility of deposits for the entire banking system (e.g., Calomiris and Gorton, 1991), in essence because a dollar of reserves could not concurrently meet a customer’s demand for cash and also satisfy re­ serve requirements. To maintain stability of the financial system, the Federal Reserve System was created in 1913; in it, Reserve Banks could act as lenders of last resort by ac­ commodating banks’ temporary liquidity needs. While this seemingly eliminated the need for reserve requirements, they continued to be imposed on transaction and time deposits, albeit at lower levels than during the national banking era. Starting in 1917, banks could only satisfy these requirements by keeping non-interest-bearing balances at the Federal Reserve. Page 8 of 58

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Creation and Regulation of Bank Liquidity By 1931, reserves were not only viewed as a source of liquidity for deposits, but also as a monetary policy tool used by the central bank to influence the expansion of bank (p. 191) lending (Federal Reserve, 1933). To reduce the burden on small banks, which tended to hold high cash balances, banks were able to count vault cash to meet reserve require­ ments from 1950 onward. In the late 1960s, new liabilities that were functionally equiva­ lent to deposits also became subject to reserve requirements. In the 1970s, rising interest rates increased the cost that banks incurred for satisfying re­ serve requirements, since the Federal Reserve paid no interest on reserves. This caused banks to leave the Federal Reserve System (Feinman, 1993). To stop this trend, Congress adopted the Depository Institutions Deregulation and Monetary Control Act (DIDMCA or MCA) of 1980 which mandated that all depository institutions—regardless of membership status—be subject to reserve requirements and be given access to the discount window. Regulation D of the Act specifies the reserve requirements. Initially, they were set at 3 percent on the first $25 million of transaction deposits and 12 percent on the rest, and 3 percent on non-transaction deposits. Over time, these percentages have declined, possi­ bly to avoid disintermediation due to non-payment of interest on reserves. The Garn–St. Germain Act of 1982 introduced an exemption amount for transaction deposits, initially set at $2 million. The reserve requirement on non-transaction accounts was lowered to 0 percent in December 1990 and has been at that level ever since. In April 1992, the 12 percent rate was reduced to 10 percent and has stayed at that level. As of January 2019, the exemption amount is $16.3 million, a 3 percent rate is imposed on transaction de­ posits between $16.3 million and $124.2 million, and amounts above are subject to a 10 percent rate. Figure 7.1 Panel A shows the dollar amounts of required reserves and vault cash for the US banking sector from January 1960 to July 2018. While both required reserves and vault cash have increased over time, the banking system’s cash balances exceeded the re­ serve requirements from the late 1990s until the beginning of 2009, suggesting that de­ pository institutions were able to satisfy their entire reserve requirement with vault cash during that period. Panel B contrasts the dollar amounts of required reserves with the to­ tal amount of reserves held by the US banking sector. The picture is striking. Before the subprime lending crisis, total reserves of the banking sector showed a steady increase (from $18.8 billion in January 1960 to $42.9 billion in July 2007) and were on average a mere 2.0 percent higher than required reserves. During the initial phase of the crisis, to­ tal reserves increased somewhat, but they exploded after the collapse of Lehman Broth­ ers in September 2008, reaching a level of $860.2 billion by January 2009 (almost four­ teen times the required level of $63.4 billion). Total reserves peaked at a record $2,842.0 billion by July 2014 (twenty times the required level of $142.9 billion) and had dropped to $2,014.6 billion (over ten times the required level of $190.5 billion) by July 2018.

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Creation and Regulation of Bank Liquidity

Figure 7.1 Total Reserves, Required Reserves, and Vault Cash Over Time. Note: This figure focuses on reserves of the US bank­ ing sector from January 1960—July 2018. Panel A shows both the dollar amounts of required reserves and vault cash, while Panel B contrasts the dollar amounts of required reserves with the total amount of reserves held. Source: Aggregate Reserves of Depository Institu­ tions and the Monetary Base, Not Seasonally Adjust­ ed—H.3 Table 2.

The dramatic increase in reserves during the crisis coincided with the Federal Reserve’s decision to pay interest on reserve balances for the first time in its history.23 (p. 192) This has led many (e.g., Barrons, 2009; Edlin and Jaffee, 2009; Huffington Post, 2010) to conclude that banks are simply “parking” funds at the Federal Reserve—they do not want to lend since earning a sure return by sitting on funds kept at the Federal Re­ serve is more lucrative.24 Others (e.g., Keister and McAndrews, 2009) suggest that this perspective is incorrect, arguing that the increase in reserves merely mirrors the un­ precedented scale of the Federal Reserve’s liquidity facilities and other credit programs. (p. 193)

In Donaldson, Piacentino, and Thakor (2018), liquidity requirements reduce funding liq­ uidity creation. Empirically, this raises an interesting question that deserves further in­ vestigation. For now, from a theoretical perspective at least, it seems that liquidity re­ quirements and their limiting case of narrow banking (100 percent reserves) are both bad ideas when it comes to promoting funding liquidity creation.

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Creation and Regulation of Bank Liquidity

7.2.5 Capital Requirements Prior to the Subprime Lending Crisis As discussed above, safety nets can facilitate liquidity creation. But these safety nets give rise to moral hazard in that the bank has a perverse incentive to increase risk at the ex­ pense of the deposit insurer—see Merton’s (1977) analysis showing that deposit insur­ ance gives the bank a put option on its assets, and that the value of this option is decreas­ ing in the bank’s capital. The observation that safety nets induce banks to lower their capital ratios is supported by the sharp drop in capital ratios (measured as aggregate book equity normalized by aggregate book assets of the banking sector) after the adop­ tion of federal deposit insurance in the US in 1934 (see Figure 7.2).

Figure 7.2 Capital Ratios Over Time (1934–2017). Note: This figure shows capital ratios of all insured commercial banks in the US from 1934–2017. The capital ratios are measured as aggregate book equity normalized by aggregate book assets of the banking sector. Source: Table CB14 of FDIC’s Historical Statistics on Banking

To increase bank capital and reduce the bank’s risk-taking appetite, regulatory monitor­ ing and capital requirements can be used (e.g., Campbell, Chan, and Marino, 1992; Chan, Greenbaum, and Thakor, 1992; Merton and Bodie, 1992; Bhattacharya and Thakor, 1993; Thakor, 1996; Hellmann, Murdock, and Stiglitz, 2000).25 Formal capital requirements were introduced in the US only in 1981. Prior to the 1980s, supervisors merely applied informal and subjective measures, including managerial capa­ bility and loan portfolio quality, because they could not agree on a framework (FDIC, 2003). Starting in 1981, banks were subject to a leverage ratio of primary capital (mainly equity and loan loss reserves) to average total assets. The minimum requirements were not uniform across the three regulators (the Federal Reserve, the Office of the Comptrol­ ler of the Currency, and the Federal Deposit Insurance Corporation) but ranged from 5 percent to 6 percent. There were also differences internationally. Over the (p. 194) next few years, regulators worked together to devise a uniform capital framework necessary to

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Creation and Regulation of Bank Liquidity ensure that banks around the world had adequate capital and were operating on a level playing field. The Basel Capital Accord (commonly referred to as Basel I), adopted in 1988, became partially effective for all US banks and thrifts at year-end 1990, and was fully implement­ ed at year-end 1992. Basel I made three important advances: (i) it recognized that not all assets have equal risk and therefore introduced risk weights; (ii) it enforced capital re­ quirements on off-balance-sheet activities for the first time; and (iii) it harmonized capital requirements across countries to eliminate artificial comparative advantages. Basel I primarily focused on credit risk and forced banks to risk-weight their assets and off-balance-sheet items based on their perceived credit risk. While loans to private bor­ rowers and standby letters of credit serving as financial guarantees for loans were riskweighted at 100 percent, residential mortgages and long-term loan commitments were weighted at 50 percent, claims on, or guarantees by, qualifying banks were weighted at 20 percent, and low-risk assets (e.g., cash, US government debt, and short-term loan commitments) were weighted at 0 percent. So banks had to hold more capital if they chose riskier assets. Banks were required to hold tier 1 capital of at least 4 percent of risk-weighted assets and total capital of at least 8 percent of risk-weighted assets.26 Tier 1 (p. 195) capital is comprised of shareholders’ equity and non-redeemable non-cumula­ tive preferred stock. Total capital also includes capital/debt hybrids such as long-term subordinated debt (which counts as capital because it is at risk before deposits and other bonds). In 1991, US bank regulators (OCC, FRB, FDIC, and OTS) also passed the Federal Deposit Insurance Corporation Improvement Act (FDICIA), which introduced an addition­ al leverage requirement and specified that to operate without regulatory restrictions, a bank must be adequately or well-capitalized. To be adequately (well-) capitalized, it must have a tier 1 leverage ratio of at least 4 percent (5 percent), a tier 1 risk-based ratio of at least 4 percent (6 percent), and a total risk-based capital ratio of at least 8 percent (10 percent). Soon after the introduction of Basel I, shortcomings became apparent. For example, capi­ tal requirements were the same on loans to highly-rated corporations and much riskier distressed firms. Furthermore, capital requirements were typically higher for on-balancesheet loans than for off-balance-sheet exposures to the same borrowers even when the risks to the bank were similar. These shortcomings gave banks incentives to engage in regulatory capital arbitrage, that is, they tried to find ways to reduce their risk-weighted assets without truly lowering risk. Basel II, initially published in June 2004, aimed to better align the minimum capital re­ quired with the underlying risks and focused on the denominator of the capital ratios. Credit ratings play a critical role: the risk weights used to calculate risk-weighted assets (the denominator in several capital ratios) depend on the credit assessments assigned by external rating agencies.27 Investment grade borrowers are subject to lower capital re­ quirements than sub-investment grade or unrated borrowers. In contrast to Basel I, Basel II consists of three pillars. Pillar 1 encompasses risk-based capital requirements for credit Page 12 of 58

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Creation and Regulation of Bank Liquidity risk, market risk, and operational risk (risks arising from people, systems, or processes). Unlike Basel I, it does not prescribe one approach, but offers banks three approaches for credit risk (the standardized approach, the foundation internal ratings-based approach (FIRB), and the advanced IRB approach (A-IRB))28 and for operational risk (the basic indica­ tor approach, the standardized approach, and the advanced measurement approach (AMA)). The A-IRB for credit risk and the AMA for operational risk together are called the “Advanced Approaches.” Pillar 2 involves a supervisory review of banks’ internal assess­ ments of capital and risk, giving regulators discretion to impose higher capital require­ ments. Pillar 3 promotes market discipline by mandating banks to increase public disclo­ sure of capital and risk. The European Parliament approved Basel II for all banks in the EU in 2005 and formally adopted it in 2006 (European Parliament, 2011).29 While most banks in Europe can choose any of the three approaches, many member states require the very largest banks to adopt at least the A-IRB. In contrast to the EU, the US never fully implemented Basel II. US banking regulators adopted a final regulation only in late 2007 (Federal Re­ serve, 2007). It required the very largest banks (eleven or twelve “core banks” with con­ solidated total assets of at least $250 billion or with consolidated total on-balance-sheet (p. 196)

foreign exposure of at least $10 billion) to apply the Advanced Approaches; other banks could obtain authorization to use those approaches (“opt-in banks”) or had to stay on Basel I. The rule stipulated that banks would first be subject to a one-year parallel run of Basel I and Basel II, and would then start a three-year transition period. However, the subprime lending crisis occurred and the Dodd–Frank Act outlawed the use of credit rat­ ings in regulations, which made it impossible to implement Basel II since it relied heavily on such ratings. The focus thus shifted to Basel III (discussed in section 7.4.1.1).

7.3 From Originate-To-Hold (OTH) to a Mix of OTH and Originate-To-Distribute (OTD) and the Emergence of the Shadow-Banking System As discussed above, cash-asset reserve requirements steadily declined in the US until the subprime lending crisis for two main reasons. First, as a tool of prudential regulation, they simply became too costly since the Federal Reserve did not pay interest on reserves, and market interest rates—the shadow price of holding reserves—spiked up dramatically in the 1970s. Second, as a tool of monetary policy, reserve requirements were hardly ever used because they represented a rather blunt instrument compared to other tools like the discount window and fed funds borrowing rates. Thus, before Basel III, reliance on re­ serve requirements had fallen over the years and we were in a period in which banks were largely subject to capital requirements. Yet, as discussed below, there may be a role for both in moderating bank liquidity creation in the present-day economy. To properly understand these issues, we first need to step back and take a closer look at the econom­ ics of traditional banking and its evolution to modern-day banking.

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Creation and Regulation of Bank Liquidity (p. 197)

7.3.1 Originate-To-Hold

The research on financial-intermediary existence implied that banks generate proprietary information about their borrowers.30 This then suggested that banks could use their infor­ mation to resolve informational frictions and increase the surplus generated by the bank– borrower relationship. This insight paved the way for the emergence of literature on rela­ tionship banking which highlights the benefits of deep relationships between banks and their borrowers. The pioneering theoretical contributions in this area are Greenbaum, Kanatas, and Venezia (1989), Sharpe (1990), Rajan (1992), and Boot and Thakor (1994, 2000). Boot (2000) defines relationship banking as “the provision of financial services by a financial intermediary that: (i) invests in obtaining customer-specific information, often proprietary in nature; and (ii) evaluates the profitability of these investments through multiple interactions with the same customer over time and/or across products.” The first part highlights that banks obtain information while providing screening and/or monitor­ ing services. The second part emphasizes the fact that information can be used in multi­ ple interactions with the same customer, which allows the bank to reuse information. To address whether relationships benefit borrowers, empirical studies have typically in­ cluded measures of duration, scope, distance, and/or the number of bank relationships in regressions to explain the cost and availability of credit. While the international evidence is at times mixed, most US studies tend to find clear benefits: stronger relationships re­ sult in lower cost, lower collateral requirements, loser covenants, and better access to credit (e.g., Petersen and Rajan, 1994; Berger and Udell, 1995; Prilmeier, 2017; for a re­ view, see Degryse, Kim, and Ongena, 2009, and Chapter 14 in this volume).31 Consistent with this, bank loan announcements are associated with significantly positive abnormal returns (e.g., James, 1987; Billett, Flannery, and Garfinkel, 1995).32 Banks benefit as well —stronger lending relationships are associated with a higher probability of winning SEO underwriting business (Drucker and Puri, 2005)33 and future lending and investment banking business (Bharath et al., 2007). Small banks tend to form stronger relationships with customers than large banks, likely because they are better at processing soft infor­ mation (Berger et al., 2005). Relationship banking involves the bank making the loan and holding it on its balance sheet, with bank monitoring and collateral requirements (Boot and Thakor, 1994, 2000). (p. 198) This is the so-called “originate-to-hold” model, in which banks fund relationship loans with core deposits. The loans are illiquid—banks keep them on their balance sheets until maturity. This reduces moral hazard on the side of the bank—the fact that the loans stay on the balance sheet gives the bank incentives to perform upfront screening and then monitor on an ongoing basis. Relationships can lose value if they have to be liquidated prematurely due to a bank run; often, a bank’s failure will result in the resolution authority arranging for the bank to be acquired by another institution, which results in a loss of the original relationship and its associated economic surplus, even if the loan is not liquidated.34 To prevent such runs

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Creation and Regulation of Bank Liquidity and protect the value of relationships, deposit insurance and lender-of-last-resort facili­ ties were introduced.

7.3.2 Originate-To-Distribute During the 1990s and 2000s, loan syndications, loan sales, and securitization skyrocket­ ed, in essence moving banks more and more away from the “originate-to-hold” (OTH) model toward a mix of OTH and the “originate-to distribute” (OTD) model. Sufi (2007) focuses on loan syndications. He examines how information asymmetries be­ tween lenders and borrowers affect syndicate structures. He documents that lead banks retain more and form more concentrated syndicates when information asymmetries are more severe. Bord and Santos (2012) assess the impact of the OTD model on corporate lending. They document that while lead banks retained 21 percent of the term loans they originated in 1988, that share had dropped to a mere 3.4 percent by 2010. Banks’ in­ creasing use of the OTD model helped to fuel the syndicated loan market from $339 bil­ lion in 1988 to an all-time high of $2.2 trillion in 2007. The secondary loan market trans­ formed from a market in which banks hardly participated to an active market with vol­ umes that rose from $8 billion in 1991 to $176 billion in 2005. While loan sales are easy to grasp, it is helpful to show how securitization works and how it contrasts with traditional banking. As shown in Figure 7.3 Panel B, the bank originates loans as it does in the traditional OTH model, but then transfers the loans to a trust called a Special Purpose Vehicle (SPV), which issues various tranches of debt claims called as­ set-backed securities (ABS) against this pool of loans. These ABS are sold to institutional investors and the money received by the SPV is transferred in part to the bank.35 Thus, like loan sales, securitization provides banks with extra funding that can be used to origi­ nate new loans. (p. 199)

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Creation and Regulation of Bank Liquidity

Figure 7.3 Traditional Banking vs. Securitization in the Shadow Banking System. Note: This figure compares the Originate-To-Hold (OTH) model of traditional banking with the Origi­ nate-To-Distribute (OTD) model of the shadow bank­ ing system.

Greenbaum and Thakor (1987), presenting the first formal theoretical treatment of secu­ ritization, examine which assets banks will securitize, and show that with asymmetric in­ formation about borrowers’ payoffs, banks securitize higher-quality assets (see also Gor­ ton and Pennacchi, 1995). Boot and Thakor (1993) show that banks may want to create tranches of claims against pooled assets, so as to diversify away idiosyncratic noise and then create information-sensitive claims that maximize issuer revenue. The push to split up securities in Gorton and Pennacchi (1990) is demand-driven instead: uninformed in­ vestors can reduce their trading losses if they can trade relatively information-insensitive securities. While these papers focus on the bright side of securitization, recent papers point to a dark side:36 it may negatively affect screening incentives since it allows lenders to pass onto others the loans they have originated (Aghion, Bolton, and Tirole, 2004; Stiglitz, 2007).37 Evidence from the subprime lending crisis tends (p. 200) to support this view (e.g., Mian and Sufi, 2009; Demyanyk and Van Hemert, 2011; Purnanandam, 2011; Dell’Ariccia, Igan, and Laeven, 2012; Keys, Seru, and Vig, 2012; Dai, Zhang, and Zhao, 2013), although skin in the game seems to improve banks’ screening incentives (Demiroglu and James, 2012). In Gennaioli, Shleifer, and Vishny (2013), securitization leads to greater bank interconnections and raises their exposure to tail risks. Banks may benefit from loan sales. Pennacchi (1988) shows that selling banks have an ad­ vantage in originating loans and a disadvantage in providing funding; the reverse holds for buying banks. James (1988) finds that loan sales can reduce the underinvestment problems of banks with risky debt. Firms may also benefit from loan sales. It may enable them to borrow more (Drucker and Puri, 2009; Gande and Saunders, 2012), and it can lower their cost of capital due to increased liquidity in the secondary loan market (Gupta, Singh, and Zebedee, 2008) or risk-sharing benefits between the originating bank and loan buyers (Parlour and Winton, 2013). There is also a dark side. Firms whose loans are sold Page 16 of 58

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Creation and Regulation of Bank Liquidity by banks underperform their peers (Berndt and Gupta, 2009), maybe because banks sell loans of lower-quality borrowers and/or loan sales reduce bank monitoring since the bank–borrower relationship is broken.

7.3.3 Originate-to-Distribute and the Shadow-Banking System The OTD model fuelled the development of the so-called “shadow-banking system.”38 While a consensus definition does not exist, Bernanke (2010) defines shadow banks as “fi­ nancial entities other than regulated depository institutions (commercial banks, thrifts, and credit unions) that serve as intermediaries to channel savings into investment.” Adri­ an and Ashcraft (2012) add that such channeling takes place “through a range of securiti­ zation and secured funding techniques,” highlighting the importance of securitization in shadow banking.39 The shadow-banking system includes institutions such as investment banks, brokerage houses, and finance companies; securitization structures such as assetbacked securities (ABS) and asset-backed commercial paper (ABCP); and key investors in securitized structures, such as money market mutual funds (MMMFs), which heavily rely on short-term funding like tri-party repurchase agreements (Repos) and commercial pa­ per (CP). See Gorton and Metrick (2010), Adrian and Ashcraft (2012), Claessens et al. (2012), and Martin, Skeie, and Von Thadden (2014a) for more discussions on shadow banking.40 As in the case of the OTH model, banks create liquidity in the OTD model as well, since they continue to originate the loans that are subsequently sold or securitized. There are two key differences, however, from a liquidity creation perspective. The first is that with the OTH model, the risk associated with liquidity creation is borne by the bank, whereas with the OTD model this risk is borne largely by the investors who purchase the loans or securities created by securitization.41 The second difference is that funding for loans in the OTH model tends to come from (core) deposits, while funding for securitized structures in the OTD model typically comes eventually from Repos and CP, even though the pre-securitization origination of the loan may have involved deposit funding. Unlike core deposits, there is no deposit insurance backing Repos and CP funding, so runs are possible. Various papers document that such runs indeed occurred during the subprime lending crisis—see Gorton and Metrick (2012) for evidence on a “run on repos”42 and Covitz, Liang, and Suarez (2013) for evidence on “runs on ABCP.”43 These differences aside, loan sales and securitization do not alter the fact that bank-intermediated liquidity creation occurs in the economy—it merely reflects a change in the process by which this liquidity creation is occurring. (p. 201)

7.4 Regulation to Preserve Uninterrupted Liq­ uidity Creation Going Forward Liquidity creation occupies an important seat at the table in both the OTH and OTD mod­ els. But for liquidity creation to not be ruptured, it is critical that banks operate with suf­ ficiently high equity capital and liquidity. That became apparent during the subprime Page 17 of 58

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Creation and Regulation of Bank Liquidity lending crisis, which brought issues regarding both to the forefront of the discussions, and has prompted a call for revised capital regulation and new liquidity regulation. We now discuss some of the key regulatory issues and the progress made in the implementa­ tion of new regulations in the US and Europe. We first focus on Basel III’s (p. 202) capital requirements and then on its liquidity requirements. Bank capital requirements after the financial crisis are also discussed in Chapter 22 in this volume.

7.4.1 Capital Requirements for Traditional OTH Banking and for OTD Shadow Banking 7.4.1.1 Basel III The subprime lending crisis revealed important weaknesses in Basel I and II. Both Ac­ cords seemed to provide inadequate incentives for banks to hold sufficient capital. More­ over, these accords failed to appropriately incorporate the risks posed by securitization, lacked liquidity standards, and failed to incorporate systemic risks associated with the build-up of leverage in the financial system. Inadequate levels of capital may have led to imprudent asset choices by banks, which then raised solvency concerns that contributed to the drying up of liquidity for banks during the recent crisis. In response to these perceived shortcomings, various academics have written proposals. They argue that there are externalities, due to the safety net provided to banks, and thus social efficiency can be improved by requiring banks to operate with more capital, espe­ cially during financial crises (e.g., Kashyap, Rajan, and Stein, 2008; Hart and Zingales, 2011; Calomiris and Herring, 2012; Admati et al., 2014; Thakor, 2014; Acharya, Mehran, and Thakor, 2016).44 Consistent with the academic perspective, Basel III—released in December 2010—impos­ es higher capital requirements and raises the quality of capital to address the seeming deficiencies of the prior Basel Accords (BIS, 2010, 2013b). Figure 7.4 compares Basel II and Basel III capital requirements.

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Creation and Regulation of Bank Liquidity

Figure 7.4 Comparison of Basel II and Basel III Capi­ tal Requirements. Note: This figure shows the Basel II and Basel III risk-based capital requirements, and the Basel III tier 1 minimum leverage ratio. It also explains the US im­ plementation of Basel III’s leverage ratio.

First, Basel III increases the minimum tier 1 risk-based capital ratio from 4 percent to 6 percent, and requires that the common equity component of tier 1 capital (CET1) goes up from 2 percent to 4.5 percent to ensure that a bank holds sufficient truly loss-absorbing capital (both requirements fully phased in by January 1, 2015). It leaves the minimum to­ tal risk-based capital ratio unchanged at 8 percent. Second, to reduce procyclicality and better withstand future periods of stress, it introduces a capital conservation buffer (“CCB”—additional common equity tier 1 of 2.5 percent of risk-weighted assets, fully phased in by January 1, 2019). The CCB is the lowest of a bank’s actual minus its mini­ mum capital ratio calculated based on three ratios: the CET1, tier 1, and total capital ra­ tios. Third, to reduce systemic risk that has built up due to excessive credit growth, a country’s regulator may impose a countercyclical capital buffer (“CCyB”—additional com­ mon equity tier 1, generally of 0 percent to 2.5 percent of risk-weighted assets).45 This buffer is (p. 203) to be built up during good times and can be used during a financial cycle downturn, thus supporting the flow of credit during periods of financial stress. Table 7.1 presents the CCyB levels in the thirteen countries that have activated or are about to acti­ vate this buffer as of March 2019. The US has not activated the CCyB: some (including several Federal Reserve Presidents) argue that it should be activated, while others argue it should be scrapped since bank stress tests already impose increasing capital buffers (see Financial Times, 2018). (p. 204) 46

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Creation and Regulation of Bank Liquidity Table 7.1 Countercyclical Capital Buffers Country

CCyB

Announced on

Effective since

Bulgaria

0.500%

Sep. 2018

Oct. 2019

Czech Republic

0.500%

Dec. 2015

Jan. 2017

1.000%

Jun. 2017

Jul. 2018

1.250%

Dec. 2017

Jan. 2019

1.500%

Jun. 2018

Jul. 2019

1.750%

Dec. 2018

Jan. 2020

Denmark

0.500%

Mar. 2018

Mar. 2019

France

0.250%

Jul. 2018

Jul. 2019

Hong Kong

0.625%

Jan. 2015

Jan. 2016

1.250%

Jan. 2016

Jan. 2017

1.875%

Jan. 2017

Jan. 2018

2.500%

Jan. 2018

Jan. 2019

1.000%

Mar. 2016

Mar. 2017

1.250%

Nov. 2016

Nov. 2017

1.750%

May 2018

May 2019

2.000%

Feb. 2019

Feb. 2020

Ireland

1.000%

Jul. 2018

Jul. 2019

Lithuania

0.500%

Dec. 2017

Dec. 2018

1.000%

Jun. 2018

Jun. 2019

0.250%

Dec. 2018

Jan. 2020

Iceland

Luxembourg

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Creation and Regulation of Bank Liquidity Norway

Slovakia

Sweden

United Kingdom

1.000%

Dec. 2013

Jun. 2015

1.500%

Jun. 2015

Jun. 2016

2.000%

Dec. 2016

Dec. 2017

2.500%

Dec. 2018

Dec. 2019

0.500%

Jul. 2016

Aug. 2017

1.250%

Jul. 2017

Aug. 2018

1.500%

Jul. 2018

Aug. 2019

1.000%

Sep. 2014

Sep. 2015

1.500%

Jun. 2015

Jun. 2016

2.000%

Mar. 2016

Mar. 2017

2.500%

Sep. 2018

Sep. 2019

0.500%

Mar. 2016

Mar. 2017

1.000%

Nov. 2017

Nov. 2018

Note: This table shows which countries have implemented (or have announced implementation of) countercyclical capital buffers as of March 2019, and how their levels have changed over time. Sources: BIS, National Authorities, and European Systemic Risk Board (https://www.esrb.europa.eu/national_policy/ccb/all_rates/html/ index.en.html). Fourth, to constrain leverage and to introduce extra safeguards against model risk and measurement error, it supplements the risk-based capital requirements with a minimum leverage ratio (based on tier 1 capital to on- and off-balance-sheet assets) of 3 percent. The US imposes higher leverage ratios: a 4 percent tier 1 leverage ratio (calcu­ lated using on-balance-sheet assets only) on all banks; a 4 percent supplementary lever­ age ratio (“SLR”) on Advanced Approaches Banks, and 5 percent and 6 percent enhanced supplementary leverage ratios (“eSLRs”) on globally systemically important banks (“GSIBs”) and their insured banking subsidiaries, respectively.47 Fifth, it subjects G-SIBs to additional loss absorbency requirements (extra common equity tier 1 of 1 percent to 3.5 percent of risk-weighted assets depending on assessed systemic importance, fully phased (p. 205)

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Creation and Regulation of Bank Liquidity in by January 1, 2019).48 The US subjects each US G-SIB to a surcharge that is the higher of its Basel III surcharge (“method 1”) and a surcharge that takes the G-SIB’s reliance on short-term wholesale funding into account (“method 2”), with the latter typically being binding (Federal Reserve, 2016). Table 7.2 provides an overview of the G-SIB surcharges. (p. 206)

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Creation and Regulation of Bank Liquidity Table 7.2 G-SIB Surcharges G-SIB

Basel III G-SIB Sur­ charge

Actual Sur­ charge US G-SIBs

G-SIB

Basel III G-SIB Sur­ charge

1

JP Morgan Chase

2.5%

3.5%

16

Credit Suisse

1.0%

2

Bank of America

2.0%

2.5%

17

Groupe Crédit Agricole

1.0%

3

Citigroup

2.0%

3.0%

18

ING Bank

1.0%

4

Deutsche Bank

2.0%

19

Mizuho FG

1.0%

5

HSBC

2.0%

20

Morgan Stanley

1.0%

6

Bank of China

1.5%

21

Nordea

1.0%

7

Barclays

1.5%

22

Royal Bank of Canada

1.0%

Actual Sur­ charge US G-SIBs

3.0%

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Creation and Regulation of Bank Liquidity 8

BNP Paribas

1.5%

23

Royal Bank of Scotland

1.0%

9

China Con­ struction Bank

1.5%

24

Santander

1.0%

10

Goldman Sachs

1.5%

25

Société Générale

1.0%

11

Industrial and Com­ mercial Bank of China Ltd

1.5%

26

Standard Chartered

1.0%

12

Mitsubishi UFJ FG

1.5%

27

State Street

1.0%

13

Wells Far­ go

1.5%

28

Sumitomo Mitsui FG

1.0%

14

Agricultur­ al Bank of China

1.0%

29

UBS

1.0%

2.5%

2.0%

1.5%

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Creation and Regulation of Bank Liquidity 15

Bank of New York Mellon

1.0%

1.5%

30

Unicredit Group

1.0%

Note: This table shows the Basel III G-SIB surcharges and the actual (higher) surcharges the Federal Reserve im­ poses on US G-SIBs as of November/December 2017. Sources: FSB (2017) and US G-SIBs’ websites.

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Creation and Regulation of Bank Liquidity The EU applies Basel III to all financial institutions. The US applies it to all US insured depository institutions, bank holding companies (BHCs) with at least $500 million in as­ sets, and savings and loan holding companies. In April 2018, the Board of Governors issued two proposals relating to the capital require­ ments for large banking organizations: a “Stress Buffer Proposal” (Federal Reserve, 2018a) and a “Scale Back Enhanced Supplementary Leverage Ratio (eSLR) Proposal” (Federal Reserve, 2018b). The “Stress Buffer Proposal” aims to simplify capital rules for the thirty-nine banks subjected to the Federal Reserve’s annual stress test, the Comprehensive Capital Analysis and Review (CCAR), that is, BHCs with consolidated as­ sets over $50 billion and intermediate holding companies of non-US banks. The proposal introduces two firm-specific, risk-sensitive capital buffer requirements: (i) A “stress capi­ tal buffer (SCB) requirement” calculated as stress test losses (= institution’s CET1 capital ratio minus its lowest projected CET1 capital ratio under the stress test’s severely ad­ verse scenario) plus four quarters of planned common stock dividends scaled by riskweighted assets. The SCB would have to be at least 2.5 percent and would replace the 2.5 percent capital conservation buffer. The US G-SIBs would be required to add on (p. 207) their G-SIB surcharges; (ii) A “stress leverage buffer requirement,” calculated in a similar way as the SCB, will be imposed in addition to the Basel III minimum 4 percent Tier 1 leverage ratio requirement. The “Scale Back Enhanced Supplementary Leverage Ratio (eSLR) Proposal” is only applicable to US G-SIBs and their insured bank subs: their eSLRs are currently 2 and 3 percentage points higher than the standard 3 percent SLR imposed on other banks. The proposal would replace these supplements with a supple­ ment equal to half of a BHC’s G-SIB surcharge, in an attempt to tie the supplement to the institution’s systemic footprint. If the G-SIB surcharge is 3.5 percent, the eSLR would de­ cline from 5 percent to 4.75 percent at the holding company level and from 6 percent to 4.75 percent at the bank level. The Federal Reserve estimates that this proposal will re­ duce the amount of required capital at the holding company by $400 million across all eight G-SIBs, and by $121 billion at the bank level.49 Some argue that Basel III is not aggressive enough and that higher capital requirements are needed (e.g., Financial Times, 2012; Haldane and Madouros, 2012; Bloomberg, 2013; Passmore and Von Haften, 2017).50 In deciding on the appropriate level (and form) of fu­ ture capital requirements, two key issues need to be considered: the effect on bank out­ put, and the need for capital regulation in the shadow-banking system.

Key Issue #1: Effect of Higher Capital Requirements on Bank Output The first issue is how higher capital requirements affect bank output (lending or liquidity creation).51 Bankers are vocal in this respect—they claim that increases in capital would negatively affect their performance and lead to less lending. The academic literature sug­ gests a more complex picture. The theories produce opposite predictions. Some predict that the relation between capi­ tal and bank liquidity creation or lending should be negative (e.g., Diamond and Rajan, 2001) because demandable deposits help to resolve a hold-up problem that cannot be re­ Page 26 of 58

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Creation and Regulation of Bank Liquidity solved by bank capital.52 Others argue that capital facilitates liquidity creation and other forms of bank output, in part because it helps to absorb the risks associated with those activities and improves incentives (e.g., Bhattacharya and Thakor, 1993; Allen and San­ tomero, 1998; Allen and Gale, 2004; Repullo, 2004; Von Thadden, 2004; Coval and Thakor, 2005; Begenau, 2018). The funding liquidity creation theory of Donaldson, Piacentino, and Thakor (2018) also predicts a positive effect of bank capital on liquidity creation. The US evidence is mixed. In the early 1990s, US regulators imposed new lever­ age requirements, as well as the Basel I risk-based capital standards. Many studies con­ clude that the leverage requirements may have reduced lending (e.g., Berger and Udell, 1994; Hancock, Laing, and Wilcox, 1995; Peek and Rosengren, 1995), while Thakor (1996) shows that the risk-based capital requirements may have had a similar effect, at least in the short run. However, the unusual combination of several major changes in cap­ ital regulation, a recession, and a toughening of supervision makes it challenging to sepa­ rate the different effects and draw general conclusions. (p. 208)

European evidence suggests that the effect of higher capital requirements differs by bank type and the state of the business cycle. Using data from the UK, Aiyar, Calomiris, and Wieladek (2012) find that increases in minimum capital requirements are associated with a decline in lending by some (UK banks and branches of foreign banks) and an increase in lending by others (subsidiaries of foreign banks). Using unique data from changes in capi­ tal regulation in Spain, Jiménez et al. (2017) show that countercyclical capital buffers mit­ igate the effect of business cycles—while such buffers lead to less credit in good times, they result in more lending in bad times. The studies discussed above focus on capital “requirements,” and Thakor’s (2014) conclu­ sion is that an increase in capital requirements often leads to a temporary reduction in lending as banks adjust to the new regime. But this is different from the issue of whether higher capital in banks leads to higher or lower lending. Many papers have focused di­ rectly on this issue, and the general conclusion is that there is a significant reduction in lending following a decline in capital. For example, this happened when capital declined due to loan losses in the 1920s to the 1930s (e.g., Calomiris and Wilson, 2004) and the late 1980s to the early 1990s (e.g., Peek and Rosengren, 1995), consistent with a positive causal effect of bank capital on bank lending. Using data on 165 large US BHCs from 1992 to 2009, Berrospide and Edge (2010) also find that higher capital (actual level or measured relative to an estimated target) is associated with higher loan growth, although the effect seems to be small. Francis and Osborne (2012) use data on banks in the UK from 1989 to 2007 to show that banks with greater surplus capital have higher growth in lending and off-balance-sheet activities. They argue that higher capital requirements would reduce the amount of surplus capital and that a positive relationship between sur­ plus capital and lending should be viewed as evidence that higher capital requirements reduce lending. While this argument may be valid in the short run in which capital is hard to adjust, it does not seem appropriate in the long run. Using data from 2001 to 2011, Carlson, Shan, and Warusawitharana (2013) find that banks with higher capital ratios tend to experience stronger loan growth during and shortly after the recent financial cri­ Page 27 of 58

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Creation and Regulation of Bank Liquidity sis, not during other times. Chu, Zhang, and Zhao (2017) document a positive effect of capital on lending. They show that higher-capital banks and Troubled Assets Relief Pro­ gram (TARP) recipients participating in the same syndicated loan contribute more to that loan. Using data from 1998 to 2015 from forty-seven countries, Klein and Turk-Ariss (2018) show that higher capital ratios improve lending. The effect on the economy is large: a one percentage point higher capital ratio raises real GDP growth by 1.25 percent­ age points. Some recent empirical contributions in this area define bank output as liquidity creation instead of lending, thereby permitting a test of the predictions of liquidity cre­ ation theories. Berger and Bouwman (2009) examine the relation between bank capital and the amount of liquidity they create using data on banks in the US from 1993 to 2003. For large banks, which create by far most of the liquidity (over 80 percent), they find a positive relationship (driven largely by the effect on off-balance-sheet activities), whereas for small banks, the relationship is negative. Evidence on this topic using data from Rus­ sia (Fungáčová, Weill, and Zhou, 2010) and Europe (e.g., Distinguin, Roulet, and Tarazi, 2013; Horvath, Seidler, and Weill, 2014) is starting to emerge. It tends to suggest that capital and on-balance-sheet liquidity creation are negatively related outside the US. (p. 209)

While the papers discussed above examine the effect of higher capital requirements and higher capital on bank output, it is important to remember that a key reason to impose higher capital requirements is to obtain a safer and less fragile banking sector.53 Consistent with this objective, Mehran and Thakor (2011) show theoretically and find em­ pirically that bank capital and bank value are positively related in the cross-section. Bel­ tratti and Stulz (2012) provide evidence that banks with higher tier 1 capital ratios before the recent subprime lending crisis showed better stock performance during the crisis. Berger and Bouwman (2013) show that capital helps small banks to survive at all times (during crises and normal times), and helps large banks primarily during banking crises. Baker and Wurgler (2015) document that in the past forty years, banks with higher capi­ tal had lower betas but higher stock returns, leading them to conclude that higher capital requirements will increase the cost of capital in banking, although they will also make banks systematically safer. Bouwman, Kim, and Shin (2018) show that higher-capital banks earn higher risk-adjusted returns during bad times than low-capital banks, while earning similar returns during other times. In sum, it appears that the effects of higher capital requirements on bank output are mixed, but in the US, this is in part because the introduction of higher capital require­ ments in the early 1990s coincided with changes in the type of capital requirements and a recession, which makes it harder to interpret the results. In contrast, it seems that higher capital generally benefits banks and their borrowers, reduces bank-specific and systemic risks (e.g., Farhi and Tirole, 2012; Acharya and Thakor, 2016), and reduces the need for taxpayer-funded bailouts (e.g., Farhi and Tirole, 2012).54 See also Thakor (2014) for an extensive review of the theories and empirical evidence on these topics.

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Creation and Regulation of Bank Liquidity (p. 210)

Key Issue #2: Capital Requirements and the Shadow-Banking System

A second issue is that imposing higher capital requirements might lead to widespread mi­ gration of financial intermediation toward the less regulated shadow-banking system (Hanson, Kashyap, and Stein, 2011; FSB, 2012b). This is a concern since the subprime lending crisis showed that the absence of an explicit government safety net in this market can cause runs and that liquidity can dry up for institutions in the shadow-banking sys­ tem, which can then threaten overall liquidity creation in the economy. Many of these in­ stitutions are considered “systemically important,” so the government has an (ex post) in­ centive to rescue them, as we saw with non-deposit-insured institutions like Bear Stearns and American International Group (AIG) in the subprime lending crisis. One way to address this is to impose capital requirements on shadow banks. Basel III in­ cludes steps in this direction (FSB, 2011, 2012b): it increases capital requirements for short-term liquidity facilities provided to securitization vehicles, and for exposures to un­ regulated financial institutions regardless of size. The Basel Committee decided against increasing capital requirements related to banks’ short-term liquidity facilities to MMFs, fearing this could have unintended consequences and might be unnecessary in light of the introduction of the liquidity coverage ratio. The Dodd–Frank Act imposes capital re­ quirements on shadow banks that are considered SIFIs. The Financial Stability Oversight Council proposed in early June 2013 to designate AIG, Prudential Financial, and GE Capi­ tal as such. More steps are likely needed to prevent migration toward the shadow-banking system. Gorton and Metrick (2010) discuss several additional proposals, including the conversion of MMFs that offer bank-like services (transaction accounts and the ability to withdraw funds on demand at par) into “narrow savings banks” with appropriate supervision, gov­ ernment insurance, and access to lender-of-last-resort facilities.

7.4.2 Liquidity Requirements—International and US Developments Although reserve requirements have taken a back seat in US regulation, a desire to have explicit liquidity requirements for financial institutions grew in the US and in other coun­ tries after the subprime lending crisis. These developments are reviewed here. The Basel Committee introduced liquidity regulation as part of Basel III. This was a de­ parture from Basel I and II, which focused on strengthening capital regulation. The origi­ nal December 2010 liquidity framework (BIS, 2010) specifies two minimum liquidity re­ quirements with complementary objectives. The first is the liquidity coverage ratio (LCR) which promotes short-term resilience: to survive a specified stress scenario which lasts one month, banks have to operate with enough high-quality liquid assets. (p. 211) The sec­ ond is the net stable funding ratio (NSFR) which promotes long-run resilience: to be able to survive an extended closure of wholesale funding markets, banks have to operate with a minimum acceptable amount of “stable funding” over a one-year period. Below, we dis­ cuss both: we first cover the BIS minimum standards and then their US implementations.

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Creation and Regulation of Bank Liquidity The LCR requires that a bank’s stock of unencumbered high-quality liquid assets (HQLA) generally equals or exceeds its projected net cash outflows (NCOF) over a 30-day horizon under a stress scenario prescribed by the supervisors:

.55 HQLA,

the numerator, includes three groups of assets, with a different expected ability to serve as liquid assets during periods of stress. Level 1 assets (cash, central bank reserves, and certain marketable securities backed by sovereigns and central banks) are considered the most liquid. Level 2A assets (certain government securities, covered bonds, and corpo­ rate debt securities) are viewed to be less liquid, and Level 2B assets (lower-rated plainvanilla senior corporate bonds and certain residential mortgage-backed securities) are viewed to be the least liquid. Therefore, Level 2A (2B) assets are discounted by 15 per­ cent (50 percent) and may not account for more than 40 percent (15 percent) of the bank’s total stock of HQLA. NCOF, the denominator, is defined as total expected cash out­ flows minus total expected cash inflows in the specified stress scenario for the next thirty days. Total expected cash outflows are calculated by multiplying the outstanding balances of different types of liabilities and off-balance-sheet commitments by the rates at which they are expected to run off or be drawn down in the prescribed stress scenario. For ex­ ample, unsecured interbank loans are assumed to run off fully if they come due during the stress scenario, while deposits are assumed to run off by 5 percent or 10 percent, de­ pending on the type of deposit. To ensure a minimum level of HQLA holdings at all times, total cash inflows are subject to a cap of 75 percent of total expected cash outflows. The LCR is supposed to stay above 100 percent, but can briefly drop below this floor during times of stress (BIS, 2013b). The NSFR requires that a bank has a sufficient level of available stable funding (ASF) to meet their required stable funding (RSF) over a one-year horizon:

.56

ASF, the numerator, is the portion of capital and liabilities expected to be reliable over a one-year period. ASF is determined by first assigning capital and liabilities to five buck­ ets, then weighting the amount in each bucket by an ASF factor (100 percent, 95 percent, 90 percent, 50 percent, or 0 percent), and finally summing the weighted amounts. The ASF factors aim to measure the stickiness of each funding source—the less likely it is to run, the higher the ASF factor.57 RSF, the denominator, is calculated (p. 212) using a simi­ lar process as that used for the numerator. Assigned RSF factors include 0 percent, 5 per­ cent, 10 percent, 15 percent, 50 percent, 65 percent, 85 percent, and 100 percent. Activi­ ties that are more liquid receive the lowest RSF factors (and require less stable funding) because they can act as a source of extended liquidity in case of stress.58 The US versions of the LCR and NSFR differs somewhat from their Basel III counterparts, as explained in the LCR final rule (Federal Reserve, 2014) and the NSFR notice of pro­ posed rulemaking (Federal Reserve, 2016). First, the US LCR rule and NSFR proposal use a more conservative definition of HQLA. For example, securities issued by financial insti­ tutions and some privately-issued mortgage-backed securities do not count as HQLA un­ der the US rule, but do count as such under Basel III.59 In addition, the US LCR rule uses the largest liquidity mismatch over a 30-day stress period, while the Basel standard focus­ es on cumulative cash flows over this window. Second, the US LRC rule and NSFR pro­ Page 30 of 58

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Creation and Regulation of Bank Liquidity posal differ by bank size. The full LCR and full NSFR apply to BHCs with at least $250 bil­ lion in consolidated assets, BHCs with at least $10 billion in on-balance-sheet foreign ex­ posure (e.g., loans to foreign firms), and depository institutions with at least $10 billion in consolidated assets that are subsidiaries of covered BHCs. A modified LCR and a modified NSFR apply to BHCs with consolidated assets between $50 billion and $250 billion that are not subject to the full versions. These institutions have to meet less stringent require­ ments: their net cash outflows and required stable funding (the denominators in the LCR and NSFR, respectively) are multiplied by 70 percent. No LCR (p. 213) or NSFR require­ ments are imposed on banking organizations with consolidated assets of less than $50 bil­ lion and on-balance-sheet foreign exposure of less than $10 billion. The three US agencies are expected to issue a final rule on the NSRF in 2019. The Trea­ sury Department recommended in 2017 that US regulators delay the implementation of the NSFR until they have been able to appropriately assess and calibrate it (Mnuchin and Phillips, 2017). Various opponents urge regulators not to implement the NSFR. The presi­ dent of the American Bankers Association argues that it would impose significant need­ less costs, given that other regulations (including the LCR and G-SIB surcharge) already limit reliance on short-term funding and encourage stable funding (ABA Banking Journal, 2017).

Key Issue #1: Better Understanding Liquidity Requirements Very few papers try to examine the purpose and effect of liquidity regulation. Allen and Gale (2017) provide a useful overview of this short literature. We highlight some recent contributions that explicitly aim to examine the optimality and design of liquidity require­ ments in light of Basel III. Diamond and Kashyap (2016) consider monopolist banks that provide liquidity insurance to customers with uncertain withdrawal needs. They make two modifications to Diamond and Dybvig (1983). First, the bank can invest in a liquid asset with a return greater than the return from liquidating illiquid assets, so selling liquid assets is an efficient way to meet withdrawal needs. Second, only some customers receive a signal about the bank’s health so in case of a run, not all customers will run. They show that regulations similar to the LCR and NSFR can make runs less likely. Dewatripont and Tirole (2018) focus on the LCR, since their model only has a single liq­ uidity shock, which does not allow them to distinguish between two horizons. They show that banks’ liquidity buffers should not cover extreme risks—in such cases, it is socially optimal for the state to step in and provide liquidity assistance. Since banks underinvest in liquidity under laissez-faire, it is important to regulate liquidity coverage. The privately and socially optimal liquidity solution is for banks to meet a liquidity requirement similar to the LCR (hold sufficient low-yield, highly liquid assets to meet ordinary liquidity shocks, and sufficient higher-yield, less liquid assets to address larger shocks) and for the state to provide liquidity support in case of exceptional liquidity shocks.

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Creation and Regulation of Bank Liquidity In contrast, Thakor (2018) argues against liquidity requirements, suggesting that their genesis in Basel III may be based on a misreading of the subprime lending crisis as a liq­ uidity crisis, when the empirical evidence suggests it was an insolvency risk crisis. His ar­ gument is partly based on Donaldson, Piacentino, and Thakor (2018), in which liquidity requirements reduce liquidity creation. Berger and Bouwman (2016) show correlations between the two Basel liquidity require­ ments and bank liquidity creation. They do this separately for small, medium, and large banks. Their results suggest that the three capture different things, suggesting that it is important to measure all three and to conduct new research to see which are better at predicting performance of individual banks and the banking sector.

Key Issue #2: Understanding How Liquidity Requirements Interact with Capital Requirements (p. 214)

Liquidity requirements and capital requirements are designed to address two different problems and affect different sides of the balance sheet. Specifically, liquidity require­ ments deal with withdrawal risk on the liability side by stipulating that a fraction of the bank’s assets be held as cash or deposits with the central bank, while capital require­ ments deal with asset-substitution risk by stipulating that a fraction of the bank’s liabili­ ties be in the form of equity. Nonetheless, liquidity requirements and capital require­ ments may interact. Little research has been done in this important area. A few recent papers address this issue theoretically. Calomiris, Heider, and Hoerova (2015) incorporate two unique aspects of cash relative to capital: the value of cash is ob­ servable at all times, and cash is riskless, making it impervious to risk shifting. These fea­ tures mean that cash mitigates both liquidity risk associated with exogenous withdrawal shocks and endogenous asset risk. Specifically, the market recognizes that banks with higher cash holdings make more prudent risk-management decisions and thus will be more willing to provide funds, which implies that in bad states of the world, banks will avoid higher asset risk and increase their cash holdings to preserve market confidence. A key insight of the paper is that liquidity requirements should not be viewed as a mere in­ surance policy to deal with liquidity risk that may occur in a financial crisis, but also as a prudential regulatory tool that—like capital requirements—can limit default risk and en­ courage good risk management. That is, liquidity requirements and capital requirements act as (imperfect) substitutes. Acharya, Mehran, and Thakor (2016) examine optimal capital regulation for banks that face two moral hazard problems: shirking by managers and risk-shifting by shareholders. A simple minimum capital requirement can rule out the second problem, but not the first problem, since it makes debt so safe that it takes away managers’ monitoring incentives. To deal with both moral hazards, they propose two kinds of capital requirements: a regu­ lar minimum capital requirement and a “special capital account.” The regular capital can be used to invest in any type of assets. The special capital has to be invested in relatively safe and liquid assets such as Treasuries, and can be viewed as a “capital-cum-liquidity” requirement. The key innovation in the paper is that the special capital belongs to the Page 32 of 58

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Creation and Regulation of Bank Liquidity bank’s shareholders as long as the bank is solvent, but when the bank is insolvent, it goes to the regulator, not the bank’s creditors. This means that this special capital is “invisi­ ble” to the bank’s creditors and does not dilute their incentive to discipline the bank. Carletti, Goldstein, and Leonello (2018) examine how capital and liquidity affect bank sta­ bility. They show that higher capital reduces the likelihood of a solvency crisis, while higher liquidity increases it. In their model, the probability of a liquidity crisis crucially depends on the bank’s capital and liquidity position. When capital or portfolio liquidity are low, an increase in either makes a liquidity crisis more likely, since both raise debtholders’ repayment. When capital or liquidity are intermediate, injections of capital or liquidity are beneficial. When capital or liquidity are high, the main risk facing a bank is (p. 215) a solvency crisis, for which higher capital is beneficial, but more liquidity is not since it makes a solvency crisis more likely. They show that capital and liquidity require­ ments only restore full efficiency when market funding conditions are good and the cost of capital and liquidity for banks is small. Thakor (2018) concludes that liquidity requirements, at least as presently designed, are counterproductive: they seem to lead to lower bank lending and may not even reduce liq­ uidity risk.60 The paper points out that lowering/eliminating liquidity requirements and in­ creasing capital requirements will reduce the likelihood of banks facing short-term fund­ ing dry-ups during times of stress, which will reduce their reliance on central banks to flood the market with liquidity. Moreover, this will free up loanable funds for banks to in­ vest in stimulating economic growth, and will lead to a more transparent, simpler, and ef­ ficient regulatory structure. The observations by Calomiris, Heider, and Hoerova (2015) and Thakor (2018) are in line with the idea that capital and liquidity requirements are substitutes.61 Robust enough capital requirements minimize the risk of banks not having access to sufficient market liq­ uidity when they need it. This, in turn, reduces the need to impose onerous liquidity re­ quirements that freeze assets in the sense that they cannot be invested productively. Moreover, the “L” in CAMELS, the supervisory rating system applied to every bank in the US and many banks outside the US to evaluate banks’ performance and determine their weaknesses and strengths,62 refers to bank liquidity, so liquidity is attended to as part of the normal bank examination process. Finally, at the end of the day, it is the job of the central bank as an LOLR to provide banks with liquidity.63 It seems far more efficient for the LOLR to provide liquidity to banks when needed than to require each bank to hold sufficient liquid assets on its balance sheet. The optimal design of both capital and liquidity requirements can only be addressed with a good understanding of the nature of government intervention in financial crises. It would be preferable to acknowledge up front that such intervention is unavoidable and ask how capital and liquidity requirements should be designed ex ante, conditional on knowing that bailouts will occur ex post in circumstances that can be identified ex ante.

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Creation and Regulation of Bank Liquidity (p. 216)

7.5 Conclusion

This chapter has covered the theory and empirical evidence related to bank liquidity cre­ ation to shed light on the underlying economics of this central aspect of the financial sys­ tem. It has discussed two distinct notions of bank liquidity creation developed in the theo­ retical literature—funding liquidity creation and improved risk sharing for risk-averse de­ positors. It has also covered regulatory issues and how these are affected by the evolu­ tion of banking from an Originate-To-Hold (OTH) model to one that has a mix of OTH and Originate-To-Distribute (OTD). These developments have profound implications for regu­ latory policy that is designed to ensure that liquidity creation continues without the costly breaches associated with financial crises. An important conclusion is that while higher bank capital seems to increase liquidity creation, liquidity requirements seem to reduce it. As discussed, much work remains to be done. Foremost among these is the question of how capital requirements ought to be designed for both traditional OTH banking activi­ ties as well as for the newly emerged shadow-banking system. A second question is whether bank liquidity requirements serve any useful purpose, and if so, what the best way is to design them to minimize their adverse impact on liquidity creation. These two issues should not be addressed in isolation. Finally, Farhi and Tirole (2012) highlight the fact that inefficient bailouts of banks by regulators may occur because regulators cannot distinguish between insolvency and illiquidity even ex post, so research that informs reg­ ulators about how to distinguish between insolvency and illiquidity, as a precursor to in­ tervening in what looks like a crisis, would be very useful.

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Bank Reserves of the Federal Reserve System,” 19th Annual Report of the Board of Gov­ ernors of the Federal Reserve System, Washington, DC, 260–85. Federal Reserve (2007). “Risk-based Capital Standards: Advanced Capital Adequacy Framework – Basel II,” 72 Federal Register 235, December 7. Federal Reserve (2014). “Liquidity Coverage Ratio: Liquidity Risk Measurement Stan­ dards,” Final Rule, 79 Federal Register 61440, October 10. Federal Reserve (2016). “Regulatory Capital Rules: Implementation of Capital Require­ ments for Global Systemically Important Bank Holding Companies,” Final Rule, 12 CFR Part 217 Regulation Q, Docket No. R01535, December 9. Federal Reserve (2018a). “Amendments to the Regulatory Capital, Capital Plan, and Stress Test Rules,” Notice of Proposed Rulemaking, 83 Federal Register 18160, April 25. Federal Reserve (2018b). “Regulatory Capital Rules: Regulatory Capital, Enhanced Sup­ plementary Leverage Ratio Standards for US Global Systemically Important Bank Hold­ ing Companies and Certain of their Subsidiary Insured Depository Institutions; Total LossAbsorbing Capacity Requirements for US Global Systemically Important Bank Holding Companies,” Proposed Rule, 83 Federal Register 171317, April 19. Federal Reserve (2018c). “Liquidity Coverage Ratio Rule: Treatment of Certain Municipal Obligations as High-quality Liquid Assets,” Interim Final Rule, 83 Federal Register 44451, August 31.

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Creation and Regulation of Bank Liquidity Feinman, J. N. (1993). “Reserve Requirements: History, Current Practice, and Potential Reform,” Federal Reserve Bulletin, (June), 569–89. Financial Times (2012). “Get Basel III Right and Avoid Basel IV,” by T. Hoenig, December 12. Financial Times (2018). “Federal Reserve Debates Banks’ Capital Buffers as Markets Surge,” by Sam Fleming, August 29. Francis, W. A. and Osborne, M. (2012). “Capital Requirements and Bank Behavior in the UK: Are there Lessons for International Capital Standards?” Journal of Banking and Fi­ nance, 36, 803–16. Freixas, X. and Rochet, J.-C. (2008). Microeconomics of Banking, 2nd edn (Boston, MA: MIT Press). FSB (Financial Stability Board) (2011). “Shadow Banking: Strengthening Oversight and Regulation,” Recommendations of the Financial Stability Board. FSB (2012a). “Securities Lending and Repos: Market Overview and Financial Stability Is­ sues,” Interim Report of the FSB Workstream on Securities Lending and Repos, April 27. FSB (2012b). “Strengthening Oversight and Regulation of Shadow Banking: An Integrat­ ed Overview of Policy Recommendations,” November 18. FSB (2017). “2017 List of Global Systemically Important Banks (G-SIBs),” November 21. Fungáčová, Z., Weill, L., and Zhou, M. (2017). “Bank Capital, Liquidity Creation and De­ posit Insurance,” Journal of Financial Services Research, 51, 97–123. Furfine, C. (2001). “The Reluctance to Borrow from the Fed,” Economics Letters, 72, 209– 213. Gande, A. and Saunders, A. (2012). “Are Banks still Special when there is a Secondary Market for Loans?” Journal of Finance, 67, 1649–84. Garcia-de-Andoain, C., Heider, F., Hoerova, M., and Manganelli, S. (2016). “Lending-ofLast-Resort Is as Lending-of-Last-Resort Does: Central Bank Liquidity Provision and Inter­ bank Market Functioning in the Euro Area,” Journal of Financial Intermediation, 28, 32– 47. Gatev, E., Schuermann, T., and Strahan, P. E. (2006). “How do Banks Manage Liquidity Risk? Evidence from the Equity and Deposit Markets in the Fall of 1998,” in M. Carey and R. Stulz (eds.), Risks of Financial Institutions (Chicago, IL: University of Chicago Press), 105–27. Gatev, E., Schuermann, T., and Strahan, P. E. (2009). “Managing Bank Liquidity Risk: How Deposit–Loan Synergies Vary with Market Conditions,” Review of Financial Studies, 22, 995–1020. (p. 223)

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Creation and Regulation of Bank Liquidity Gennaioli, N., Shleifer, A., and Vishny, R. W. (2013). “A Model of Shadow Banking,” Jour­ nal of Finance, 68, 1331–63. Genotte, G. and Pyle, D. H. (1991). “Capital Controls and Bank Risk,” Journal of Banking and Finance, 15, 805–24. Goel, A. and Thakor, A. V. (2015). “Information Reliability and Welfare: A Theory of Coarse Credit Ratings,” Journal of Financial Economics, 115, 541–57. Gorton, G. (1988). “Banking Panics and the Business Cycle,” Oxford Economic Papers, 40, 751–81. Gorton, G. B. and Haubrich, J. G. (1990). “The Loan Sales Market,” in G. Kaufman (ed.), Research in Financial Services: Private and Public Policy, Vol. II (Greenwich, CT: Jai Press), 85–135. Gorton, G. B. and Metrick, A. (2010). “Regulating the Shadow Banking System,” Brook­ ings Papers on Economic Activity, 41, 261–312. Gorton, G. B. and Metrick, A. (2012). “Securitized Banking and the Run on Repo,” Journal of Financial Economics, 104, 425–51. Gorton, G. B. and Pennacchi, G. G. (1990). “Financial Intermediaries and Liquidity Cre­ ation,” Journal of Finance, 45, 49–71. Gorton, G. B. and Pennacchi, G. G. (1995). “Banks and Loan Sales: Marketing Non-mar­ ketable Assets,” Journal of Monetary Economics, 3, 389–411. Greenbaum, S. I. and Thakor, A. V. (1987). “Bank Funding Modes: Securitization versus Deposits,” Journal of Banking and Finance, 11, 379–401. Greenbaum, S. I., Kanatas, G., and Venezia, I. (1989). “Equilibrium Loan Pricing under the Bank–Client Relationship,” Journal of Banking and Finance, 13, 221–35. Greenbaum, S. I., Thakor, A. V., and Boot, A. W. A. (2015). Contemporary Financial Inter­ mediation, 3rd edn (Amsterdam: North-Holland/Elsevier/Academic Press). Gupta, A., Singh, A. K., and Zebedee, A. A. (2008). “Liquidity in the Pricing of Syndicated Loans,” Journal of Financial Markets, 11, 339–76. Haldane, A. G. and Madouros, V. (2012). “The Dog and the Frisbee,” Speech at the Jack­ son Hole Economic Policy Symposium, August 31. Hancock, D., Laing, A. J., and Wilcox, J. A. (1995). “Bank Balance Sheet Shocks and Ag­ gregate Shocks: Their Dynamic Effects on Bank Capital and Lending,” Journal of Banking and Finance, 19, 661–77. Hanson, S. G., Kashyap, A. K., and Stein, J. C. (2011). “A Macroprudential Approach to Fi­ nancial Regulation,” Journal of Economic Perspectives, 25, 3–28. Page 44 of 58

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Creation and Regulation of Bank Liquidity Hart, O. and Zingales, L. (2011). “A New Capital Regulation for Large Financial Institu­ tions,” American Law and Economics Review, 13, 453–90. Hellmann, T. F., Murdock, K. C., and Stiglitz, J. E. (2000). “Liberalization, Moral Hazard in Banking, and Prudential Regulation: Are Capital Requirements Enough?” American Eco­ nomic Review, 90, 147–65. Hellwig, M. (1994). “Liquidity Provision, Banking, and the Allocation of Interest Rate Risk,” European Economic Review, 39, 1363–89. Ho, T. S. Y. and Saunders, A. (1983). “Fixed Rate Loan Commitments, Take-Down Risk, and the Dynamics of Hedging with Futures,” Journal of Financial and Quantitative Analy­ sis, 18, 499–516. Holmstrom, B. and Tirole, J. (1998). “Public and Private Supply of Liquidity,” Journal of Political Economy, 106, 1–40. Horvath, R., Seidler, J., and Weill, L. (2014). “Bank Capital and Liquidity Creation: Granger-Causality Evidence,” Journal of Financial Services Research, 45, 341–61. (p. 224)

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Creation and Regulation of Bank Liquidity Jiménez, G., Ongena, S., Peydró, J.-L., and Saurina, J. (2017). “Macroprudential Policy, Countercyclical Bank Capital Buffers and Credit Supply: Evidence from the Spanish Dy­ namic Provisioning Experiments,” Journal of Political Economy, 125, 2126–77. Kane, E., Laeven, L., and Demirgüç-Kunt, A. (2008). “Determinants of Deposit Insurance Adoption and Design,” Journal of Financial Intermediation, 17, 407–38. Kashyap, A. K., Rajan, R. G., and Stein, J. C. (2002). “Banks as Liquidity Providers: An Ex­ planation for the Coexistence of Lending and Deposit-taking,” Journal of Finance, 57, 33– 73. Kashyap, A. K., Rajan, R. G., and Stein, J. C. (2008). “Rethinking Capital Regulation,” Fed­ eral Reserve Bank of Kansas City Symposium on Maintaining Stability in a Changing Fi­ nancial System, Federal Reserve Bank of Kansas City, Kansas City, 431–71. Keister, T. and McAndrews, J. J. (2009). “Why are Banks Holding so many Excess Re­ serves?” Current Issues in Economics and Finance—Federal Reserve Bank of New York, 15, 1–10. Keys, B., Seru, A., and Vig, V. (2012). “Lender Screening and Role of Securitization: Evi­ dence from Prime and Subprime Mortgage Markets,” Review of Financial Studies, 25, 2071–108. Kim, D. and Santomero, A. M. (1988). “Risk in Bank and Capital Regulation,” Journal of Finance, 43, 1219–33. Klein, P.-O. and Turk-Ariss, R. (2018). “Is the Cost of a Safer Banking System Lower Eco­ nomic Activity?” Working Paper. Klimenko, N., Pfeil, S., Rochet, J.-C., and De Nicolo, G. (2016). “Aggregate Bank Capital and Credit Dynamics,” Working Paper. Koehn, M. and Santomero, A. M. (1980). “Regulation of Bank Capital and Portfolio Risk,” Journal of Finance, 35, 1235–44. Krishnamurthy, A., Nagel, S., and Orlov, D. (2014). “Sizing Up Repo,” Journal of Finance, 69, 2381–417. Leland, H. E. and Pyle, D. H. (1977). “Informational Asymmetries, Financial Structure and Financial Intermediation,” Journal of Finance, 32, 371–87. Li, L. (2013). “TARP Funds Distribution and Bank Loan Supply,” Journal of Banking and Finance, 37, 4777–92. Loutskina, E. (2011). “The Role of Securitization in Bank Liquidity and Funding Management,” Review of Financial Studies, 100, 663–84. (p. 225)

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Creation and Regulation of Bank Liquidity Martin, A., Skeie, D., and von Thadden, E.-L. (2014a). “Repo Runs,” Review of Financial Studies, 27, 957–89. Martin, A., Skeie, D., and von Thadden, E.-L. (2014b). “The Fragility of Short-Term Se­ cured Funding Markets,” Journal of Economic Theory, 149, 15–42. McCulley, P. (2007). “Teton Reflections,” PIMCO Global Central Bank Focus. Mehran, H. and Thakor, A. V. (2011). “Bank Capital and Value in the Cross-Section,” Re­ view of Financial Studies, 24, 1019–67. Melnik, A. and Plaut, S. (1986). “Loan Commitment Contracts, Terms of Lending, and Credit Allocation,” Journal of Finance, 41, 425–35. Merton, R. C. (1977). “On the Pricing of Contingent Claims and the Modigliani–Miller Theorem,” Journal of Financial Economics, 5, 241–9. Merton, R. C. and Bodie, Z. (1992). “On the Management of Financial Guarantees,” Finan­ cial Management, 21, 87–109. Merton, R. C. and Thakor, R. T. (forthcoming). “Customers and Investors: A Framework for Understanding the Evolution of Financial Institutions,” Journal of Financial Intermedi­ ation. Mester, L. J., Nakamura, L. I., and Renault, M. (2007). “Transactions Accounts and Loan Monitoring,” Review of Financial Studies, 20, 529–56. Mian, A. and Sufi, A. (2009). “The Consequences of Mortgage Credit Expansion: Evidence from the US Mortgage Default Crisis,” Quarterly Journal of Economics, 124, 1449–96. Millon, M. H. and Thakor, A. V. (1985). “Moral Hazard and Information Sharing: A Model of Financial Information Gathering Agencies,” Journal of Finance, 40, 1403–22. Mnuchin, S. T. and Phillips, C. S. (2017). “A Financial System that Creates Economic Op­ portunities: Banks and Credit Unions,” US Department of Treasury Report to President Donald J. Trump, Executive Order 13772 on Core Principles for Regulating the United States Financial System, June. Morgan, D. P. (1994). “Bank Credit Commitments, Credit Rationing, and Monetary Poli­ cy,” Journal of Money, Credit and Banking, 26, 87–101. O’Hara, M. and Shaw, W. (1990). “Deposit Insurance and Wealth Effects: The Benefit of Being Too Big To Fail,” Journal of Finance, 45, 1587–600. Parlour, C. A. and Winton, A. (2013). “Laying Off Credit Risk: Loan Sales versus Credit Default Swaps,” Journal of Financial Economics, 107, 25–45.

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Creation and Regulation of Bank Liquidity Passmore, W. and Von Haften, A. H. (2017). “Are Basel’s Capital Surcharges for Global Systemically Important Banks Too Small?” Finance and Economics Discussion Series 2017–12. Washington, DC: Board of Governors of the Federal Reserve System. Peek, J. and Rosengren, E. S. (1995). “The Capital Crunch: Neither a Borrower Nor a Lender Be,” Journal of Money, Credit and Banking, 27, 625–38. Pennacchi, G. G. (1988). “Loan Sales and the Cost of Bank Capital,” Journal of Finance, 43, 375–96. Perignon, C., Thesmar, D., and Vuillemey, G. (2018). “Wholesale Funding Dry-ups,” Jour­ nal of Finance, 73, 575–617. Petersen, M. A. and Rajan, R. G. (1994). “The Benefits of Lending Relationships: Evidence from Small Business Data,” Journal of Finance, 49, 3–37. Prilmeier, R. (2017). “Why do Loans Contain Covenants? Evidence from Lending Relation­ ships,” Journal of Financial Economics, 123, 558–79. Purnanandam, A. (2011). “Originate-to-Distribute Model and the Subprime Mort­ gage Crisis,” Review of Financial Studies, 24, 1881–915. (p. 226)

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Creation and Regulation of Bank Liquidity Sufi, A. (2009). “Bank Lines of Credit in Corporate Finance: An Empirical Analysis,” Re­ view of Financial Studies, 22, 1057–88. Sumner, S. (2009). “Comment on Brad Delong: Can We Generate Controlled Reflation in a Liquidity Trap?” The Economists’ Voice, 6(4), art. 7. Systemic Risk Council (2012). “Comment Letter Regarding: Regulatory Capital Rules,” October 4. Thakor, A. V. (1982). “Toward a Theory of Bank Loan Commitments,” Journal of Banking and Finance, 6, 55–83. Thakor, A. V. (1996). “Capital Requirements, Monetary Policy and Aggregate Bank Lend­ ing: Theory and Empirical Evidence,” Journal of Finance, 51, 279–324. Thakor, A. V. (2005). “Do Loan Commitments Cause Overlending?” Journal of Money, Credit and Banking, 37, 1067–100. Thakor, A. V. (2014). “Bank Capital and Financial Stability: An Economic Trade-off or a Faustian Bargain?” Annual Review of Financial Economics, 6, 185–223. Thakor, A. V. (2015). “The Financial Crisis of 2007–09: Why Did It Happen and What Did We Learn?” Review of Corporate Finance Studies, 4, 115–205. Thakor, A. V. (2018). “Post-crisis Regulatory Reform in Banking: Address Insolvency Risk, not Illiquidity!” Journal of Financial Stability, 37, 107–11. Thakor, A. V., Hong, H., and Greenbaum, S. I. (1981). “Bank Loan Commitments and Inter­ est Rate Volatility,” Journal of Banking and Finance, 5, 497–510. Van den Heuvel, S. J. (2018). “The Welfare Effects of Bank Liquidity and Capital Require­ ments,” Working Paper. Von Thadden, E.-L. (2004). “Bank Capital Adequacy Regulation Under the New Basel Ac­ cord,” Journal of Financial Intermediation, 13, 90–95. Wall Street Journal (2018). “A Vote to Upend Banking As We Know It,” by Brian Black­ stone, June 1.

Notes: (1) Some view the fact that the bank gives depositors access to instant interim liquidity through a demand deposit contract in these models as an aspect of liquidity creation. However, depositors in these models have liquidity anyway, even without a bank—this is the money they have in their pockets that they could keep to meet a future liquidity need even without depositing it in a bank. This liquidity is invested in a bank deposit account because it provides better consumption smoothing than without a bank. So it is not mere­ ly giving the depositor access to instant liquidity through the deposit account that creates Page 49 of 58

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Creation and Regulation of Bank Liquidity liquidity per se. Rather, it is that the deposit contract provides better risk sharing while giving the depositor access to a liquid claim that is viewed as liquidity creation in these models. (2) Requiring banks to hold more liquid assets, however, reduces the amount of liquidity banks create (e.g., Berger and Bouwman, 2009) and may be wasteful. Thakor (2018) points out that JPMorgan Chase invested 38 percent of its deposits ($524 billion/$1.38 trillion) in liquid securities, and this liquidity hoarding was in part due to Basel III liquidi­ ty requirements and stress test results. If it had held only 10 percent in liquid securities and had lent the remainder to corporations, it would have created $772 billion more in liquidity. (3) There are alternative theories as to why banks fund with so much short-term debt. Some argue that short-term debt has a disciplining role in that the threat of non-renewal of funding makes bank managers behave (Calomiris and Kahn, 1991; Dewatripont and Ti­ role, 1994; Diamond and Rajan, 2001). Others argue it may be the outcome of a maturity rat race (Brunnermeier and Oehmke, 2013) or debt overhang problem (Admati et al., 2018). (4) In practice, it also exposes banks to credit risk and interest rate risk (both are absent in Diamond and Dybvig, 1983) related to maturity transformation. Hellwig (1994) discuss­ es the relation between both in a model of maturity transformation. (5) In Diamond and Dybvig (1983), a bank run is a “sunspot” phenomenon caused by a co­ ordination failure among depositors, not attributable to any specific economic trigger in the real economy. Chari and Jagannathan (1988) show that a bank run can arise as a unique equilibrium that is triggered by adverse fundamental information. Gorton’s (1988) evidence indicates that bank runs are preceded by declining fundamentals and stresses in the real sector, and thus do not appear to be caused by sunspots. It is thus more consis­ tent with Chari and Jagannathan (1988). The recent evidence of Perignon, Thesmar, and Vuillemey (2018) suggests that the subprime lending crisis was one in which European banks did not suffer a liquidity shortage due to coordination failures. Rather, it was linked to bank solvency—banks with better assets and higher capital were able to obtain more liquidity at the expense of banks with worse assets and lower capital. (6) Diamond and Dybvig (1983) take the sequential servicing constraint (SSC: first-come, first-served rule) as a given. Calomiris and Kahn (1991) provide an endogenous rationale. They show that demandable debt disciplines the manager because depositors can vote with their feet, and that the SSC gives depositors an incentive to monitor (avoids free-rid­ ing). Jacklin (1987, 1993) shows that the allocation achieved by the deposit contract in Di­ amond and Dybvig (1983) can be replicated by traded dividend-paying equity, so bank runs can be avoided this way, without relying on deposit insurance. (7) Kane, Laeven, and Demirgüç-Kunt (2008) examine deposit insurance in 170 countries from 1960–2003. They document that explicit deposit insurance schemes were not avail­ able in most countries before 1960. The number of countries with such schemes had Page 50 of 58

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Creation and Regulation of Bank Liquidity grown to forty-five by the beginning of 1995 and to eighty-seven by year-end 2003. They argue that countries that do not have explicit schemes typically have some form of implic­ it deposit insurance. (8) In the UK, the analogous rate is LIBOR, the London InterBank Offered Rate. (9) Allen, Peristiani, and Saunders (1989) show that small banks tend to act as lenders while large banks tend to act as borrowers in this market. They argue this may be be­ cause small banks: prefer to use deposits to fund their activities; can attract deposits more cheaply due to local monopoly power; and face greater information asymmetries which makes fed funds more expensive for them than for large banks. (10) In the words of the Chairman of the Federal Reserve, Bernanke (2008): “ … the effica­ cy of the discount window has been limited by the reluctance of depository institutions to use the window as a source of funding. The “stigma” associated with the discount win­ dow, which if anything intensifies during periods of crisis, arises primarily from banks’ concerns that market participants will draw adverse inferences about their financial con­ dition if their borrowing from the Federal Reserve were to become known.” Ennis and Weinberg (forthcoming) provide a theoretical model on the origin and implications of stig­ ma. Furfine (2001) provides some empirical evidence on stigma by examining data on a special Y2K Federal Reserve liquidity facility. In an attempt to quantify the costs associat­ ed with stigma using data from the recent subprime lending crisis, Armantier et al. (2015) show that banks were on average willing to pay a 37-basis-point premium over a similar funding source (term auction facility) during the height of the crisis. (11) Information on who obtains funds from the central bank is generally not available. However, data on access during the recent subprime lending crisis were recently made available. Berger et al. (2017) examine which kinds of banks obtained such funds from the Federal Reserve. Drechsler et al. (2016) instead focus on banks that used funds from the European Central Bank. (12) Sometimes the Diamond and Dybvig (1983) model is characterized as a model of ma­ turity transformation, since long-maturity projects are financed with demandable (shorter maturity) deposits. However, this seems to be incorrect because the loans in the model are also demandable—the bank can demand repayment at the interim date when deposits are withdrawn. That is, it is more appropriately viewed as a model of demandable loans financed with demandable deposits. (13) The Donaldson, Piacentino, and Thakor (2018) model does not have asymmetric infor­ mation, so the bank is not learning anything from deposit flows. But the natural and en­ dogenous synergy between deposits and lending in their model is consistent with the idea that there are multiple ways in which deposits and loans in a bank are intimately linked. This perspective points out that proposals, such as Gorton’s (1988), that deposit-taking and lending can be separated by having mutual funds replace deposits and having fi­ nance companies make loans, necessarily imply a loss in economic efficiency.

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Creation and Regulation of Bank Liquidity (14) Thakor, Hong, and Greenbaum (1981) and Thakor (1982) pioneered theories on bank loan commitments. (15) As evidence, they report that loan commitments and transaction deposits are positive­ ly correlated across banks. Gatev, Schuermann, and Strahan (2009) test whether this leads to a diversification benefit and find it does: bank risk (stock return volatility) in­ creases in unused commitments except for banks with high deposit levels. Building on this, Gatev, Schuermann, and Strahan (2006) argue that transaction deposits and loan commitments may be negatively correlated during crises since banks enjoy deposit in­ flows and greater demand for loan commitments during such times. Such inflows occur because banks are viewed as a safe haven given explicit government guarantees, access to the discount window and other emergency liquidity facilities, and additional support for too-big-to-fail banks (e.g., O’Hara and Shaw, 1990). (16) See also Leland and Pyle (1977), Millon and Thakor (1985), and Allen (1990). Coval and Thakor (2005) provide a theory of financial intermediation as a “beliefs bridge” be­ tween optimists and pessimists in which screening by the bank plays a role in the service the bank provides as an intermediary; higher bank capital leads to more screening. (17) Other explanations for the existence of loan commitments include: they provide a mechanism for optimal risk sharing (Campbell, 1978; Ho and Saunders, 1983), and they ameliorate informational frictions between the borrower and the bank (Berkovitch and Greenbaum, 1991; Boot, Thakor, and Udell, 1991). (18) Quarterly data on liquidity created by virtually every bank in the US from 1984:Q1 until “now” are available for research purposes on my website (updated regularly). (19) This assumes that the return earned exceeds the costs associated with posting eligi­ ble collateral and the possible stigma associated with borrowing from the discount win­ dow mentioned above. (20) Merton and Thakor (forthcoming) point out another cost of removing deposit insur­ ance: it exposes the bank’s depositors to bank-specific credit risk, which is socially ineffi­ cient. (21) They also had to deposit 111 percent of (the lesser of) the face or market value of these notes in US government bonds with the US Treasury. In 1900, this was reduced to 100 percent. (22) Calomiris and Mason (2008) argue that this created economies of scope between note issuance and deposit-taking because banks that issued notes had lower marginal costs of maintaining reserves associated with deposit-taking. (23) The Financial Services Regulatory Relief Act (FSRRA) of 2006 authorized the Federal Reserve to pay interest on balances held by, or on behalf of, depository institutions start­ ing October 1, 2011. Section 128 of the Emergency Economic Stabilization Act (EESA) of 2008 moved the effective date forward to October 1, 2008. While the interest rate on re­ Page 52 of 58

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Creation and Regulation of Bank Liquidity quired reserves is intended to get rid of the implicit tax that reserve requirements used to impose on depository institutions, the interest rate on excess reserves gives the Federal Reserve an extra monetary policy tool. The Federal Reserve initially set the interest rate on required (excess) reserves at 10 (75) basis points below the average target fed funds rate over the reserve maintenance period. From December 18, 2008 onward, it has in­ stead paid a fixed rate on both required and excess reserves. Through December 16, 2015, it paid a fixed rate of 25 basis points on both. Since then, both rates have steadily increased to: 0.50 percent on December 17, 2015; 0.75 percent December 15, 2016; 1.00 percent on March 16, 2017; 1.25 percent on June 15, 2017; 1.50 percent on December 14, 2017; 1.75 percent on March 22, 2018; and 1.95 percent on June 14, 2018. (24) To curb this, excess reserves may have to be subject to a maximum (Dasgupta, 2009) or taxed (Sumner, 2009). (25) Higher capital requirements may increase portfolio risk in certain circumstances (Koehn and Santomero, 1980; Kim and Santomero, 1988; Genotte and Pyle, 1991; Be­ sanko and Kanatas, 1996). Mailath and Mester (1994) examine the regulator’s incentive to close banks and how that affects its ability to influence the riskiness of banks’ asset portfolios. (26) They had to meet interim minimum standards of 3.625 percent (tier 1 capital) and 7.25 percent (total capital) by year-end 1990. (27) Credit ratings have their limitations because they are coarse indicators of default risk (e.g., Goel and Thakor, 2015). (28) The standardized approach groups exposures into several risk categories (as Basel I does), but the risk weights for loans to corporates, sovereigns, and banks depend on ex­ ternal credit ratings assigned to the borrower instead of being fixed. The F-IRB approach allows banks to use their own models to estimate probability of default (PD), while relying on the supervisor to provide estimates of loss given default (LGD), exposure at default (EAD), and maturity (M). The A-IRB approach allows banks with the most advanced risk management and modeling skills to provide all the estimates (PD, LGD, EAD, and M) needed to determine their capital requirement. (29) Benink and Benston (2005) provide a more detailed discussion on changes in EU banking regulation. (30) Using unique data on small business borrowers, Mester, Nakamura, and Renault (2007) show that transaction accounts provide banks with ongoing information regarding borrowers’ activities, thereby facilitating bank monitoring. (31) The benefits of relationships seem stronger during or after bad times (e.g., Bolton et al., 2016; Beck et al., 2018). (32) In contrast to the short-run effect, Billett, Flannery, and Garfinkel (2006) find signifi­ cant long-run underperformance after firms have obtained bank loans. Page 53 of 58

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Creation and Regulation of Bank Liquidity (33) In contrast to evidence provided by Drucker and Puri (2005), Calomiris and Pornroj­ nangkool (2009) show that banks may charge higher prices when combining lending and underwriting. (34) Song and Thakor (2007) show theoretically how this influences the bank’s choice of funding mix between core deposits and purchased money. Berlin and Mester (1999) pro­ vide empirical evidence that banks with greater reliance on core deposits give their bor­ rowers better insurance against negative shocks to their creditworthiness. Consistent with this, Ivashina and Scharfstein (2010) and Cornett et al. (2011) show that banks that relied more on (stable) deposits, cut their lending less during the subprime lending crisis. (35) The bank may also purchase some of these ABS and use them as collateral to obtain repo funding from institutional investors like money-market mutual funds. (36) Gorton and Haubrich (1990) argue that this is a natural way in which a market devel­ ops: initially, easy-to-value assets are sold; later, increasingly complex and risky contracts are made. Loutskina (2011) points at another dark side—securitization makes banks more susceptible to funding shocks when the securitization market is disrupted. (37) These problems may be more severe when the economy is doing well: Thakor (2005) and Dell’Ariccia and Marquez (2006) show that lending standards decline during econom­ ic booms. Hellwig (1994) focuses on the incentive effects of securitization and argues that it should be structured such that the bank retains asset-specific return risks to ensure proper screening and monitoring of clients, that is, the securitizing bank needs the right kind of “skin in the game.” (38) The term “shadow banking” is attributed to money manager Paul McCulley (2007). (39) The Financial Stability Board (FSB, 2012a) describes the shadow-banking system more broadly as “credit intermediation involving entities and activities (fully or partially) outside the regular banking system” or non-bank credit intermediation. (40) Calomiris, Himmelberg, and Wachtel (1995) discuss how growth of the CP market was driven by growth of finance companies, and how it fuelled disintermediation by pro­ viding high-quality firms with a low-cost alternative to short-term debt. (41) Banks typically continue to bear some risk—they often provide guarantees and keep (part of) the lowest-rated tranche. (42) They focus on the bilateral (i.e., interdealer) repo market and interpret an increase in margin requirements (“haircuts”) as a run. Copeland, Martin, and Walker (2014) find that no such run seemed to have taken place in the tri-party repo market, which may have ac­ counted for 50 to 60 percent of all outstanding repo in the US. Krishnamurthy, Nagel, and Orlov (2014) find similar results and argue that Gorton and Metrick’s (2012) “run on re­ po” is not the equivalent of a traditional bank run by depositors—to establish that, one should not analyze inter-dealer data but rather examine whether investors run on deal­ ers. Martin, Skeie, and Von Thadden (2014a) show that increasing margin requirements Page 54 of 58

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Creation and Regulation of Bank Liquidity can be stabilizing: while it results in some loss of funding, it is better than losing all fund­ ing, as seemed to have happened with Lehman. (43) Martin, Skeie, and Von Thadden (2014b) show under what conditions short-term funding markets such as the repo market are immune to expectation-driven runs and dis­ cuss the scope of regulation to stabilize such markets. (44) The externalities include excessive risk-taking and excessive leverage, which increase the risk of crises, which adversely affect other banks and the real economy. (45) A bank-specific CCyB is calculated as the weighted average of the CCyB rates in the jurisdictions where the bank’s relevant credit exposures are located. Countries may im­ plement a rate exceeding 2.5 percent for banks in their jurisdiction, and more than half of the EU and other advanced economies indicate they are willing to exceed this level (BIS, 2017). However, other countries do not have to apply buffers above 2.5 percent when im­ plementing reciprocity. (46) Following the financial crisis, regulators realized the limitations of using only capital requirements, which are essentially backward looking in the sense that they depend on the risks of assets already on the bank’s books and not on the risks to which banks could be exposed under future economic stress scenarios. In many countries, large banks now have to be stress tested. Each stress test subjects a bank to hypothetical unfavorable eco­ nomic scenarios (e.g., deep recession) to determine whether it has enough capital to with­ stand their impact. These stress tests are forward looking. The European Central Bank’s stress tests cover approximately 70 percent of the banks across the Eurozone. The US ini­ tially only stress-tested the very largest banks. It then imposed on banks with assets be­ tween $10 billion and $50 billion one stress test a year; and on banks with assets above $50 billion two stress tests a year (one run by the Federal Reserve and one run by the bank itself as mandated by the Dodd–Frank Act). In 2018, the Dodd–Frank Act Stress Test requirement was eliminated for banks with assets less than $250 billion. (47) As discussed above, US banks had already been subject to a minimum leverage ratio (based on tier 1 capital relative to on-balance-sheet assets) since the early 1980s. (48) G-SIBs are banks whose distress or disorderly failure would significantly disrupt the wider financial system and economic activity (BIS, 2018). G-SIBs have been identified every year in November (from 2011 onward) based on five equally important characteris­ tics: bank size, complexity, interconnectedness, lack of substitutability, and cross-jurisdic­ tional activity. (49) See footnotes 27 and 29 in Federal Reserve (2018b) for further details on these num­ bers. (50) The Systemic Risk Council, chaired by former FDIC Chairman Sheila Bair, proposes a minimum leverage ratio of 8 percent (2012). Admati and Hellwig (2013) propose it should be 20 to 30 percent. Passmore and Von Haften (2017) estimate that G-SIB surcharges should be 375–525 basis points higher, and that some very large and systemically impor­ Page 55 of 58

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Creation and Regulation of Bank Liquidity tant banks that are currently not subject to these charges should be subjected to a 225 basis point surcharge. (51) For an earlier discussion on this, see Berger, Herring, and Szego (1995). (52) Klimenko et al. (2016) focus on aggregate bank capital and show that minimum capi­ tal requirements reduce excessive lending. (53) Several recent papers examine how capital injections by the government affect bank lending in the US (e.g., Black and Hazelwood, 2013; Li, 2013; Duchin and Sosyura, 2014) or liquidity creation in Germany (Berger et al., 2016). (54) Loan rates may also be affected. Specifically, if higher capital requirements cause banks to operate with more capital, then two effects may be generated. First, the replace­ ment of tax-advantaged debt with equity may increase the bank’s weighted average cost of capital, putting upward pressure on loan rates. Second, higher capital will reduce the bank’s debt funding cost (due to the cushioning effect of capital and also its incentive ef­ fects), and this reduction may be large enough to increase the bank’s return on equity, so that higher capital in the bank may exert downward pressure on loan rates. The overall effect of bank capital on loan rates may thus turn out to be small. Simulations by Hanson, Kashyap, and Stein (2011) support this notion—depending on the chosen scenario, a 10 percentage point increase in the capital ratio would cause loan rates to increase by a mere 25 to 45 basis points. Cross-country studies on the relationship between capital (not capital requirements) and loan rates tend to find evidence consistent with this (e.g., Demirgüç-Kunt and Huizinga, 1999; Saunders and Schumacher, 2000). (55) The BIS first published the LCR in December 2010 (BIS, 2010) and issued the full text of a revised LCR in January of 2013 (BIS, 2013b). The LCR was phased in gradually from January 1, 2015, with a minimum requirement starting at 60 percent, increasing in 10 percent annual increments to 100 percent on January 1, 2019. (56) The BIS issued its final standard for the NSFR on October 31, 2014 (BIS, 2014). (57) A 100 percent ASF factor is assigned to capital instruments with residual maturities exceeding one year, and to borrowings and liabilities (including term deposits) with resid­ ual maturities exceeding one year. ASF factors of 95 percent and 90 percent are given to stable, non-maturity (demand) deposits and/or term retail and small business deposits with residual maturities less than one year. A 50 percent ASF factor is assigned to, for ex­ ample, operational deposits and funding with a residual maturity of less than one year provided by non-financial corporate customers, sovereigns, public sector entities, and multilateral and national development banks. A 0 percent ASF factor is assigned to, for example, other liabilities without a stated maturity. (58) Cash and central bank reserves receive a weight of 0 percent. Unencumbered Level 1 assets (except those receiving a 0 percent RSF) are weighted at 5 percent. Unencum­ bered loans to financial institutions with remaining maturities up to six months are weighted at 10 percent or 15 percent; the latter weight is also assigned to unencumbered Page 56 of 58

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Creation and Regulation of Bank Liquidity Level 2A assets. A 50 percent RSF factor is assigned to unencumbered Level 2B assets, HQLA that are unencumbered for six to twelve months, loans to financial institutions and central banks with residual maturity of six to twelve months, operational deposits, and non-HQLA with a remaining maturity up to one year. A 65 percent RSF factor is for unen­ cumbered residential mortgages and other unencumbered loans not included above with a remaining maturity of at least one year that would receive a 35 percent or lower risk weight under the Basel II standardized approach. An 85 percent RSF factor is for cash/se­ curities posted as initial margin for derivatives; unencumbered not-in-default securities that do not qualify as HQLA with a remaining maturity of at least one year; exchangetraded equities; and physical traded commodities. A 100 percent RSF factor is for all as­ sets that are encumbered for at least one year, and all other assets not included above (e.g., non-performing loans, loans to financial institutions with a remaining maturity of at least one year, non-exchange traded equities, fixed assets, subsidiary interests, and de­ faulted securities). (59) The 2014 rule did not treat securities issued by public sector entities below the na­ tional level as HQLA. The Federal Reserve changed its rule in 2016, permitting a limited amount of municipal obligations to be included in Level 2B HQLA. An interim final rule is­ sued by the Board, the OCC, and FDIC in August 2018 allows municipal obligations that are investment grade, liquid, and readily marketable to be treated as Level 2B HQLA (Federal Reserve, 2018c). (60) Barroso, Gonzalez, and Nazar Van Doornik (2017) show that higher reserve require­ ments in Brazil reduced the credit supply by its banks. The ClearingHouse expects that the NSFR will be a binding constraint for banks and can hence impose substantial costs on the economy because it may reduce lending (Covas and Nelson, 2016). (61) In contrast, Van den Heuvel (2018) argues that they are not substitutes. His model shows that it is socially optimal for liquidity requirements to deal with liquidity risk and for capital requirements to reduce credit risk. (62) CAMELS stands for capital adequacy, asset quality, management, earnings, liquidity, and sensitivity to market risk. (63) See Calomiris, Flandreau, and Laeven (2016) for a global historical perspective on the evolution of the LOLR; and Garcia-de-Andoain et al. (2016) for an examination of the impact of liquidity provision by the European Central Bank in its role as LOLR from 2008– 2014.

Christa H. S. Bouwman

Christa H. S. Bouwman is Associate Professor of Finance and Patricia & Bookman Pe­ ters Professor of Finance at Mays Business School at Texas A&M University; and Fel­ low of the Wharton Financial Institutions Center at the University of Pennsylvania. She was Associate Professor of Banking & Finance at Case Western Reserve Univer­ sity where she also held the Lewis-Progressive Chair; Visiting Assistant Professor of Page 57 of 58

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Creation and Regulation of Bank Liquidity Finance at MIT’s Sloan School of Management; Research Associate at the Federal Reserve Bank of Cleveland; and Visiting Scholar at the Federal Reserve Bank of Boston and the Federal Reserve Board in Washington DC. Her research interests are in Financial Intermediation and Corporate Finance. She is Co-Editor-in-Chief of the Journal of Financial Intermediation. She is Associate Editor of the Journal of Banking & Finance; and former Associate Editor of the Journal of Financial Intermediation, the Review of Finance, and Corporate Governance: An International Review. Her re­ search papers have been published in the American Economic Review, Journal of Fi­ nancial Economics, Review of Financial Studies, Journal of Financial Intermediation, Journal of Financial Stability, Journal of Banking & Finance, and MIT/Sloan Manage­ ment Review. She is a co-author of the book “Bank Liquidity Creation and Financial Crises” (Elsevier, 2015). She worked for five years at ABN AMRO Bank (in Venture Capital, Project Finance Advisory, and Capital Structure Advisory), and as a part-time litigation consultant for the US Department of Justice. She received a Ph.D in Fi­ nance from the University of Michigan, an M.B.A. from Cornell University, and a B.A./ M.A. in Economics and Business (cum laude) from the University of Groningen, the Netherlands.

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The Performance of Financial Institutions Modeling, Evidence, and some Policy Implications

The Performance of Financial Institutions Modeling, Evidence, and some Policy Implications   Joseph P. Hughes and Loretta J. Mester The Oxford Handbook of Banking (3rd edn) Edited by Allen N. Berger, Philip Molyneux, and John O. S. Wilson Print Publication Date: Oct 2019 Subject: Economics and Finance, Financial Economics Online Publication Date: Nov 2019 DOI: 10.1093/oxfordhb/9780198824633.013.9

Abstract and Keywords The unique capital structure of commercial banking—funding production with demand­ able debt that participates in the economy’s payments system—affects various aspects of banking. It shapes commercial banks’ comparative advantage in providing financial prod­ ucts and services to informationally opaque customers, their ability to diversify credit and liquidity risk, and how they are regulated, including the need to obtain a charter to oper­ ate, and explicit and implicit federal guarantees of bank liabilities to reduce the probabili­ ty of bank runs. These aspects of banking affect a bank’s choice of risk versus expected return, which, in turn, affects bank performance. Banks have an incentive to reduce risk to protect their valuable charters in periods of financial distress but also an incentive to increase risk to exploit the cost-of-funds subsidy of mispriced deposit insurance. The bal­ ance of these contrasting incentives is tied to bank size. Measuring bank performance and its relationship to size requires untangling cost and profit from decisions about risk. This chapter gives an overview of two general empirical approaches to measuring bank performance and discusses some of the applications of these approaches found in the lit­ erature. One application explains how better diversification available at a larger scale of operations generates scale economies that are obscured by higher levels of risk-taking. Studies of commercial banking cost that ignore endogenous risk-taking find little evi­ dence of scale economies at the largest banks, while those that control for this risk-taking find large-scale economies at the largest banks—evidence with important implications for regulation. Keywords: bank, cost, efficiency, profit, risk, scale economies, X-inefficiency

8.1 Introduction THE commercial banking industry is undergoing disruption from other types of financial intermediaries. To understand the future evolution of the industry in the wake of such dis­ ruption, it is important to take a step back and ask: What do commercial banks do? What Page 1 of 36

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The Performance of Financial Institutions Modeling, Evidence, and some Policy Implications are the key components of commercial banking technology that allow them to do it? And what determines whether banks do it efficiently? Banks’ ability to ameliorate informational asymmetries between borrowers and lenders and to manage risks is the essence of bank production. The literature on financial inter­ mediation suggests that commercial banks, by screening and monitoring borrowers, can help solve potential moral hazard and adverse selection problems caused by the imper­ fect information between borrowers and lenders. Commercial banks are unique in issuing demandable debt that participates in the economy’s payments system. This debt confers an informational advantage to banks over other lenders in making loans to informational­ ly opaque borrowers. In particular, the information obtained from checking account trans­ actions and other sources allows banks to assess and manage risk, write contracts, moni­ tor contractual performance, and, when required, resolve non-performance problems. Bhattacharya and Thakor (1993) review the modern theory of financial intermediation, which takes an informational approach to banking. That commercial banks’ liabilities are demandable debt also gives banks an incen­ tive advantage over other intermediaries. The relatively high level of debt in a bank’s cap­ ital structure disciplines managers’ risk-taking and their diligence in producing financial (p. 230)

services by exposing the bank to an increased risk of insolvency. The demandable feature of the debt, to the extent that it is not fully insured, further heightens performance pres­ sure and safety concerns by increasing liquidity risk. These incentives tend to make banks good monitors of their borrowers. Thus, banks’ unique funding by demandable debt that participates in the economy’s payments system gives banks both an incentive advantage and an informational advantage in lending to firms too informationally opaque to borrow in public debt and equity markets. The uniqueness of commercial bank produc­ tion, in contrast to the production of other types of lenders, is derived from the special characteristics of banks’ capital structure: the funding of informationally opaque assets with demand deposits.1 Calomiris and Kahn (1991) and Flannery (1994) discuss the opti­ mal capital structure of commercial banks. But banks’ ability to perform efficiently—to adopt appropriate investment strategies, to obtain accurate information concerning their customers’ financial prospects, and to write and enforce effective contracts—depends in part on the property rights and legal, regula­ tory, and contracting environments in which they operate. Such an environment includes accounting practices, chartering rules, government regulations, and the market condi­ tions (e.g., market power) under which banks operate. Differences in these features across political jurisdictions can lead to differences in the efficiency of banks across juris­ dictions.2 Banks’ unique funding by demand deposits motivates key components of the legal and regulatory environments that influence managerial incentives for risk-taking and efficien­ cy. Banks’ participation in the payments system leads to their regulation and, in particu­ lar, to restrictions on entry into the industry. The need to obtain a charter to open a bank confers a degree of market power on banks operating in smaller markets and, in general, Page 2 of 36

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The Performance of Financial Institutions Modeling, Evidence, and some Policy Implications permits banks to exploit valuable investment opportunities related to financial intermedi­ ation and payments. Government regulation and supervision of banks promotes their safety and soundness in order to protect the payments system from bank runs that re­ duce bank lending and threaten macroeconomic stability. Protecting the payments system frequently involves deposit insurance. To the extent that the insurance (p. 231) is credible, it reduces depositors’ incentive to run banks when they have fears about banks’ solvency. Consequently, it reduces banks’ liquidity risk and, to the extent it is underpriced, gives banks the incentive to take additional risk for higher expected return. Moreover, if unin­ sured creditors also believe they will be protected from losses because government regu­ lators will treat the bank as too big to fail, the risk-taking incentive is heightened further.

8.2 Banking Technology and Performance 8.2.1 Banks’ Risk Menu and Conflicting Incentives for Risk-Taking Mispriced deposit insurance and too-big-to-fail policies can create a cost-of-funds subsidy that gives banks an incentive to take additional risk.3 But banks also have an incentive to avoid risk to protect their valuable charters from episodes of financial distress. Distress involves liquidity crises resulting from runs by uninsured depositors, regulatory interven­ tion in banks’ investment decisions, and even the loss of the charter when distress results in insolvency. As discussed in Hughes and Mester (2013b), Marcus (1984) finds that banks with high-valued investment opportunities maximize their expected market value by pursuing lower-risk investment strategies that protect their charters and thereby pre­ serve their ability to exploit these opportunities. On the other hand, banks with low-val­ ued investment opportunities maximize their expected value by adopting higher-risk in­ vestment strategies that exploit the cost-of-funds subsidy of mispriced deposit insurance (Keeley, 1990). Mid-range risk strategies do not maximize value. These dichotomous in­ vestment strategies, as well as other sources of risk-taking and risk-avoidance, fundamen­ tally shape production decisions and must be taken into account when modeling bank production. Herring and Vankudre (1987) offer a similar analysis of these dichotomous in­ vestment strategies. Hughes, Mester, and Moon (2016) provide evidence of these dichoto­ mous value-maximizing strategies in banks’ capitalization, and Hughes and Moon (2018) find similar evidence in credit risk strategies. The risk environment banks face can be characterized by a frontier of expected return and return risk, which shows a bank’s menu of efficient investment choices.4 (p. 232) In Figure 8.1, from Hughes and Mester (2013b), a smaller bank’s menu of investment choic­ es is given by the lower frontier. Consider a smaller bank that operates at point A.5 To il­ lustrate scale-related diversification, suppose a larger bank is created by scaling up the assets of this smaller bank. In principle, the larger bank can obtain better diversification of its assets, which reduces credit risk, and better diversification of its deposits, which re­ duces liquidity risk. Thus, the larger bank can efficiently produce the expected return of the smaller bank (point A) with less return risk (point A´). In fact, the larger bank will likely take advantage of its better diversification and produce a different (and perhaps Page 3 of 36

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The Performance of Financial Institutions Modeling, Evidence, and some Policy Implications more complicated) mix of financial services. Nonetheless, the risk-expected-return fron­ tier of the larger bank lies above that of the smaller bank because the larger bank has a better menu of investment choices resulting from improved diversification.

Figure 8.1 Scale-Related Diversification and Risk-Re­ turn Frontiers. Source: Hughes and Mester (2013b).

Textbooks point to better diversification, which reduces the costs of risk management, as a key source of scale economies. The link between better diversification and scale economies is apparent when comparing a larger bank operating at point A´ with one op­ erating at point B. A larger bank operating at point A´ has the same expected return but lower risk than the smaller bank operating at point A, while a larger bank at point B oper­ ates with the same return risk as the smaller bank but obtains a higher expected return. At point B, the better diversification of deposits allows the larger bank to economize on liquid assets without increasing liquidity risk, while the better diversification of loans (p. 233) allows it to economize on equity capital without increasing insolvency risk. Thus, its expected return for the same risk as the smaller bank is higher. Better diversification, though, does not necessarily mean that the larger bank operates with less risk; rather, it means the larger bank experiences a better risk-expected-return frontier. Heightened competition and lower-valued growth opportunities in the larger bank’s markets, or lower marginal costs of risk management, might induce the larger bank to choose to produce its output with more risk in order to obtain a higher expected return—say, the strategy at point C or point D. A bank’s risk-taking is also influenced by external and internal mechanisms that disci­ pline bank managers. Internal discipline might be induced or reduced by organizational form, ownership and capital structure, governing boards, and managerial compensation. External discipline might be induced or reduced by government regulation and the safety net, capital market discipline (takeovers, cost of funds, stakeholders’ ability to sell stock), managerial labor market competition, outside blockholders of equity and debt, and prod­ uct market competition.6 This operating environment can also create agency conflicts that influence managers’ incentives to pursue value-maximizing risk strategies. Managers Page 4 of 36

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The Performance of Financial Institutions Modeling, Evidence, and some Policy Implications whose wealth consists largely of their undiversified human capital tend to avoid riskier in­ vestment strategies that maximize the value of banks with poorer investment opportuni­ ties. However, the presence of a diversified outside owner of a large block of stock might encourage the board of directors to put in place a compensation plan that overcomes managers’ risk aversion and encourages value-maximizing risk-taking (Laeven and Levine, 2009; Cheng, Hong, and Scheinkman, 2015). Thus, in order to measure the efficiency of bank production, it is important to account for bank risk-taking and the optimality of this risk-taking.

8.2.2 The Empirical Measurement of Banking Technology and Perfor­ mance There are two broad approaches to measuring technology and explaining performance: non-structural and structural. Using a variety of financial measures that capture various aspects of performance, the non-structural approach compares performance among banks and considers the relationship of performance to investment strategies and other factors such as characteristics of regulation and governance. For example, the non-struc­ tural approach might investigate technology by asking how performance measures (p. 234) are correlated with such investment strategies as growing by asset acquisitions and diversifying or focusing the bank’s product mix. It looks for evidence of agency prob­ lems in correlations of performance measures and variables characterizing the quality of banks’ governance. While informal and formal theories may motivate some of these inves­ tigations, no general theory of performance provides a unifying framework for these stud­ ies. The structural approach is choice-theoretic and, as such, relies on a theoretical model of the banking firm and a concept of optimization. The older literature applies the tradition­ al microeconomic theory of production to banking firms in much the same way as it is ap­ plied to non-financial firms and industries. The newer literature views the bank as a finan­ cial intermediary that produces informationally intensive financial services and takes on and diversifies risks—unique, essential aspects of financial intermediation that are not generally taken into account in traditional applications of production theory.7 For exam­ ple, the traditional theory defines a cost function by a unique cost-minimizing combina­ tion of inputs for any given level of outputs. Thus, the cost function gives the minimum cost of any given output vector without regard to the return risk implied by the cost-mini­ mizing input vector. Ignoring the implied return risk may be appropriate for non-financial firms, but for financial institutions, return risk plays an essential role in maximizing the discounted flow of expected profits. First, return risk influences the rate at which future expected profits are discounted. Second, return risk affects the expected cost of financial distress. The bank with high-valued investment opportunities may find the level of risk as­ sociated with the cost-minimizing vector too high. If so, it may choose to reduce the cred­ it risk of the given output vector by adding more labor and physical capital to improve its credit evaluation and loan monitoring capabilities. In doing so, it trades higher cost (low­ er profit) for lower profit risk to reduce the expected costs of financial distress and the Page 5 of 36

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The Performance of Financial Institutions Modeling, Evidence, and some Policy Implications discount rate on its expected cash flow, thus maximizing its market value. This trade-off suggests that measuring bank performance by a cost metric or a profit metric that fails to account for endogenous risk-taking is likely to be seriously biased. Notice in this example that risk influences the decision of how to produce a given output vector and, thus, must influence the cost of producing it. In Figure 8.1, when the risk-ex­ pected-return frontier for the larger bank is narrowly interpreted as showing different in­ vestment strategies for producing the same output vector—the scaled-up outputs of the smaller bank—it is clear that larger banks with higher-valued investment opportunities are likely to choose a lower risk-expected-return strategy, say, point B or (p. 235) A´, than banks with lower-valued opportunities, say, point C or D. Since the cost of producing the scaled-up output vector is likely to differ along the frontier, the value-maximizing input vector and, hence, the cost of the output, will be driven in part by risk considerations. And these risk considerations imply that revenue influences cost when risk matters. How, then, can managers’ preferences for these production plans and their implied risk be rep­ resented? Letting the output vector be represented by q, the input vector by x, and equity capital by k, the technology for producing a given output vector is represented by the transforma­ tion function T(x, k; q) ≤ 0. Points C and D in Figure 8.1 arise from different input vectors (x, k) that produce the given output q. Let z represent the production plan and price envi­ ronment. Managers’ beliefs about how production plans interact with a given state of the world, s, to yield profit, π, imply a realization of profit, π = g(z, s), that is conditioned on the state of the world. And managers’ beliefs about the probability distribution of states of the world imply a subjective distribution of profit that is conditional on the production plan: f(π; z). Under well-known restrictive conditions, this distribution can be represented by its first two moments, E(π; z) and S(π; z).8 The traditional literature on bank production and efficiency assumes that banks choose their production plan to minimize expected cost and maximize expected profit: Managers rank production plans by their expected profit and cost, the first moment of their subjec­ tive probability distribution of profit, f(π; z), attached to each production plan. The newer research assumes that bank managers maximize the utility of their production plans. Rather than define the utility function over the first two moments, the newer literature defines it over profit and the production plan, U(π; z), which is equivalent to defining it over the conditional probability distributions f(π; z). Utility maximization is a more gener­ al objective that subsumes profit maximization and cost minimization (e.g., Hughes, 1999; Hughes et al., 1999; Hughes et al., 2000; Hughes, Mester, and Moon, 2001; Hughes and Mester, 2013b). However, when higher moments of the profit distribution influence man­ agers’ preferences, managers may trade profit to achieve other objectives involving risk, say, value maximization. The model treats the choice of risk as endogenous. Note, though, that the other objectives might reflect agency problems: Managers might take on too little risk in order to protect their jobs, or they might consume private bene­ fits that reduce shareholder wealth. Thus, the utility-maximizing framework can explain Page 6 of 36

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The Performance of Financial Institutions Modeling, Evidence, and some Policy Implications inefficient as well as efficient production. When the output vector is held constant, the utility-maximizing cost of output can be derived from the utility-maximizing input de­ mands. This cost function accounts for the choice of whether to produce the particular output vector using a method that has lower risk and lower expected return or a method with higher risk and higher expected return (e.g., point B versus point C in Figure 8.1). This choice depends on differences in the value of investment opportunities. In this case, managers’ ranking of production plans captures the profit and profit-risk environment they face. How one gauges performance in structural models, then, depends on whether one views bank managers as ranking production plans by their first moments (i.e., minimum expected cost or maximum expected profit), or, more generally, by higher moments as well as the first moment, that is, considerations involving risk. In the latter case, one would want to gauge the tradeoffs between risk and expected return being made by banks where there is less of an agency problem between owners and managers—that is, banks with strong corporate controls (see Hughes, Mester, and Moon, 2001). In both the structural and non-structural approaches, the performance metric and the specification of the performance equation reflect implicitly or explicitly an underlying theory of manageri­ (p. 236)

al behavior. As a general specification of the structural and non-structural approaches, let yi represent the measure of the ith bank’s performance. Let zi be a vector of variables that capture key components of the ith bank’s technology (e.g., output levels and input prices) and let τi be a vector of variables affecting the technology (e.g., the ratio of non-performing to total loans). Jensen and Meckling (1979) add a vector, θi, of characteristics of the propertyrights system, contracting, and regulatory environment in which the ith firm operates (e.g., whether the country has a deposit insurance scheme and the degree of investor pro­ tection that exists) and a vector, ϕi, of characteristics of the organizational form and the governance and control environment of the ith firm (e.g., whether the bank is organized as a mutual or stock-owned firm, the degree of product market concentration, and the num­ ber of outside directors on its board). When the sample of banks used in the estimation includes financial institutions located in environments with different property rights and contracting environments or with different governance and control structures, estimating this model permits one to investigate how these differences are correlated with differ­ ences in bank performance. Allowing for random error, the performance equation to be estimated takes the form,

(1)

The specification of the vectors zi and τi differs between the structural and non-structural approaches.

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The Performance of Financial Institutions Modeling, Evidence, and some Policy Implications

8.2.3 The Structural Approach to Bank Efficiency Measurement: Cost Minimization, Profit Maximization, X-Inefficiency, and Managerial Utility Maximization The traditional structural approach usually relies on the economics of cost minimization or profit maximization, where the performance equation (1) denotes a cost function or a profit function. Occasionally, the structural performance equation denotes a production function. While estimating a production function might tell us if the firm is technically ef­ ficient, that is, if managers organize production such that the firm maximizes the amount (p. 237) of output produced with a given amount of inputs (so that the firm is operating on its production frontier), we are more interested in economic efficiency, that is, whether the firm is responding to relative prices in choosing its inputs and outputs to minimize cost and/or to maximize profit, which subsumes technical efficiency. Risk plays no explicit role in these performance functions, although some papers include one or more dimen­ sions of risk in the estimation as control variables. See Berger and Mester (1997, 2003) and Mester (2008) for further discussion. Including risk components as controls does not fully capture the tradeoff between risk and the expected return that banks face. While in­ cluding risk, for example, the variance of profit, in the cost function might control for the second moment of return, higher moments would not be taken into account, and these higher moments may be an important element in the bank’s production decision. So the standard cost function conditioned on risk is unlikely to capture important considerations in banking production and value maximization. In addition, as discussed below, the as­ sumptions of cost minimization and profit maximization underlying the standard structur­ al approach have been tested and rejected by some papers in the literature. See, for ex­ ample, Evanoff (1998), Evanoff, Israilevich, and Merris (1990), Hughes et al. (1996, 2000), Hughes, Mester, and Moon (2001), and Hughes and Mester (2013b). In the newer literature, the optimization problem is managerial utility maximization, where the manager ranks production plans not just by their first moment—expected prof­ it—but also by higher moments, such as skewness and kurtosis risk, as well as variance risk, that characterize profit risk. The utility-maximizing cost function is derived from the profit function, conditioned on the output vector. Thus, the cost function includes argu­ ments that characterize revenue. In Figure 8.1 the larger bank can produce its scaled-up output vector with a menu of production plans that differ by their expected profit and profit risk. The utility-maximizing cost function captures the plan that maximizes manage­ rial utility and, thus, reflects a risk-expected-return trade-off. To specify the utility-maximizing performance equation (1), Hughes et al. (1996, 1999, 2000) adapt the Almost Ideal Demand System to derive a utility-maximizing profit equa­ tion and its associated input demand equations. This profit function does not necessarily maximize profit, since it follows from managers’ assessment of risk and risk’s effect on asset value; it might also reflect managers’ concerns about their job security. Profit maxi­ mization (cost minimization) can be tested by noting that the standard translog profit (cost) function and share equations are nested within the model and can be recovered by imposing the parameter restrictions implied by profit maximization (cost minimization) on Page 8 of 36

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The Performance of Financial Institutions Modeling, Evidence, and some Policy Implications the coefficients of this adapted system. Hughes et al. (1996, 1999, 2000) and Hughes and Mester (2013b) test these restrictions in their applications and reject the hypothesis of profit maximization (and cost minimization). Both newer and traditional performance functions can differ by the definition of cost they use: Accounting (cash-flow) cost excludes the cost of equity capital, while economic cost includes it. The challenge of specifying economic cost is in estimating the cost of equity capital. McAllister and McManus (1993) arbitrarily pick the required return and assume it is uniform across banks. Clark (1996) and Fiordelisi (2007) use the Capital Asset Pric­ ing Model to estimate it. Fiordelisi (2007) describes the resulting profit function as (p. 238) “economic value added.” Alternatively, the quantity of equity capital can be substi­ tuted for its price. In these cases of restricted cost and profit functions, the expense of equity capital is excluded from the empirical measure of cost and profit. The traditional structural performance equation can be fitted to the data as an average relationship, which assumes that all banks are equally efficient at minimizing cost or max­ imizing profit, subject to random error, εi, which is assumed to be normally distributed. Alternatively, it can be estimated as a frontier to capture best observed practice and to gauge X-inefficiency, the difference between the best-observed-practice performance and achieved performance. The literature has used four basic methods for estimating the frontier: the stochastic frontier, the distribution-free approach, the thick frontier, and data envelopment analysis (DEA). Berger and Mester (1997) review the estimation methods and present evidence on scale economies, cost X-inefficiency, and profit X-inefficiency using the stochastic frontier and distribution-free methods.9 Mester (2008) reviews the concept, measurement, and empirical literature on X-efficiency and Dijkstra (2017) catalogs many of the studies. In the stochastic frontier method, the error term, εi, consists of two components: One is a two-sided random error that represents noise (νi), and the other is a one-sided error rep­ resenting inefficiency (μi). The stochastic frontier approach disentangles the inefficiency and random error components by making explicit assumptions about their distributions. The inefficiency component measures each bank’s extra cost or shortfall of profit relative to the frontier—the best-practice performance observed in the sample. Leibenstein (1966) called the type of inefficiency that can result from poor managerial incentives or the fail­ ure of the labor market to allocate managers efficiently and weed out incompetent man­ agers, X-inefficiency. Jensen and Meckling (1976) called such inefficiency agency costs and provided a theoretical model of managerial utility maximization to explain how, when incentives between managers and outside stakeholders are misaligned, managers may trade off the market value of their firm to enjoy more of their own private benefits, such as consuming perquisites, shirking, discriminating prejudicially, and taking too much or too little risk to enhance their control. Let yi denote either the cost or profit of firm i. The stochastic frontier gives the highest or lowest potential value of yi given zi, τi, ϕi, and θi, Page 9 of 36

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The Performance of Financial Institutions Modeling, Evidence, and some Policy Implications

(2)

where εi ≡ μi + νi is a composite error term comprising νi, which is normally distributed with zero mean, and μi, which is usually assumed to be half-normally distributed and neg­ ative when the frontier is fitted as an upper envelope in the case of a profit function and positive when the frontier is fitted as a lower envelope as in the case of a cost function. β are parameters of the deterministic kernel, F(zi, τi, ϕi, θi | β), of the stochastic (p. 239) frontier. The ith bank’s inefficiency is usually estimated by the mean of the conditional dis­ tribution of μi given εi,, i.e., E(μi|εi,). The difference between best-observed-practice and achieved performance gauges managerial inefficiency in terms of either excessive cost— cost inefficiency—or lost profit—profit inefficiency. Expressing the shortfall and excess as ratios of their frontier (best observed practice) values yields profit and cost inefficiency ratios. While the fitted stochastic frontier identifies best-observed-practice performance of the banks in the sample, it cannot explain the behavior of inefficient banks. A number of papers have surveyed investigations of bank performance using these concepts: for ex­ ample, Berger and Humphrey (1997), Berger and Mester (1997), and Berger (2007). A re­ cent comprehensive survey and classification of these models is found in Dijkstra (2017).10 As discussed in Hughes et al. (2000) and Mester (2008), since inefficiency is derived from the regression residual, selection of the characteristics of the banks and the environmen­ tal variables to include in the frontier estimation is particularly important. These vari­ ables define the peer group that determines best-practice performance against which a particular bank’s performance is judged. If something extraneous to the production process is included in the specification, this might lead to too narrow a peer group and an overstatement of a bank’s level of efficiency. Moreover, the variables included determine which type of inefficiency gets penalized. If bank location, for example, urban versus rur­ al, is included in the frontier, then an urban bank’s performance would be judged against other urban banks but not against rural banks, and a rural bank’s performance would be judged against other rural banks. If it turned out that rural banks are more efficient than urban banks, all else equal, the inefficient choice of location would not be penalized. An alternative to including the variable in the frontier regression is to measure efficiency based on a frontier in which it is omitted and then see how it correlates with efficiency. Several papers have looked at the correlations of efficiency measures and exogenous fac­ tors, including Mester (1993, 1996, 1997), and Berger and Mester (1997). Mester (1997) shows that estimates of bank cost efficiency can be biased if bank heterogeneity is ig­ nored. See also Bos et al. (2005) on the issue of whether certain differences in the eco­ nomic environment belong in the definition of the frontier. Since the utility-maximizing profit function explains inefficient as well as efficient produc­ tion, it cannot be fitted as a frontier. To gauge inefficiency, Hughes et al. (1996) and Hughes, Mester, and Moon (2001) estimate a best-observed-practice risk-return frontier and measure inefficiency relative to it. The estimated utility-maximizing profit function Page 10 of 36

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The Performance of Financial Institutions Modeling, Evidence, and some Policy Implications yields a measure of expected profit for each bank in the sample, and, when divided by eq­ uity capital, the expected profit is transformed into expected return on equity, E(πi/k i). Each bank’s expected (or predicted) return is a function of its production plan and other explanatory variables. When the estimation of the profit function allows for heteroscedas­ ticity, the standard error of the predicted return (profit), σi, which is a measure of econo­ metric prediction risk, is also a function of the production plan and (p. 240) other explana­ tory variables and varies across banks in the sample.11 The estimation of a stochastic frontier similar to (2) gives the highest expected return at any particular risk exposure:

(3)

where νi is a two-sided error term representing noise, and μi is a one-sided error term representing inefficiency. A bank’s return inefficiency is the difference between its poten­ tial return and its noise-adjusted expected return, gauged among its peers with the same level of return risk. (Note, however, that if a bank’s managers are taking too much or too little risk relative to the value-maximizing amount, this inappropriate level of risk is not taken into account by this measure of inefficiency.) Koetter (2006) uses the model of managerial utility maximization and the associated mea­ sure of risk-return efficiency developed in Hughes et al. (1996, 1999, 2000) to investigate the efficiency of universal banks in Germany between 1993 and 2004. Comparing the measure of return efficiency with cost and profit efficiency estimated by standard formu­ lations, he finds evidence that efficient banks using a low-risk investment strategy score poorly in terms of standard profit efficiency measures, since they also expect lower profit. Hughes, Mester, and Moon (2001) take this a step further by recognizing that the utilitymaximizing choices of bank managers need not be value maximizing to the extent that there are agency problems within the firm and managers are able to pursue their own non-value-maximizing objectives. To identify the value-maximizing banks among the set of all banks, they select the quarter of banks in the sample that have the highest predicted return efficiency. These banks are the most likely group to be maximizing value or, at least, producing with the smallest agency costs. One can use this set of efficient banks to gauge characteristics of the value-maximizing production technology. For example, mean scale economies across this set of banks would indicate whether there were scale economies as banks expand output along a path that maximizes value. In contrast, mean scale economies across all banks would indicate whether there were scale economies as banks expand output along a path that maximizes managers’ utility, but this can differ from the value-maximizing expansion path to the extent that managers are able to pursue their own objectives and these objectives differ from those of outside owners. While the model of managerial utility maximization yields a structural utility-maxi­ mizing profit function that includes as special cases the standard maximum profit func­ tion and a value-maximizing profit function, it is, nevertheless, based on accounting mea­ sures of performance. An alternative model developed by Hughes and Moon (2003) (p. 241)

Page 11 of 36

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The Performance of Financial Institutions Modeling, Evidence, and some Policy Implications gauges performance using the market value of assets. They develop a utility-maximizing q-ra­ tio function derived from a model where managers allocate the potential (frontier) market value of their firm’s assets between their consumption of agency goods (market-value in­ efficiency) and the production of market value, which, given their ownership stake, deter­ mines their wealth. The utility function is defined over wealth and the value of agency goods and is conditioned on capital structure, outside blockholder ownership, stock op­ tions held by insiders, and other managerial incentive variables. The authors derive a util­ ity-maximizing demand function for market value and for agency goods (inefficiency). Hence, their q-ratio equation is structural and, consequently, enjoys the properties of a well-behaved consumer demand function. The authors use these properties to analyze the relationship between value (or inefficiency) and the proportion of the firm owned by insid­ ers, which is their opportunity cost of consuming agency goods.

8.2.4 The Non-structural Approach to Bank Efficiency Measurement The non-structural approach to bank performance measurement usually focuses on achieved performance and measures yi, in equation (1), by a variety of financial ratios, such as the return-on-assets, the return-on-equity, or the ratio of fixed costs to total costs. However, some applications have used measures of performance that are based on the market value of the firm (which inherently incorporates market-priced risk), such as Tobin’s q-ratio (which is the ratio of the market value of assets to the book value of as­ sets); the Sharpe ratio (which measures the ratio of the firm’s expected return in excess of the risk-free return to the volatility of this excess return (where volatility is measured by the standard deviation of the excess return)); or an event study’s cumulative abnormal return (CAR), which is the cumulative error terms of a model predicting banks’ market re­ turn around a particular event. Other applications have measured performance by an in­ efficiency ratio obtained by estimating either a non-structural or a structural perfor­ mance equation as a frontier. The non-structural approach focuses on the relationship of these performance measures to various bank and environmental characteristics, including the bank’s investment strat­ egy, location, governance structure, and corporate control environment. For example, the non-structural approach might investigate technology by asking how performance ratios are correlated with characteristics of the bank, such as asset acquisitions, the bank’s product mix, whether the bank is organized as a mutual or stock-owned firm, and the ra­ tio of outside to inside directors on its board. While informal and formal theories may mo­ tivate some of these investigations, no general theory of performance provides a unifying framework for these studies. For example, Hughes et al. (2018) use stochastic frontier techniques to estimate banks’ best-practice return on assets (ROA) achieved for a given level of ROA risk. The best-practice ROA gauges the potential return of a bank’s investment opportunities, while the difference between a bank’s best-practice ROA and its achieved ROA, adjusted for noise, eliminates the influence of luck (statistical noise) and gauges its systematic failure to achieve its potential return. ROA inefficiency measures a bank’s effectiveness in ex­ (p. 242)

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The Performance of Financial Institutions Modeling, Evidence, and some Policy Implications ploiting its investment opportunities and adds an important performance measure to the standard measures of achieved ROA and risk-normalized ROA. Assaf et al. (2018) estimate cost and profit functions and use the distribution-free ap­ proach to gauge cost and profit efficiency in the years preceding the financial crises in the US economy. They then ask how these measures of efficiency are related to perfor­ mance during a financial crisis. They find that cost efficiency in periods of normal eco­ nomic activity is related to improved ROA and return on equity (ROE) and reduced return risk and risk of failure during crises. However, profit efficiency yields limited benefits, perhaps because it could reflect higher returns from riskier investments. Fiordelisi, Marques-Ibanez, and Molyneux (2011) investigate the intertemporal relation­ ship of cost and revenue efficiency, capital, and risk in European banks during the period 1995–2007. Their evidence suggests that lower efficiency is associated with higher future bank risk and that increases in capital are related to future cost efficiency improvements. Moreover, higher efficiency is associated with higher future capitalization. In an innovative study of bank performance, Egan, Lewellen, and Sunderam (2017) devel­ op two measures of bank productivity: one focused on deposit-taking and the other on the returns generated by a bank’s asset allocation. They study how the market-to-book ratio is related to the two measures and find that deposit productivity is associated with the majority of variation in bank value. Moreover, they find synergies between deposit-taking and lending. High deposit productivity is associated with high asset productivity. These results are consistent with those of Mester, Nakamura, and Renault (2007), who find syn­ ergies between the liability and asset sides of a commercial bank’s balance sheet. Using the frontier methods in a non-structural approach, Hughes et al. (1997) proposed a proxy for Jensen and Meckling’s agency cost: a frontier of the market value of assets fit­ ted as a potentially non-linear function of the book-value investment in assets and the book value of assets squared. This frontier gives the highest potential value observed in the sample for any given investment in assets. For any bank, the difference between its highest potential value and its noise-adjusted achieved value represents its lost market value—a proxy for agency cost (X-inefficiency). Several studies have used either this sys­ tematic lost market value or the resulting noise-adjusted q-ratio to measure performance: Baele, De Jonghe, and Vander Vennet (2006), Hughes et al. (2003), De Jonghe and Vander Vennet (2005), Hughes and Moon (2003), Hughes et al. (1999), Hughes, Mester, and Moon (2001), Hughes and Mester (2013a and 2013b), and Hughes, Mester, and Moon (2016). Habib and Ljungqvist (2005) specified an alternative market-value frontier as a function of a variety of managerial decision variables, including size, financial leverage, capital (p. 243) expenditures, and advertising expenditures. Thus, the peer grouping on which the frontier is estimated is considerably narrower than the wide grouping based on invest­ ment in assets, and inefficient choices of these conditioning values are not accounted for in the measurement of agency costs. Page 13 of 36

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The Performance of Financial Institutions Modeling, Evidence, and some Policy Implications

8.2.5 Specifying Outputs and Inputs in Structural Models of Produc­ tion In estimating the standard cost or profit function or the managerial utility maximization model, one must specify the outputs and inputs of bank production. The intermediation approach (Sealey and Lindley, 1977) focuses on the bank’s production of intermediation services and the total cost of production, including both interest and operating expenses. Outputs are typically measured by the dollar volume of the bank’s assets in various cate­ gories. As mentioned above, an exception is Mester (1992), who, to account for the bank’s screening and monitoring activities, measured outputs as loans previously purchased (which require only monitoring), loans currently originated for the bank’s own portfolio, loans currently purchased, and loans currently sold. Inputs are typically specified as la­ bor, physical capital, deposits and other borrowed funds, and, in some studies, equity cap­ ital. While the intermediation approach treats deposits as inputs, there has been some discus­ sion in the literature about whether deposits should be treated as an output, since banks provide transactions services for depositors. Hughes and Mester (1993) formulated an empirical test for determining whether deposits act as an input or an output. Consider variable cost, VC, which is the cost of non-deposit inputs and is a function of the prices of non-deposit inputs, w, output levels, y, other variables affecting the technology, τ, and the level of deposits, x. If deposits are an input, then ∂VC/∂x < 0: Increasing the use of some input should decrease the expenditures on other inputs. If deposits are an output, then ∂VC/∂x > 0: Output can be increased only if expenditures on inputs are increased. Hughes and Mester’s empirical results indicate that insured and uninsured deposits are inputs at banks in all size categories.

8.2.6 Specifying Capital Structure in Performance Equations Typically, cost and profit functions are measured without considering the bank’s capital structure, which results in a seriously mis-specified model that omits an important fund­ ing input: equity capital. However, the newer literature recognizes the importance of bank managers’ choice of risk and capital structure to bank performance. Some of the first structural models to include equity capital as an input are Hancock (1985, 1986), McAllister and McManus (1993), Hughes and Mester (1993), Clark (1996), and Berger and Mester (1997). As discussed in Hughes and Mester (1993), Berger and Mester (1997), Hughes (1999), and Mester (2008), a bank’s insolvency risk depends not only on the riskiness of its portfolio but also on the amount of financial capital it has to absorb losses. Insolvency risk affects bank costs and profits through (1) the risk premium the bank has to pay for uninsured debt, (2) the intensity of risk management activities the bank undertakes, and (3) the discount rate applied to future profits. A bank’s capital level also directly affects (p. 244)

costs by providing an alternative to deposits as a funding source for assets.

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The Performance of Financial Institutions Modeling, Evidence, and some Policy Implications Most studies use the cash-flow (accounting) concept of cost, which includes the interest paid on debt (deposits) but not the required return on equity, as opposed to economic cost, which includes the cost of equity. Failure to include equity capital among the inputs can bias efficiency measurement. If a bank were to substitute debt for some of its finan­ cial equity capital, its accounting (cash-flow) costs could rise, making the less capitalized bank appear to be more costly than the more well-capitalized bank. To solve this problem, one can include the level of equity capital as a quasi-fixed input in the cost function. The resulting cost function captures the relationship of cash-flow cost to the level of equity capital, and the (negative) derivative of cost with respect to equity capital—the amount by which cash-flow cost is reduced if equity capital is increased—gives the shadow price of equity. The shadow price of equity will equal the market price when the amount of equity minimizes cost or maximizes profit. Even when the level of equity does not conform to these objectives, the shadow price nevertheless provides a measure of its opportunity cost. Hughes, Mester, and Moon (2001) find that the mean shadow price of equity for small banks is significantly smaller than that of larger banks. This suggests that smaller banks over-utilize equity relative to its cost-minimizing value, perhaps to protect charter value. On the other hand, larger banks appear to under-utilize equity relative to its costminimizing value, perhaps to exploit a cost-of-funds subsidy due to deposit insurance and the too-big-to-fail doctrine. In both cases, these capital strategies, while not minimizing cost, may be maximizing value.

8.2.7 Specifying Output Quality in the Performance Equation In measuring efficiency, one should control for differences in output quality to avoid label­ ing unmeasured differences in product quality as differences in efficiency. Controls for loan quality, for example, non-performing loans to total loans by loan category or loan losses, are sometimes included in the cost or profit frontier as controls (see Mester, 2008, for further discussion).12 The variable, non-performing loans, can also play a role as a quasi-fixed “input” whose quantity rather than price is included in the performance equation. As such, its “cost”—loan losses—is excluded from the performance metric, either cost or profit. Its price is the expected loan-loss rate. Hence, when the cost of non-performing loans, that is, loan losses, is excluded from the performance measure, a case can be made for includ­ ing the level of non-performing loans, and when the performance measure is net of loan losses, the logic suggests that the loss rate be included in the specification of the perfor­ mance equation. (p. 245)

Hughes and Moon (2018) suggest that the relationship between bank performance and the non-performing loan ratio can be decomposed into two parts: (1) non-performance due to the inherent credit risk the bank assumes and (2) non-performance due to the pro­ ficiency of the bank in assessing credit risk and monitoring loan performance. They use stochastic frontier techniques to estimate the minimum non-performance ratio observed in the sample, conditional on the volume and composition of a bank’s loans, the average contractual interest rate charged on these loans, and market conditions such as the aver­ Page 15 of 36

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The Performance of Financial Institutions Modeling, Evidence, and some Policy Implications age GDP growth rate and market concentration. This minimum ratio reflects the bestpractice ratio—the ratio that a bank would experience if it were fully efficient at creditrisk evaluation and loan monitoring—and gauges the inherent credit risk of the loan port­ folio. The difference between a bank’s noise-adjusted observed non-performing loan ratio and the best-practice minimum ratio reflects the elimination of the influence of luck (sta­ tistical noise) and gauges the bank’s inefficiency at lending. Restricting the sample to publicly traded US bank holding companies and gauging financial performance by market value at year-end 2013, they find that the ratio of non-performing loans to total loans is, on average, negatively related to financial performance except at the largest banks. This positive association of financial performance with non-performing loans at the largest banks can be refined by decomposing non-performance into inherent credit risk and lend­ ing inefficiency: The results suggest that taking more inherent credit risk enhances mar­ ket value at a larger group of large banks, not just the largest ones, while lending ineffi­ ciency is negatively related to market value at all banks. Thus, market discipline appears to reward riskier lending at large banks and discourage lending inefficiency at all banks. Hughes et al. (2018) use this technique to compare the business lending and commercial real estate lending performance of banks in three size groups: banks with assets of less than $1 billion (small community banks), banks with assets between $1 billion and $10 billion (large community banks), and banks with assets between $10 billion and $50 bil­ lion (mid-size banks). They find that for business lending and commercial real estate lend­ ing, large community banks and mid-size banks assume higher inherent credit risk and exhibit more efficient lending. They also find that, unlike small community banks, large community banks have financial incentives to increase lending to small businesses.

(p. 246)

8.3 Applications of the Structural Approach

8.3.1 Performance in Relation to Organizational Form, Governance, Regulation, and Market Discipline An increasing number of papers using structural models are exploring the importance of governance and ownership structure to the performance of banks. The structural model is first used to obtain a frontier-based measure of inefficiency. Then inefficiency is re­ gressed on a set of explanatory variables. Using confidential regulatory data on small, closely held commercial banks, DeYoung, Spong, and Sullivan (2001) use a stochastic frontier to measure banks’ profit efficiency. They find banks that hire a manager from outside the group of controlling shareholders perform better than those with owner-managers; however, this result depends on motivat­ ing the hired managers with sufficient holdings of stock. They calculate an optimal level of managerial ownership that minimizes profit inefficiency. Higher levels of insider hold­ ings lead to entrenchment and lower profitability.

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The Performance of Financial Institutions Modeling, Evidence, and some Policy Implications Berger and Hannan (1998) consider the relationship of bank cost efficiency, estimated by a stochastic frontier, to product market discipline, gauged by a Herfindahl index of mar­ ket power. They find that the reduced discipline of concentrated markets is associated with a loss of cost efficiency far more significant than any welfare loss due to monopoly pricing. DeYoung, Hughes, and Moon (2001) use the model of managerial utility maximization de­ veloped by Hughes et al. (1996, 2000) to estimate expected return and return risk. Using these values, they estimate a stochastic risk-return frontier as in equation (3) to obtain each bank’s return inefficiency. They consider how banks’ supervisory CAMEL ratings are related to their size, their risk-return choice, and their return inefficiency. They find that the risk-return choices of efficient banks are not related to their supervisory rating, while the higher-risk choices of inefficient banks are penalized with poorer ratings. Moreover, the risk-return choices of large inefficient banks are held to a stricter standard than smaller banks and large efficient banks. Two studies by Mester (1991, 1993) investigate differences in scale and scope measures for stock-owned and mutual savings and loans by estimating average cost functions. She finds evidence of agency problems at mutual S&Ls, as evidenced by diseconomies of scope, prior to the industry’s deregulation, and evidence that these agency costs were lessened after the deregulation in the mid-1980s. Using data for the period 1989–96, Altunbas, Evans, and Molyneux (2001) estimate sepa­ rate and common frontiers for three organizational forms in German banking: private commercial, public (government-owned) savings, and mutual cooperative banks. They ar­ gue that the same technology of intermediation is available to all so that the (p. 247) choice of technology is a management decision whose efficiency should be compared among all types of firms. The private sector appears to be less profitable and less cost ef­ ficient than the other two sectors. These results are especially clear in the case of the common frontier, but they are also obtained from the estimation of separate frontiers.

8.3.2 Uncovering Evidence of Scale Economies by Accounting for Risk and Capital Structure Former Federal Reserve Chairman Alan Greenspan (2010) summarized the literature on scale economies in banking: “For years the Federal Reserve had been concerned about the ever larger size of our financial institutions. Federal Reserve research had been un­ able to find scale economies in banking beyond a modest-sized institution.” But, in fact, many investigators, including some at the Fed, have found evidence of scale economies even at the largest financial institutions. This research includes, for example, Hughes et al. (1996), Berger and Mester (1997), Hughes and Mester (1998), Hughes, Mester, and Moon (2001), Berger and Mester (2003), Bossone and Lee (2004), Feng and Serletis (2010), Wheelock and Wilson (2012), Hughes and Mester (2013b), and Dijkstra (2017). Dijkstra (2017) provides an extensive classification of papers investigating scale and scope economies by their techniques and findings.13 Page 17 of 36

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The Performance of Financial Institutions Modeling, Evidence, and some Policy Implications The Greenspan observation raises the fundamental question: Are scale economies in banking illusive or elusive? The investment strategies of many of the largest financial in­ stitutions constituted ground zero in the recent banking crisis, and their rescue under the too-big-to-fail doctrine has prompted some prominent policymakers to call for breaking up the largest banks. For example, Fisher and Rosenblum (2012) assert, “Hordes of DoddFrank regulators are not the solution; smaller, less complex banks are. We can select the road to enhanced financial efficiency by breaking up TBTF banks—now.” Hoenig and Mor­ ris (2012) call for limiting the government safety net to the core activities of commercial banks, including lending, taking deposits, providing liquidity and credit intermediation services, and disallowing banks from doing certain non-core banking activities, including engaging in broker–dealer activities, making markets in derivatives or securities, trading derivatives and securities for their own account or their customers’, or sponsoring hedge funds or private equity funds. Tarullo (2011), however, questions whether breaking up banks would lead to efficiency and suggests there is a tradeoff between concerns for sys­ temic risk and efficiency: “An additional concern would arise if some countries made the trade-off by limiting the size or configuration of their financial firms for systemic risk rea­ sons at the cost of realizing genuine economies of scope or scale, while other countries did not. In this case, firms from the first group of countries might well be at a competitive disadvantage in the provision of certain cross-border activities.” And Powell (2013) indi­ cates that if the current regulatory reform (p. 248) agenda succeeds in substantially re­ ducing the likelihood of bank failure and minimizing the externalities caused by a large bank failure, then in his view, this would be preferable to breaking up the banks, since such a break-up would “likely involve arbitrary judgments, efficiency losses, and a diffi­ cult transition.” While textbooks assert that scale economies characterize banking (e.g., Kohn, 2004; Saunders and Cornett, 2010), these economies elude many empirical studies because the studies generally fail to account for the effects of endogenous risk-taking on banks’ cost as bank size increases. Textbooks cite diversification as one component of the technology that generates scale economies. As discussed above, in Figure 8.1, the larger bank enjoys a better risk-expected-return trade-off and chooses its risk exposure on that improved frontier to maximize managerial utility, which is likely associated with expected share­ holder value in the absence of severe agency problems. The increase in cost due to the larger output will depend on the investment strategy the larger bank chooses. For exam­ ple, as a bank scales up its output and moves from point A to point A´, diversification has resulted in lower risk, and cost is likely to have increased less than proportionately than the increase in output. If risk-taking is costly, then the investment strategy at point C may result in, say, a proportional increase in cost compared to operating at point A, while the investment strategy at point D may imply a more than proportional increase in cost. Hughes (1999) contends that studies of how cost varies with output that ignore the ef­ fects of endogenous risk-taking on cost, are likely to identify the technology as constant returns to scale when larger banks tend to produce at point C and as scale diseconomies when larger banks tend to produce at point D. To the extent that larger banks are gener­ ally more risky than smaller banks (Demsetz and Strahan, 1997), the naïve econometric Page 18 of 36

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The Performance of Financial Institutions Modeling, Evidence, and some Policy Implications investigation of banking cost that ignores endogenous risk-taking is likely to find that larger banks experience constant returns to scale or even scale diseconomies. Hughes, Mester, and Moon (2001) call the effect on cost from moving from point A to point A´, the diversification effect—diversification leads to a decline in risk for the same level of ex­ pected profit. They call the effect on cost of moving from point A´, which resulted from better scale-related diversification, to point C or D, the risk-taking effect. Accounting for endogenous risk-taking—isolating the diversification effect—in estimating scale economies requires controlling for revenue as well as cost. While the traditional cost function does not incorporate any revenue terms, the utility-maximizing cost function incorporates revenue because it is derived from the utility-maximizing profit function, conditioned on the output vector, and as noted earlier, it reflects bank managers’ choice of risk as well as expected return. In Figure 8.1, suppose that the smaller bank chooses to produce its output vector with the investment strategy at point A and the large bank chooses to produce its output vector with the strategy at point D. Scale economies esti­ mated in the neighborhood of point A refer to the increase in cost for a small proportional increase in outputs given the investment strategy at point A. If expanded output allows for better diversification that lowers costs for a given expected return, then the estimated scale economies would compare cost at point A to (p. 249) cost at point A´. In this way, it would isolate the diversification effect and avoid the bias of measuring scale economies at point D relative to point A.14 Hughes and Mester (2013b) estimate several traditional cost functions and the risk-re­ turn-driven cost function for US bank holding companies in 2003, 2007, and 2010. In all three years, estimates derived from the traditional minimum cost functions, which do not take into account the banks’ risk-expected-return choice, indicate modest scale economies or, in some cases, constant returns to scale. In contrast, the utility-maximizing cost function, which takes into account the banks’ risk-expected-return choice, yields evi­ dence of large-scale economies that increase with the scale of the bank. For example, in 2007, for the smallest banks (with less than $0.8 billion in assets), estimated scale economies is 1.12, which means that a 10 percent increase in output levels is associated with an 8.8 percent increase in cost. For the largest banks (with greater than $100 billion in assets), estimated scale economies is 1.34, which means that a 10 percent increase in output levels is associated with a 7.5 percent increase in cost. Hughes and Mester (2013b) also find that the estimated expected profit and profit risk obtained from this model explain between 94 and 99 percent of the variation in US bank market value be­ tween the years 2003 and 2010. Thus, these measures of performance and best-practice capture the capital market’s assessment of banks’ market-priced risk and performance. Dijkstra (2017) also estimates the risk-return-driven cost function and standard formula­ tions of the cost function for banks in countries in the Eurozone for each year from 2002 through 2011 and compares estimates of scale economies based on these estimated func­ tions. The results based on the standard formulations of the cost function show scale economies in the early part of the time period that turn into diseconomies around the start of the financial crisis in 2008. But estimates based on the risk-return-driven cost Page 19 of 36

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The Performance of Financial Institutions Modeling, Evidence, and some Policy Implications function indicate scale economies at banks of all sizes that rise throughout the sample pe­ riod, with magnitudes similar to those in Hughes and Mester (2013b). In addition, Dijkstra’s (2017) estimates based on the risk-return-driven cost function indicate econom­ ically significant scope economies. Dijkstra finds that scale economies measured by the risk-return-driven cost function in­ crease over the span of his data, 2002 through 2011. This finding is consistent with the substantial improvements in banking technology that have occurred over this period. Ad­ vances in information technology and communications have improved the efficiency of payments networks, credit evaluation, loan monitoring, risk management, and organiza­ tional control. In addition, deregulation of interstate banking in the US has allowed (p. 250) banks to expand their scale to exploit cost economies related to scale and has im­ proved takeover discipline in banking.15 Dijkstra’s estimates of scale economies for Euro­ pean banking increase from 1.160 in 2002 to 1.271 in 2011. Hughes et al. (2000) esti­ mate the risk-return-driven cost function and find scale economies of 1.146 for US banks in 1990. Hughes, Mester, and Moon (2001) estimate scale economies of 1.145 for US banks in 1994. Hughes and Mester (2013b) estimate scale economies of 1.183 for US banks in 2003 compared to 1.254 for US banks in 2010. For the largest US financial insti­ tutions with assets exceeding $100 billion, Hughes and Mester (2013b) estimate scale economies of 1.357 in 2003 and 1.432 in 2010. Using the methods of Wheelock and Wilson (2012), Wheelock and Wilson (2017) compare estimates of scale economies for US banks in 2006 to those in 2015. They find that 27 percent more banks experienced increasing returns in 2015 than in 2006 and that (p. 20) “… the largest four banks have seen significant increases in returns to scale since 2006, suggesting that scale economies still provide an impetus to become even larger.” These estimates of scale economies, which increase over time, are consistent with the hypothe­ sis that technological improvements substantially reduce the average cost of financial products and services and, as Wheelock and Wilson (2017) observe, provide strong incen­ tives to institutions to increase their scale to exploit these improving economies.16 Spreading overhead costs, such as those related to technology and regulatory compli­ ance, over a larger scale is often cited as an important source of scale economies in bank­ ing. Kovner, Vickery, and Zhou (2014) investigate this issue and find evidence of operat­ ing cost economies when they control for a bank’s investment strategy. Controlling for the bank’s investment strategy when measuring the effect of an increase in scale on cost can be illustrated in our Figure 8.1. This would be equivalent to assessing the increase in cost when a bank moves from A to A´ rather than when it moves from point A to C or D— points that represent riskier investment strategies. When Kovner, Vickery, and Zhou esti­ mate the cost elasticity without controlling for the investment strategy, they find that a 10 percent increase in assets implies a 9.93 percent increase in operating cost—essentially constant returns to scale. When they control for asset allocation, the cost elasticity falls to 9.79 percent. When they control for asset allocation, revenue sources, funding struc­ ture, and organizational complexity, the operating cost elasticity falls to 8.99 percent—ev­ idence of scale-related operating cost economies. Moreover, operating scale economies Page 20 of 36

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The Performance of Financial Institutions Modeling, Evidence, and some Policy Implications increase with bank size, so that the largest financial institutions obtain the largest operat­ ing cost economies. This evidence of large-scale economies at the largest financial institutions suggests that breaking them up into smaller institutions with the goal of reducing the systemic risk they pose would reduce their competitiveness in global financial markets. Using (p. 251) their 2007 estimates, Hughes and Mester (2013b) consider breaking in half each of the seventeen institutions that exceed $100 billion in consolidated assets to create thirty-four banks with total assets equal to those of the seventeen larger institutions. Holding prod­ uct mix constant, that is, assuming the smaller institutions produce the same product mix as the larger ones, their costs are 23 percent higher. In a similar exercise, Wheelock and Wilson (2012), who also find large-scale economies at banks of all sizes, scale back the four largest US institutions in 2009 to a size of $1 trillion and increase their numbers so that the total assets of the smaller institutions equal those of the larger institutions. They find that the cost of the smaller institutions is approximately 19 percent higher. These two exercises suggest that breaking up the largest institutions into smaller institutions will limit their global competitiveness and provide incentives to produce their financial services offshore, where such limits are not operative. A related issue in this literature questions whether the estimated scale economies at the largest financial institutions result from cost-of-funds subsidies due to banks being con­ sidered too big to fail. Hughes and Mester (2013b) present several pieces of evidence in­ dicating that the large-scale economies they find are not driven by a cost-of-funds subsidy derived from banks being considered too big to fail. First, they find large-scale economies at small banks in their sample as well as at large banks. Second, when they re-estimate their model excluding banks with assets greater than $100 billion, and then calculate scale economies out of sample for the largest banks, their results are unchanged. Finally, they calculate scale economies for the largest banks if they faced the cost-of-funds of smaller banks. Again, their results are unchanged. Hughes and Mester (2013b) conclude that the underlying technology, not too-big-to-fail subsidies, accounts for the scale economies of the largest financial institutions. Davies and Tracey (2014) adopt the strate­ gy used by Hughes and Mester (2013b) of replacing the observed price of borrowed funds with a price that seeks to eliminate the too-big-to-fail subsidy—one derived from a Moody’s rating for each bank that assumes government assistance in financial distress. The authors find that using the actual observed price of borrowed funds yields evidence of scale economies that disappear when the pseudo price is used. The authors assume that this difference in measured scale economies is due to a too-big-to-fail subsidy. How­ ever, there is a critical difference between their methodology and that of Hughes and Mester (2013b). Hughes and Mester measure scale economies by substituting the pseudo prices into the fitted measure of scale economies, which is derived from the cost function estimated using the actual input prices, outputs, and control variables that the banks faced. Davies and Tracey do not use the original estimated cost function. Instead, they reestimate the cost function and share equations using the pseudo prices along with the ac­ tual observed data on the other variables, including total cost, cost shares, other input prices, outputs, and control variables. Thus, the total costs and cost shares used in the rePage 21 of 36

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The Performance of Financial Institutions Modeling, Evidence, and some Policy Implications estimation do not match the prices used. The model assumes that banks minimize cost with respect to the pseudo prices, but since these pseudo prices do not give rise to the observed cost and cost shares, the resulting re-estimated technology is difficult to inter­ pret. Kroszner (2016) considers differences in funding costs not only between large and small financial institutions but also between large and small firms in non-financial (p. 252) in­ dustries—industries where there is no possibility of government support during financial distress. He finds that funding costs are lower for large firms across many industries: from 84 basis points for energy to 5 basis points for utilities, with banks in the middle at 35 basis points. Using data from the period 2004 to 2013, Ahmed, Anderson, and Zarut­ skie (2015) find that the borrowing costs of non-financial firms as well as those of finan­ cial firms tend to decline with borrower size; moreover, financial firms exhibit lower bor­ rowing costs that are less sensitive to size than those in several other industries. They suggest that size-related differences in borrowing costs may be partially influenced by higher liquidity and recovery rates of larger borrowers, rather than government subsidies related to size. Minton, Stulz, and Taboada (2017), whose investigations we discuss in the next section, study banks over the period 1987–2015 and find no evidence that larger banks benefit from too-big-to-fail subsidies.

8.4 Applications of the Non-Structural Ap­ proach 8.4.1 Measuring the Value of Investment Opportunities (“Charter Val­ ue”) The value of a bank’s investment opportunities is often measured by Tobin’s q-ratio; how­ ever, in the presence of agency costs, Tobin’s q-ratio captures only the ability of the in­ cumbent managers to exploit these opportunities. Ideally, the value of investment oppor­ tunities should be gauged independently of the ability and actions of the current manage­ ment. Hughes et al. (1997) and Hughes et al. (2003) propose a measure based on fitting a stochastic frontier to the market value of assets as a function of the book value of assets and variables characterizing the market conditions faced by banks in their local markets. These conditions include a Herfindahl index of market power and the macroeconomic growth rate. The fitted frontier gives the highest potential value of a bank’s assets in the markets in which it operates. Thus, this potential value is conditional on the location of the bank and represents the value the bank would fetch in a competitive auction. Hughes et al. (1997) define this value as the bank’s “charter value”—its value in a competitive auction.

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The Performance of Financial Institutions Modeling, Evidence, and some Policy Implications

8.4.2 Measuring the Performance of Capital Strategies Several papers have used the non-structural performance equation to examine the rela­ tionship between bank value and bank capital structure. Hughes et al. (1997) regress per­ formance measured by Tobin’s q-ratio and market-value inefficiency on a number of vari­ ables characterizing bank production. Calomiris and Nissim (2007) regress the ratio (p. 253) of the market value of equity to its book value on a similar list of variables. De Jonghe and Vander Vennet (2005) apply the market-value frontier of Hughes et al. (1997) to derive a noise-adjusted measure of Tobin’s q, which they use to evaluate how leverage and market power are related to value. Hughes, Mester, and Moon (2016) regress perfor­ mance based on the market value of assets and on the shortfall of the market value of as­ sets, obtained from a market-value frontier, on banks’ capital structure and variables that characterize banks’ business strategy. All four studies find evidence that banks follow di­ chotomous strategies for enhancing value, as predicted by Marcus (1984): a strategy that entails lower risk and lower leverage and a strategy that entails higher risk and higher leverage.

8.4.3 Measuring the Performance of Business Strategies A common result in the corporate finance literature is that non-financial conglomerates, which combine firms in different industries, trade at a discount. Klein and Saidenberg (2010) consider the extent to which such a diversification discount exists in commercial banking. Because banks’ scope is generally limited to financial products and services, a diversification discount in banking would likely result from organizational complexity rather than industry diversification. They use data from 1990–4, a period before geo­ graphical restrictions were lifted by the Riegle–Neal Act when banks crossed state lines by forming a holding company to operate separate bank subsidiaries in other states. They find that bank holding companies with many subsidiaries have, on average, a lower Tobin’s q-ratio than banks with fewer subsidiaries. They conclude that organizational complexity, in addition to scope-related diversification, may also contribute to the diversi­ fication discount reported in the corporate finance literature. Brook, Hendershott, and Lee (1998) investigate how bank performance was affected by the Riegle-Neal Act’s lifting of interstate branching restrictions, a liberalization that al­ lowed bank holding companies to consolidate subsidiaries operating across state lines. They find evidence in support of their hypothesis that relaxation of the restrictions on in­ terstate banking improved bank performance through better exploitation of scale economies and through enhanced market discipline due to more extensive takeover threats. Using event–study methodology, they investigate the reaction of bank stock prices to the passage of the legislation and find a statistically significant positive CAR. Underperforming banks whose management was least entrenched received the highest CAR. Minton, Stulz, and Taboada (2017) investigate the relationship between bank valuation and asset size. Using Tobin’s q-ratio and the market-to-book value of equity to measure Page 23 of 36

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The Performance of Financial Institutions Modeling, Evidence, and some Policy Implications valuation, they find a statistically insignificant relationship between bank asset size and valuation for banks with assets in the $10 billion to $50 billion range, but a significantly negative association between size and valuation for banks with assets greater than $50 billion. Their analysis suggests that this negative association is due to the volume of trad­ ing assets that a bank holds. Namely, they find that banks with more trading assets (p. 254) are valued less, and that larger banks tend to have larger volumes of trading as­ sets relative to assets. Cetorelli, Jacobides, and Stern (2017) use a new data set that details the organizational structure of US bank holding companies. They map a bank’s entry and exit across scoperelated sectors and find that scope expansion is, on average, associated with worse finan­ cial performance measured by the Tobin q ratio and by ROE. Schmid and Walter (2014) adopt a strategy developed by Berger and Ofek (1995) to look for evidence of a scope-re­ lated diversification discount in banking. They construct a measure of excess value that compares a bank’s value to its value were its segments operating as stand-alones. They define these segments by categorizing a bank’s assets into distinct industry segments. The value of each of these segments is given by the median ratio of the market value of assets per dollar of assets for banks that operate solely in a segment. The imputed value of a bank that operates in multiple segments were its assets divided into stand-alone seg­ ments is computed as the asset-weighted sum of values across the segments in which the bank holds assets. The authors find that, on average, the imputed stand-alone value of the portfolio is greater than that of the diversified firm. The diversification discount is ap­ proximately 11 percent in 2005 but statistically insignificant throughout the ensuing fi­ nancial crisis. The textbook definition of scope economies compares the cost of producing an output vector in a single multi-product firm with the cost of producing it in separate single-prod­ uct firms. Mester (1991) proposes a technique of estimating scope economies from the multi-product cost estimation that does not require finding banks in the sample that pro­ duce only one type of output, or setting the value of a particular type of output to zero in the estimated cost function when no firms in the sample produce at this level. Essentially, this technique indicates whether the marginal cost of a particular output increases or de­ creases with another output. If it decreases, there are scope economies between the two outputs. Hughes and Mester (1993) apply this technique to US data and do not find evi­ dence of overall scope economies. Dijkstra (2017) applies it to Eurozone banks and finds evidence of scope economies.

8.4.4 Relationship of Ownership Structure to Bank Value In an influential study, Morck, Shleifer, and Vishny (1988) hypothesized that managerial ownership creates two contrasting incentives: A higher ownership stake, first, better aligns the interests of managers and outside owners and, second, enhances managers’ control over the firm and makes it harder for managers to be ousted when they are not ef­ ficient. Measuring performance by Tobin’s q, these authors provide evidence that the socalled alignment-of-interests effect dominates the entrenchment effect at lower levels of Page 24 of 36

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The Performance of Financial Institutions Modeling, Evidence, and some Policy Implications managerial ownership, while the entrenchment effect dominates over a range of higher levels. Studies that attempt to measure the net effect of the alignment and entrenchment effects on firm valuation cannot identify these effects individually—only their sum in (p. 255) the form of the sign of a regression coefficient or a derivative of a regression equation. Adams and Santos (2006) cleverly isolate the entrenchment effect by considering how the proportion of a bank’s common stock that is controlled but not owned by the bank’s own trust department, is statistically related to the bank’s economic performance. The voting rights exercised by management through the trust department enhance management’s control over the bank but do not align their interests with outside shareholders’ because the beneficiaries of the trusts, not the managers, receive the dividends and the capital gains and losses. Caprio, Laeven, and Levine (2003) study the effect of ownership, shareholder protection laws, and supervisory and regulatory policies on the valuations of banks around the world. The authors construct a database of 244 banks across forty-four countries. They measure performance by Tobin’s q-ratio and by the ratio of the market value of equity to the book value of equity. They find evidence that (1) banks in countries with better pro­ tection of minority shareholders are more highly valued; (2) bank regulations and super­ vision have no significant effect on bank value; (3) the degree of cash-flow rights of the largest owner has a significant positive effect on bank value; and (4) an increase in own­ ership concentration has a larger positive effect on valuation when the legal protection of minority shareholders is weak. Laeven and Levine (2009) consider a sample of large banks in forty-eight countries in 2001 and investigate how the cash-flow rights of the largest shareholder and various reg­ ulatory provisions affect the probability of insolvency. They find that the cash-flow rights of the largest shareholder are positively related to the risk of insolvency. They also find that when there is a shareholder with large cash-flow rights, deposit insurance and activi­ ty restrictions are associated with increased insolvency risk, but they are uncorrelated with insolvency risk when the bank is widely held. Hughes et al. (2003) examine US bank holding companies and find evidence of manageri­ al entrenchment among banks with higher levels of insider ownership, more valuable growth opportunities, poorer financial performance, and smaller asset size. When man­ agers are not entrenched, asset acquisitions and sales are associated with reduced mar­ ket value inefficiency. When managers are entrenched, sales are associated with smaller reductions in inefficiency, while acquisitions are associated with greater inefficiency.

8.5 Conclusions and Policy Implications Great strides have been made in the theory of bank technology in terms of explaining banks’ comparative advantage in producing informationally intensive assets and financial services and in taking, diversifying, and offsetting a variety of risks. Great strides have al­ Page 25 of 36

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The Performance of Financial Institutions Modeling, Evidence, and some Policy Implications so been made in explaining sub-par managerial performance in terms of agency theory and in applying these theories to analyze the particular environment of banking. In recent years, the empirical modeling of bank technology and (p. 256) the measurement of bank performance have begun to incorporate these theoretical developments and yield inter­ esting insights that reflect the unique nature and role of banking in modern economies. This new literature recognizes that the choice of risk influences banks’ production deci­ sions (including their mix of assets, asset quality, off-balance-sheet hedging activities, capital structure, debt maturity, and resources allocated to risk management), and so, in turn, affects banks’ costs and profitability. Measures of bank performance should take ac­ count of this endogeneity. The estimation of structural models that incorporate manageri­ al preferences for expected return and risk has uncovered significant scale economies in banking that increase with bank scale, a finding that differs from the earlier literature but accords with the consolidation of the banking industry that has been occurring world­ wide. This finding of significant scale economies at the largest financial institutions also suggests that proposals to break up these institutions into smaller institutions in an at­ tempt to ameliorate too-big-to-fail problems could limit their global competitiveness and provide them with incentives to produce their financial services offshore where such lim­ its are not operative. Moreover, banks’ strategies to avoid restrictions on scale, such as moving such activities into the less-regulated non-bank sector, may create new sources of systemic risk that are harder to supervise and regulate. Performance studies based on structural models of managerial utility maximization, as well as those based on non-structural models of bank production, have incorporated vari­ ables designed to capture incentive conflicts between managers and outside stakehold­ ers. These studies have shown that factors associated with enhanced market discipline are also associated with improved bank performance and that improved bank perfor­ mance is not necessarily associated with improved financial stability when the improved performance results from investment strategies that increase financial leverage and heighten credit risk. In short, the incentive of larger banks to take extra risk to exploit the federal safety net and increase their expected market value may undermine financial stability. These results suggest an important role for capital regulation and enhanced su­ pervision of large financial institutions.

Acknowledgments The authors thank the editors Allen Berger, Phillip Molyneux, and John Wilson for helpful comments. The views expressed in this chapter are those of the authors and do not neces­ sarily reflect those of the Federal Reserve Bank of Cleveland or of the Federal Reserve System.

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The Performance of Financial Institutions Modeling, Evidence, and some Policy Implications Tarullo, D. K. (2011). “Industrial Organization and Systemic Risk: An Agenda for Further Research,” Remarks at the Conference on the Regulation of Systemic Risk, Federal Re­ serve Board, Washington, DC. Wheelock, D. and Wilson, P. (2012). “Do Large Banks Have Lower Costs? New Estimates of Returns to Scale for US Banks,” Journal of Money, Credit, and Banking, 44, 171–99. Wheelock, D. and Wilson, P. (2017). “The Evolution of Scale Economies in US Banking,” Working Paper No. 2015-021C, Federal Reserve Bank of St. Louis.

Notes: (1) Berlin and Mester (1999) find empirical evidence of an explicit link between banks’ lia­ bility structure and their distinctive lending behavior. As discussed in Mester (2007), rela­ tionship lending is associated with lower loan rates, less stringent collateral require­ ments, a lower likelihood of credit rationing, contractual flexibility, and reduced costs of financial distress for borrowing firms. Banks’ access to core deposits, which are rate in­ elastic, enables banks to insulate borrowers with whom they have durable relationships from exogenous credit shocks. Mester, Nakamura, and Renault (2007) also find empirical evidence of a synergy between the liability and asset sides of a commercial bank’s bal­ ance sheet, showing that information on the cash flows into and out of a borrower’s trans­ actions account can help an intermediary monitor the changing value of collateral that a small-business borrower has posted. (2) Demirgüç-Kunt, Kane, and Laeven (2007) use a sample of 180 countries to study the external and internal political features that influence the adoption and design of deposit insurance, which, in turn, affects the efficiency of the domestic banking system. (3) FDIC (2014) summarizes some of the estimates of the subsidy found in the literature. (4) For expository purposes, in this discussion we are assuming that only the first two mo­ ments of the distribution of returns matter for bank production. More generally, however, higher moments, such as skewness and kurtosis, can be expected to influence, for exam­ ple, calculations of value-at-risk and the choice of investment strategies that minimize the probability of financial distress or that exploit the federal safety net. Thus, risk resulting from higher moments likely plays an important role in bank production. (5) To simplify the discussion, we assume that the smaller bank operates efficiently; there­ fore, point A lies on the frontier rather than beneath it. See Hughes and Mester (2013b) for an analysis of how inefficiency is related to scale economies in banking. (6) La Porta, Lopez-de-Silanes, and Shleifer (2002) examine banking systems in ninety-two countries and find that government ownership is correlated with poorer countries and countries with less-developed financial systems, poorer protection of investors’ rights, more government intervention, and poorer performance of institutions. They also find that government ownership is associated with higher cost ratios and wider interest rate margins. Aghion, Alesina, and Trebbi (2007) provide evidence that democracy has a posi­ Page 33 of 36

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The Performance of Financial Institutions Modeling, Evidence, and some Policy Implications tive impact on productivity growth in more advanced sectors of the economy, possibly by fostering entry and competition. (7) This framework often guides the choice of outputs and inputs in the bank’s production structure. For example, as discussed in Mester (2008), the traditional application of effi­ ciency analysis to banking does not allow bank production decisions to affect bank risk, which rules out the possibility that scale- and scope-related improvements in diversifica­ tion could lower the cost of borrowed funds and induce banks to alter their risk exposure. Also, much of the traditional literature does not account for the bank’s role in producing information about its borrowers in its underwriting decisions when specifying the bank’s outputs and inputs. An exception is Mester (1992), who directly accounted for banks’ monitoring and screening role by measuring bank output, treating loans purchased and loans originated as separate outputs entailing different types of screening, and treating loans held on balance sheet and loans sold as separate outputs entailing different types of monitoring. (8) See Hughes et al. (2000) for further discussion of this model. (9) Note that the literature often uses the term “best-practice performance” and some­ times calls it “potential performance.” However, this is somewhat of an abuse of terms, since measured best-practice performance does not necessarily represent the best possi­ ble practice, but merely the best practice observed among banks in the sample (see Berg­ er and Mester, 1997; Mester, 2008). (10) See Dijkstra (2017, table 1, p. 29). (11) Note that the estimated profit (or return) function resembles a multi-factor model where the factors are the explanatory variables in the profit function. The regression co­ efficients can be interpreted as marginal returns to the explanatory variables, and the standard error of the predicted return, a function of the variance–covariance matrix of the estimated marginal returns, resembles the variance of a portfolio return. Hughes (1999) and Hughes, Mester, and Moon (2001) report that the regression of ln(market val­ ue of equity) on ln(E(πi/ki)) and ln(σi) for 190 publicly traded bank holding companies has an R-squared of 0.96, which implies that the production-based measures of expected re­ turn and risk explain a large part of a bank’s market value. For a regression of the market value of equity on E(πi/ki) and σi, Hughes and Mester (2013b) report R-squared values of 0.99, 0.94, and 0.97 for samples of data from 2003, 2007, and 2010, respectively. These values of R-squared are significantly higher than those obtained by regressing the market value on the accounting net income before and after taxes. (12) As discussed in Berger and Mester (1997), whether it is econometrically appropriate to include non-performing loans or loan losses in the cost or profit function depends on the extent to which these variables can be treated as exogenous. If the main driver of losses is economic shocks (bad luck), the variables could be considered exogenous. If losses largely reflect management decisions (e.g., management is inefficient or has made a conscious decision to cut short-run expenses by cutting back on loan origination and Page 34 of 36

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The Performance of Financial Institutions Modeling, Evidence, and some Policy Implications monitoring resources), then it may not be appropriate to treat the variables as exoge­ nous. To solve this problem, Berger and Mester (1997) use the ratio of nonperforming loans to total loans in the bank’s state as the control variable. The state average would be nearly entirely exogenous to any one bank, but can control for negative shocks that affect bank output quality. (13) See Dijkstra (2017, table 3, p. 38). (14) Demsetz and Strahan (1997) demonstrate that a larger scale of operations leads to better diversification of banking risk—in particular, bank-specific risk estimated from a multi-factor asset pricing model. To isolate this diversification effect, they regress bankspecific risk on asset size and find a small negative association. When they control for the many ways banks take risk, the relationship between risk and asset size becomes much more negative and statistically significant. They note that isolating the scale-related di­ versification effect requires controlling for differences in business strategies that influ­ ence risk exposure. Finding the effect of scale-related diversification on scale economies requires a similar approach to controlling for endogenous risk-taking. (15) See Brook, Hendershott, and Lee (1998), who investigate how the relaxation of inter­ state banking restrictions in the US improved bank performance. (16) As described previously, cost studies based on the mis-specified cost function that fails to account for potentially costly endogenous risk-taking are likely to underestimate scale economies. Using data from the 1980s, such studies typically failed to find evidence of scale economies except at the smallest banks. On the other hand, data obtained from the 1990s were more likely to yield estimates of scale economies at larger banks. Thus, even these estimates suggest technological advances. For a detailed catalogue of these studies, see Dijkstra (2017).

Joseph P. Hughes

Joseph P. Hughes is Professor of Economics at Rutgers University. He has been a Fel­ low of the Wharton Financial Institutions Center and a Visiting Scholar at the Feder­ al Reserve Bank of Cleveland, the Federal Reserve Bank of Philadelphia, the Federal Reserve Bank of New York, and the Office of the Comptroller of the Currency. His re­ search has been published in such journals as the American Economic Review, the Journal of Banking and Finance, the Journal of Economic Theory, the Journal of Fi­ nancial Intermediation, the Journal of Financial Services Research, the Journal of Money, Credit, and Banking, and the Review of Economics and Statistics. He re­ ceived his Ph.D from the University of North Carolina at Chapel Hill. Loretta J. Mester

Loretta J. Mester is president and chief executive officer of the Federal Reserve Bank of Cleveland. In addition, she is an Adjunct Professor of Finance at the Wharton School, University of Pennsylvania, and a fellow at the Wharton Financial Institutions Center. She is the managing editor of the International Journal of Central Banking Page 35 of 36

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The Performance of Financial Institutions Modeling, Evidence, and some Policy Implications and a co-editor of the Journal of Financial Services Research. In addition, she is an associate editor of several other academic journals and serves on the management committee of the International Journal of Central Banking. Her publications include research on the organizational structure and production efficiency of financial insti­ tutions, the theory and regulation of financial intermediation, agency problems in credit markets, credit card pricing, central bank governance, and inflation. Her re­ search has been published in the Journal of Finance, the American Economic Review, the Review of Financial Studies, and the Review of Economics and Statistics, among other journals. She received her Ph.D in economics from Princeton University.

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Technological Change and Financial Innovation in Banking: Some Implica­ tions for FinTech

Technological Change and Financial Innovation in Banking: Some Implications for FinTech   W. Scott Frame, Larry Wall, and Lawrence J. White The Oxford Handbook of Banking (3rd edn) Edited by Allen N. Berger, Philip Molyneux, and John O. S. Wilson Print Publication Date: Oct 2019 Subject: Economics and Finance, Financial Economics Online Publication Date: Nov 2019 DOI: 10.1093/oxfordhb/9780198824633.013.10

Abstract and Keywords Financial intermediation has changed dramatically over the past thirty years, due in large part to technological change. The chapter first describes the role of the financial system in a modern economy and how technological change and financial innovation can affect social welfare. We then survey the empirical literature relating to several specific finan­ cial innovations, broadly categorized as new production processes, new products or ser­ vices, or new organizational forms. In each case, we also include examples of significant FinTech innovations that are transforming various aspects of banking. Drawing on the lit­ erature on innovations from the 1990s and 2000s informs what we might expect from re­ cent developments. Keywords: banking, blockchain, financial innovation, FinTech, marketplace lenders, online banking, subprime lending, technological change

9.1 Introduction FINANCIAL intermediation has changed dramatically over the past thirty years, due in large part to technological change arising from advances in telecommunications, informa­ tion technology, and financial practice. This technological progress has spurred financial innovations that have altered many financial products, services, production processes, and organizational structures. To the extent that such financial innovations reduce costs or risks, social welfare may be improved. Of course, many financial innovations fail owing to fundamental design flaws or simply being replaced by better alternatives. A good example of technological change that has been dramatically reshaping the finan­ cial services industry is the ongoing shift from relying on human judgment to automated analysis of consumer data. This has taken what had been largely local markets for bank­ ing services and opened them up to nationwide competition from other banks and nonbank financial institutions. For example, retail loan applications are now routinely evalu­ ated using credit-scoring tools built using comprehensive historical credit registry data­ Page 1 of 27

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Technological Change and Financial Innovation in Banking: Some Implica­ tions for FinTech bases. This automated approach eliminates the need to have a local presence to make a loan and substantially reduces underwriting and compliance costs for lenders, and the re­ sulting data can be leveraged to improve further their risk measurement and manage­ ment. Such a reliance on hard information also makes underwriting transparent to third parties and hence facilitates secondary markets for retail loans (p. 263) through securiti­ zation, which allows non-bank firms that lack deposit funding to compete via capital mar­ ket financing. Given the growing importance of technology to financial services, it is perhaps not too surprising that the latest trend has been for technology-based firms to offer financial ser­ vices, a development that is often called “FinTech.” Many FinTech firms combine auto­ mated analysis of retail customers with more user-friendly interfaces to provide services that are more convenient, and sometimes a at lower cost, to consumers. For example, “marketplace lending” platforms have emerged as a new organizational form that attracts borrowers with a simplified loan application process, leverages credit scoring tools to an­ alyze these applications, and then matches creditworthy borrowers directly to investors. Furthermore, in some jurisdictions, machine learning (artificial intelligence) is now being leveraged to further improve retail loan risk measurement. Another set of recent technological developments is being touted as having the potential to have an even more fundamental impact on the financial system, potentially eliminating the need for trusted third parties such as banks. Whether, and to what extent, blockchains and cryptocurrencies will disrupt the existing financial system remains to be seen, as the technology is too new and immature to draw firm conclusions. However, the potential benefits of cryptocurrencies and blockchain technology are sufficient to attract considerable interest from tech-knowledgeable individuals, large financial organizations, and even major governments. This chapter surveys the research literature pertaining to several specific financial inno­ vations that have appeared in recent decades that were specifically driven by technologi­ cal change. Particular attention is paid to innovations that may provide insights into the prospects for certain widely discussed FinTech applications. To set the stage, we begin by providing some additional clarity about what is meant by financial innovation.

9.2 Financial Innovation: Definition and Deter­ minants As described by Merton (1992, p. 12), the primary function of a financial system is to fa­ cilitate the allocation and deployment of economic resources—both spatially and across time—in an uncertain environment. This function encompasses a payments system with a medium of exchange; the transfer of resources from savers to borrowers; the gathering of savings for pure time transformation; and the reduction of risk through insurance and di­ versification.

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Technological Change and Financial Innovation in Banking: Some Implica­ tions for FinTech The operation of a financial system involves real resources employed by financial interme­ diaries, and a large share of these resources is expended in the data collection and analy­ ses to deal with problems of asymmetric information. There are also uncertainties about future states of the world that generate risks that represent costs to risk-averse individu­ als. Hence, new or improved financial (i) production processes, (ii) products and ser­ vices, and (iii) organizational structures that can better satisfy financial system partici­ pants’ demand and reduce costs and risk processes, should generally be welcomed. Viewed in this context, Frame and White (2004) define a financial innovation as “some­ thing new that reduces costs, reduces risks, or provides an improved product/service/in­ strument that better satisfies financial system participants’ demands.” Importantly, Tu­ fano (2003) emphasizes that financial innovation includes the process of both invention (the ongoing research and development function) and diffusion (or adoption) of new prod­ ucts, services, or ideas. (p. 264)

The centrality of finance in an economy, and its importance for economic growth, natural­ ly raises the significance of financial innovations (and their diffusion).1 Finance facilitates virtually all production activity and much consumption activity; and so improvements in the financial sector can have direct positive implications for an economy. Moreover, an improved financial sector can encourage more and better saving and investment deci­ sions, making financial innovation even more valuable for an economy. This positive view of financial innovation has been discussed in a number of articles, including: Van Horne (1985), Miller (1986, 1992), Merton (1992, 1995), Berger (2003), Tufano (2003), and Frame and White (2004). However, the recent global financial crisis has led some ob­ servers to cast doubt on the usefulness of most financial innovation—seeing such activity as being largely associated with financial malpractice and instability (e.g., Krugman, 2007; Volcker, 2009).2 This negative view focuses on the “dark side” of financial innova­ tion, which some view as the root cause of the Global Financial Crisis of the late 2000s. While such a re-evaluation is natural in light of the crisis, it is important to recognize that not every financial innovation will be welfare-enhancing or successful. Innovation in­ volves trial and error, and failures can be costly—especially for widely diffused innova­ tions (e.g., Lerner and Tufano, 2011). So, financial innovation should more accurately be viewed as likely being beneficial “on net.” Consistent with these conjectures, Beck et al. (2016) conduct a cross-country analysis and find that financial innovation is associated with higher (but more volatile) economic growth and with greater bank fragility. Campbell (1988) offers four environmental conditions that are conducive to financial in­ novation: The first relates to underlying technologies and the ability of their improvement to increase efficiency. For example, the information technology revolution has facilitated the creation and use of “big data” and applied statistics for financial risk (p. 265) measure­ ment and management; and machine learning is now used to leverage the data further. A second condition is an unstable macroeconomic environment, as the concomitant fluctu­ ating asset prices are likely to spur risk-transfer innovations. A third condition is regula­ Page 3 of 27

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Technological Change and Financial Innovation in Banking: Some Implica­ tions for FinTech tion, which can inhibit some innovations and encourage others (often as a mechanism to avoid regulation). Finally, taxes can spur financial innovations to the extent that they cre­ ate incentives to repackage (or re-label) specific income streams so as to reduce tax lia­ bility. Over the past thirty years, each of these environmental conditions was markedly al­ tered and resulted in substantial changes to the practice of financial intermediation. The remainder of this chapter focuses mostly on Campbell’s first environmental condi­ tion: The role of technological change in driving financial innovation.

9.3 Process Innovation The past thirty years have witnessed important changes in financial institution production processes. The use of electronic transmission of bank-to-bank retail payments, which had modest beginnings in the 1970s, has exploded owing to greater retail acceptance, online banking, and check conversion. In terms of intermediation, credit bureau data have been used to create credit scores that increasingly substitute for manual underwriting—and this has been extended even into historically relationship-oriented products, such as small business loans. This trend toward hardening information has facilitated deep secondary consumer loan markets in the United States and has provided key inputs for risk management systems. Recently, the advent of blockchain/distributed ledger technology and significant advances in artificial intelligence/machine learning has raised important questions about the future of financial intermediation. We discuss each of these topics below.

9.3.1 Research Evidence from Past Process Innovations Automated Clearinghouse. An automated clearinghouse (ACH) is an electronic funds transfer network that connects banks and is primarily used for recurring, small-dollar payments. While several ACH networks emerged in the 1970s, volumes grew only mod­ estly through the 1980s, with the networks’ being used almost exclusively for direct pay­ roll deposits. Over the past twenty years, however, consolidation has occurred, and vol­ umes have soared. According to the National Automated Clearing House Association, in 2015 there were some 24 billion ACH payments totaling $41 trillion. The modest literature on ACH networks has focused on the Federal Reserve’s ACH pric­ ing policies. On the supply-side, Bauer and Hancock (1995) estimate a cost function and find that over the 1979–94 period the cost of processing an ACH item fell (p. 266) dramati­ cally—owing to scale economies, technological change, and lower input prices.3 Stavins and Bauer (1999), on the other hand, estimated ACH demand elasticities by exploiting FedACH price changes over time—finding ACH demand to be highly inelastic. More re­ cently, two papers studied network externalities for ACH. Gowrisankaran and Stavins (2004) find support for significant network externalities, which they ascribe to technologi­ Page 4 of 27

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Technological Change and Financial Innovation in Banking: Some Implica­ tions for FinTech cal advancement, peer-group effects, economies of scale, and market power. Ackerberg and Gowrisankaran (2006) identify large fixed costs of bank adoption as the barrier to greater use of ACH transactions and thus to society’s capturing the accompanying poten­ tial cost savings. Small Business Credit Scoring. Banks use a number of different approaches to lending to informationally opaque small businesses (Berger and Udell, 2006). One method that was introduced in the 1990s and continues to evolve is small business credit scoring (SBCS). This screening technology involves analyzing consumer data about the owner of the firm and combining it with relatively limited data about the firm itself, using statisti­ cal methods to predict future credit performance. Credit scores had long been pervasive in consumer credit markets (e.g., mortgages, credit cards, and automobile loans)—and re­ sulted in widely available, low-cost, commoditized credits that are often packaged and sold into secondary markets. The empirical literature that has studied SBCS has focused on the determinants of bank adoption and diffusion of this technology, as well as on how SBCS has affected credit availability. Two studies have statistically examined the determinants of the probability and timing of large US banks’ adoption of SBCS. Both Frame, Srinivasan, and Woosley (2001) and Akhavein, Frame, and White (2005) find an important role for size and organi­ zational structure in the adoption decision: Larger banking organizations with fewer bank charters and more bank branches were not only more likely to adopt, but also to adopt sooner. This suggests that large banks with a more “centralized” structure were more likely to adopt SBCS. More recent research suggests, however, that the use of credit scores for small business lending has subsequently diffused to small banks (Berger, Cow­ an, and Frame, 2007) and community development organizations (Fracassi et al., 2016). Several studies have focused on the relationship between SBCS adoption and credit avail­ ability. Three studies documented increases in the quantity of lending (Frame, Srinivasan, and Woosley, 2001; Frame, Padhi, and Woosley, 2004; Berger, Frame, and Miller, 2005). One found evidence that is consistent with more lending to relatively opaque, risky bor­ rowers (Berger, Frame, and Miller, 2005); another with increased lending within low-in­ come as well as high-income areas (Frame, Padhi, and Woosley, 2004); and another with lending over greater distances (DeYoung et al., 2011). In instances in which SBCS is used in conjunction with traditional underwriting methods to reduce information asymmetries, it is also shown to result in increased loan maturity (Berger et al., 2005) and reduced col­ lateral requirements (Berger et al., 2011). A continuing puzzle with respect to SBCS is why a secondary market for securi­ tized small business loans has not developed in the way that credit scoring for consumer loans led to securitization of those credits. (p. 267)

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Technological Change and Financial Innovation in Banking: Some Implica­ tions for FinTech

9.3.2 FinTech Process Innovations Blockchain/Distributed Ledgers. One new production process that is being touted as potentially revolutionizing banking (as well as other areas of finance and even broader ar­ eas of databases and contracts generally) is the blockchain and related technologies. In­ terest in blockchain technology was sparked by a white paper by Nakamoto (2008), which developed peer-to-peer “electronic cash” using blockchain technology that allowed elec­ tronic payments to be made without going through a financial intermediary. Nakamoto’s paper has sparked a variety of innovative initiatives. Some of these are intended to re­ place financial institutions, including commercial banks and even central banks. Other initiatives have more modest goals, such as improving the efficiency of existing financial intermediation. Blockchains are an example of a distributed ledger, or a database that is shared across nodes in a network. In a blockchain, data are added to the ledger in blocks that are or­ dered by time and linked to each other using cryptology.4 Blockchain technology is highly resistant to efforts to tamper with prior records in the database. Bitcoin, along with simi­ lar cryptocurrencies, uses blockchains to record ownership of a token (cryptocurrency) that its users value as a store of wealth and form of payment. In principle, these tokens could represent ownership of any asset, including physical assets such as gold or sover­ eign-issued fiat currency such as the US dollar. However, almost all cryptocurrencies are simply electronic tokens on a blockchain and do not represent a claim to any external as­ set. Distributed ledger technology is potentially useful wherever two or more parties need to share a common understanding about current conditions—such as who owns a particular asset or the terms of a financial contract to which they are both parties. Blockchains’ po­ tential for disrupting existing financial intermediaries arises from their ability to provide tamper-resistant records—indeed some claim the records are immutable. Catalini and Gans (2017) observe that an immutable record would facilitate costless verification and thereby facilitate new markets. In essence, the blockchain would substitute for the “trust­ ed-third-party” role that large payment intermediaries currently serve, and for which they often charge fees that—to casual observers and blockchain enthusiasts—seem relatively high. However, Cong and He (2018) note that blockchains (p. 268) could also be used to facilitate collusion. In addition, instead of trusting the “trusted-third party,” users must trust the technology and the developer of the technology. Unlike ACH, distributed ledgers do not necessarily benefit from network effects or exhibit economies of scale. The central concern—but also the potential source of disruption, as we discussed above—is how to determine which transactions are valid when there is no trusted central party to verify their authenticity. The solution adopted by some distributed ledgers is to limit the set of participants to a group of firms that have some trust in each other and some capital at risk if they are caught making invalid entries to the ledger, the so-called private, permissioned blockchains. Other distributed ledgers, especially the per­ missionless public blockchains, see openness to participation by any interested party as a Page 6 of 27

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Technological Change and Financial Innovation in Banking: Some Implica­ tions for FinTech key virtue. These blockchains benefit from network effects in that more people using the blockchain for more purposes increases the potential uses for all of the users. On the oth­ er hand, the very openness of these blockchains means that they must adopt measures that raise the cost of trying to change existing records. The way this is done by some blockchains, such as Bitcoin, has the effect of imposing limits on the number of transac­ tions that may be made on that blockchain—that is, imposing infinite diseconomies of scale beyond some transactions volume. Machine Learning. The increasing capability of artificial intelligence (AI) and machine learning (ML) is another important technological advance affecting banking in recent years. Although there are not universal definitions of AI and ML, for current purposes AI can be defined as the development of computer systems to perform tasks that ordinarily require human intelligence. This definition incorporates expert systems—where humans teach machines—and also machine learning, where the machines learn from data. Inter­ est in ML in particular has become increasingly popular, due to a combination of more digitized data, faster computers, and better algorithms to analyze data. ML is similar to statistics in that both seek to learn from the data and use many of the same tools, and the two disciplines are increasingly learning from each other. The biggest difference is that statistics has historically emphasized hypothesis testing and statistical inference, whereas ML emphasizes obtaining the best prediction. As a result, ML is not guided by economic (or other social sciences) theory (which would generate the hypothe­ ses for statistical testing), which has the advantage that ML sometimes identifies relation­ ships that are not (currently) predicted by theory. The disadvantage is that some of the relationships ML identifies will not be causal and, hence, may not be able to be usefully exploited. AI and ML are general-purpose technologies that may be used in a wide variety of areas within a financial institution. These include refinements to existing products, such as bet­ ter credit and risk management, tools for uncovering asset pricing anomalies, and help­ ing institutions comply with regulatory requirements—this is a related field called “RegTech.” However, AI and ML are also essential inputs into the creation of a variety of new financial services. At the consumer level, AI and ML are being used in personal fi­ nancial management products that analyze an individual’s expenses and revenues to pro­ vide recommendations that help users obtain their financial goals. Another new product that relies on AI and ML is a “robo-advisor,” which provides automated personalized (p. 269) investment advice and, with the customer’s agreement, automated portfolio selec­ tion and rebalancing based on each investor’s goals, financial assets, and risk tolerance. Machine learning algorithms generally benefit from access to large amounts of high qual­ ity data that are pertinent to the question they are addressing. According to Wall (2018c), firms that are able to assemble such datasets may have a competitive advantage that can be leveraged to increase their market shares and build even larger datasets. The author notes that one way of reducing this advantage is through the sharing of data across firms —provided that the sharing satisfies appropriate privacy concerns. Another way of reduc­ Page 7 of 27

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Technological Change and Financial Innovation in Banking: Some Implica­ tions for FinTech ing the advantage would be for governments to take the position that consumers own— that is, have property rights with respect to—their own data and have the right to share it as they choose, as is currently being done in the European Union under Payments Sys­ tems Directive 2 (sometimes called PSD2). Although there is extensive academic literature in computer science on AI and ML algo­ rithms and a growing body of literature on their application to finance, the academic liter­ ature on their application to new bank products, such as personal financial management and robo-advising, is not very well developed. The banking application that has received the most academic attention is credit analysis, which is discussed later in this chapter in the context of marketplace lending.

9.4 Product Innovation The increased reliance on hard information for lending decisions over time has improved credit market efficiency, as evidenced by greater use of risk-based pricing and expanded credit availability to marginal borrowers. However, the US subprime mortgage crisis raised questions about the efficacy of this approach, as a staggering number of such bor­ rowers defaulted on their home mortgages and lost their homes. The secular decline in the cost and quality of computing resources in recent decades, coupled with the Internet, resulted in substantial improvement in payment system efficiency. Most recently, blockchain and distributed ledger technology appears to have the potential to disrupt payments further through cryptocurrencies and initial coin offerings.

9.4.1 Research Evidence from Past Product Innovations Subprime Lending. Subprime lending to US households has become mainstream over the past few decades. As a general matter, these are loans to borrowers with weak credit histories and limited down payments available for financing homes and automobiles. His­ torically, such borrowers had been rationed out of fixed-price loan markets and were hence credit-constrained. However, the availability of large historical performance data­ bases has allowed for the development of statistical models that improve risk measure­ ment and facilitate risk-based loan pricing. Subprime lending has the potential (p. 270) benefit of expanding access to credit to potentially creditworthy borrowers who had pre­ viously been denied credit. However, it also raises the question about whether subprime borrowers are using expanded access wisely; and also whether the lenders are properly pricing and managing the increased risk exposure. The recent US mortgage crisis high­ lighted the personal and social costs associated with subprime lending in the face of a macroeconomic shock. Before discussing subprime mortgage lending in depth, we note some key recent empiri­ cal studies of subprime automobile and credit card lending. Two papers study the US sub­ prime auto loan market using loan-level data from a single institution. Evidence that ex­ panded access to credit may be valuable comes from Adams, Einav, and Levin (2009), who find that subprime auto loan demand is highly sensitive to down payment require­ Page 8 of 27

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Technological Change and Financial Innovation in Banking: Some Implica­ tions for FinTech ments and rises sharply during tax rebate season—consistent with the presence of credit constraints. Evidence that lenders are managing this risk may be found in their response to risk factors. Auto loan default rates are found to increase in loan size, and riskier bor­ rowers demand larger loans; but lenders are found to limit loan sizes and use credit scores to price risk-based borrowers in an effort to reduce moral hazard. Evidence that borrowers may not be using the credit wisely is found in a closely related paper by Einav, Jenkins, and Levin (2012). Using the same data as Adams, Einav, and Levin, they show how car prices have little effect on borrower purchase or down payment decisions, but rather simply translate into larger loans. For the lender, down payment re­ quirements create a tradeoff between loan volume and quality that is managed using credit scores to risk-base the pricing of these loans. Additional evidence that borrowers may not be using their expanded access wisely may be found from a study of subprime credit card lending by Alan and Loranth (2013). They study borrower price sensitivity us­ ing a randomized interest rate experiment for existing loans. The authors find that for a large increase in interest rates (five percentage points), overall credit demand declines only modestly for their sample. These results reflect substantial heterogeneity as the low­ est-risk borrowers reduce credit demand significantly, while the highest-risk borrowers do not.5 As for the subprime mortgage market: The boom in subprime mortgage lending demon­ strates the extent to which borrowers were taking advantage of the expanded access. During that time, the US subprime mortgage market grew rapidly and averaged about 20 percent of residential mortgage originations between 2004 and 2006. This credit boom fa­ cilitated an expansion in the pool of potential homeowners and helped to lead the US to a record homeownership rate in 2004 of 69.2 percent—even in the face of declining hous­ ing affordability in many areas of the country. The number of outstanding subprime mort­ gages ultimately peaked at $1.2 trillion in 2007, but has declined steadily since the onset of the market meltdown as new loan originations ceased.6 Whether borrowers were using their access wisely or were being exploited is the subject of ongoing debate. Some of the early arguments that borrowers were being ex­ (p. 271)

ploited were based on a comparison of the structure of subprime mortgages versus those taken by prime borrowers. A thirty-year fixed rate loan with an embedded prepayment option is the most common type of residential mortgage in the US. By contrast, the typi­ cal subprime mortgage during the housing boom was a thirty-year adjustable rate mort­ gage (with a fixed rate for the initial two to three years) that included a prepayment penalty. Mayer, Pence, and Sherlund (2009) provide a set of “subprime mortgage facts” through the financial crisis period, including information about various loan contract structures, the degree of underwriting documentation, the presence of second liens, and the borrower occupancy status.7 However, the mere fact that subprime contract terms were different from those on prime mortgages does not mean that subprime borrowers were being exploited. A series of theoretical papers by Piskorski, and Tchistyi (2010,

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Technological Change and Financial Innovation in Banking: Some Implica­ tions for FinTech 2011), and Mayer, Piskorski, and Tchistyi (2013) suggest that subprime borrowers bene­ fited from the contract terms that distinguish their mortgages from prime mortgages. Another hypothesis is that reliance on the originate-to-distribute model created a moral hazard problem for loan underwriters (e.g., Ashcraft and Schuermann, 2008). A large fraction of the subprime loans were packaged together and sold as securities, transfer­ ring a substantial fraction of the credit risk from underwriters to investors. As a result, underwriters were not sufficiently rigorous in underwriting subprime mortgages. One line of inquiry focuses on the quality of loan-level information provided to investors. For example, Piskorski, Seru, and Witken (2015) provide evidence that there was incomplete information about the presence of subordinate financing (i.e., second liens). Jiang, Nel­ son, and Vytlacil (2014) and Griffin and Maturana (2016) find that borrowers misrepre­ sented their income and occupancy status, respectively. According to Griffin and Matu­ rana (2016) such data problems led to higher default propensities and loss severities than would have otherwise been the case. However, it is not clear that the deleterious effects were disproportionately borne by out­ side investors. Papers by Jiang, Nelson, and Vytlacil (2013) and Elul (2016) suggest that securitized and non-securitized subprime loans performed similarly (conditional on ob­ servable information) due to investor-required loan seasoning prior to securitization. There is also research that suggests that subprime mortgage lenders were lax in their screening of applicants with FICO credit scores above 620 (Keys et al., 2010; Keys, Seru, and Vig, 2012), although this interpretation has recently come into doubt (Bubb and Kauf­ man, 2014).8 See Frame (2018) for a review of the literature pertaining to agency con­ flicts in residential mortgage securitization. Another hypothesis is that borrowers and lenders acted rationally, given their ex­ pectations for residential real estate price appreciation. That is, the greater risk of dis­ (p. 272)

tress among subprime borrowers was not a problem so long as house prices continued to appreciate. Distressed borrowers with positive equity could borrow against this equity or simply sell the home and pocket any net proceeds. Hence, negative equity (owing more than the home is worth) is a necessary condition for mortgage default (see, for example, Foote, Gerardi, and Willen, 2008). The problem is that the massive expansion of subprime mortgage lending in the mid-2000s was concurrent with rapid house price appreciation, and both borrowers and lenders began to form unreasonably favorable expectations about future home price growth (e.g., Brueckner, Calem, and Nakamura, 2012). Escalat­ ing prices reduced housing affordability, and an assumption of continued future price growth would have made parties more comfortable with extreme leverage as borrowers would be expected to “grow out of it” soon. In this view, the declining underwriting stan­ dards likely emanated from the recent and expected growth in home prices, which seem­ ingly masked the heightened risk (Bhardwaj and Sengupta, 2014). Once housing prices stopped appreciating and then started declining, distressed borrowers were unable to sell or remortgage their house, leading to the observed sharp increase in delinquencies and foreclosures.

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Technological Change and Financial Innovation in Banking: Some Implica­ tions for FinTech Thus, subprime lending in general has seemingly been successful at expanding credit availability to marginal borrowers. However, that success in residential mortgage lending depended to a very large degree on the factor that was ultimately its downfall: a depen­ dence on expectations of increasing housing prices. This experience is a reminder that it often takes an economic downturn to reveal fully the weaknesses in an innovation. Whether privately financed subprime lending on a smaller scale could have been a suc­ cessful product absent the boom is unclear. What is clear is that the combination of the scale and scope of the recent crisis, the findings of negligence and malfeasance, the polit­ ical and legal uncertainty, and the sensitivity to housing displacement among vulnerable populations mean that private subprime mortgage lending is unlikely to return en masse anytime soon.9

9.4.2 Payment Services Recent retail banking service innovations primarily relate to enhanced deposit account access and new methods of payment—each of which better meets consumer demands for convenience and ease. Debit cards, which bundle ATM access with the ability to make payments from a bank account at the point-of-sale, became ubiquitous in the 1990s. In the 2000s, online banking, which allows customers to monitor accounts and originate payments using “electronic bill payment,” became widely used. Notably, (p. 273) besides improving convenience and ease, retail payment innovations may also improve access to the banking system for unbanked consumers (e.g., Gross, Hogarth, and Schmeiser, 2012; Hayashi, 2016). Debit Cards. Debit cards are essentially “pay-now” instruments linked to a checking ac­ count whereby transactions can happen either instantaneously using online (PIN-based) methods or in the near future with offline (signature-based) methods. Consumers typical­ ly have the choice of using online or offline methods, and their selection often hinges on the respective benefits: Online debit allows the cardholder also to withdraw cash at the point-of-sale, while offline provides float. According to the US Federal Reserve (2016), there were approximately 69.5 billion debit transactions in the US during 2012 that to­ taled almost $2.6 trillion. Much of the research that pertains to debit cards relates to identifying the most likely users of this payment instrument. Such demand-side explorations have been conducted individually as well as jointly across multiple payment options. Stavins (2001), for exam­ ple, uses data from the 1998 Survey of Consumer Finances (SCF) and finds that debit us­ age is positively related to educational attainment, homeownership status, marital status, business ownership, and being a white collar worker; and usage is negatively related to age and net worth. Klee (2006) extends this analysis to consider the 1995, 1998, and 2001 SCFs and reports a secular increase in adoption driven by similar demographic fac­ tors.10 Additional US evidence is provided by: Mantel and McHugh (2001), who use sur­ vey data from Vantis International; Hayashi and Klee (2003), who use data from a 2001 survey conducted by Dove Consulting; Borzekowski and Kiser (2008) and Borzekowski, Kiser, and Ahmed (2008), who use 2004 data from the Michigan Surveys of Consumers; Page 11 of 27

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Technological Change and Financial Innovation in Banking: Some Implica­ tions for FinTech and Hayashi and Stavins (2012), who use the Federal Reserve Bank of Boston’s Consumer Payment Choice surveys. Some additional analysis by Hayashi and Klee (2003) studied the circumstances under which consumers are likely to use debit cards and found that these are more often used at grocery stores and gas stations than at restaurants. Related to this, the authors also find that debit card usage is positively related to the incidence of self-service transac­ tions. Zinman (2009) finds that the choice of debit cards is positively related to being near credit card balance limits; and Fusaro (2013) shows that debit cards are used to pay-down credit card balances. Finally, Hayashi and Stavins (2012) provide evidence that a recent US law raising the cost of debit card transactions had an especially negative ef­ fect on low credit score consumers, who tend to have lower and more volatile incomes and to be less educated. Online Banking. As households and firms rapidly adopted Internet access during the late 1990s, commercial banks established an online presence. According to DeYoung (2005), the first bank websites were launched in 1995; and by 2002 nearly one-half of all US banks and thrifts operated transactional websites. Today virtually all US commercial banks offer transactional websites. The primary line of research that related to online banking has been aimed at un­ derstanding the determinants of bank adoption and how the technology has affected bank (p. 274)

performance. In terms of online adoption, Furst, Lang, and Nolle (2002) found that US banks were more likely to offer transactional websites if they were: larger, younger, affili­ ated with a holding company, located in an urban area, and had higher fixed expenses and non-interest income. Hernandez-Murillo, Llobet, and Fuentes (2010) later confirmed many of these findings using updated data, but also found that online adoption was posi­ tively related to county-level demographics (median household income, education, Inter­ net access) and market concentration and was negatively related to additional bank char­ acteristics (branching intensity, ratio of capital-to-total assets, and non-performing loans). Finally, Dow (2007) analyzes data for US credit unions and finds that online banking adoption is related to institution size and having a lower proportion of non-performing loans. On the flip side, Goddard, McKillop, and Wilson (2009) find that credit unions that do not provide transactional websites are more likely to fail and/or be acquired. With respect to online bank performance, DeYoung, Lang, and Nolle (2007) report that In­ ternet adoption improved US community bank profitability—primarily through deposit-re­ lated charges. In a related study, Hernando and Nieto (2007) find that, over time, online banking was associated with lower costs and higher profitability for a sample of Spanish banks. Both papers conclude that the Internet channel is a complement to—rather than a substitute for—physical bank branches. Additional evidence is offered by Ciciretti, Hasan, and Zazzara (2009), who also find that Italian banks that offered Internet-related services had higher profitability (and stock returns) relative to their peers. However, a contempo­ raneous study of US credit unions found no relationship between online banking adoption

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Technological Change and Financial Innovation in Banking: Some Implica­ tions for FinTech and profitability, but did find significantly higher operating expenses (Dandapani, Karels, and Lawrence, 2008). Other studies examine the demand-side for online banking services. Mantel (2000) stud­ ies the demographic characteristics of users of electronic/online bill payment. Among oth­ er things, the author finds that electronic bill payers tend to be: older, female, higher in­ come, and homeowners. Bauer and Hein (2006), who analyze data from the Survey of Consumer Finances, find that younger customers and those with previous experience with remote banking technologies are more likely to use online banking.

9.4.3 FinTech Product Innovations Two specific applications of blockchain technology—cryptocurrencies and initial coin of­ ferings—have garnered the most attention from the public and academics.11 Bitcoin, the oldest and largest blockchain (by market value in July 2018), has been studied from a va­ riety of perspectives. Huberman, Leshno, and Moallemi (2017) observe that no one (p. 275) owns Bitcoin and that the blockchain’s protocol is “almost immutable.” This raises the question of the underlying economics of the system: Specifically, what is the source of the revenue for financing Bitcoin’s operations? The answer is that the equilibrium level of transaction fees and infrastructure level is set by a congestion queuing game arising from limits set by the Bitcoin protocol on the blockchain’s throughput (transactions volume). Budish (2018) analyzes the economics of Bitcoin’s operations in terms of the incentive of infrastructure-providers (called “miners”) to rewrite the blockchain in a way that would allow them to spend the same Bitcoin twice. He notes that Bitcoin has not been subject to such a successful attack through mid-2018 but argues that this is due in part because the size of Bitcoin transactions has been small, limiting the gains from double-spending. Bitcoin and some other cryptocurrencies are being traded against each other and against some sovereign-issued fiat currencies (such as the US dollar), prompting the develop­ ment of a small amount of literature analyzing the returns, and return volatility, of cryp­ tocurrencies.12 However, most cryptocurrency trading takes place outside the direct su­ pervision of securities regulators and, thus, may be more open to manipulation than are financial instruments that trade on securities and derivatives exchanges. Gandal et al. (2018) analyze pricing data on one of the cryptocurrency exchanges, Mt. Gox, and find that prices rose an average of four percent on days with suspicious trades but were slightly down on days without such trading. Similarly, Griffin and Shams (2018) find evi­ dence consistent with market manipulation. Along with cryptocurrencies, a popular use of blockchain tokens is as a vehicle for obtain­ ing financing for start-up technology firms. Indeed, this form of financing—called initial coin offerings (ICOs)—provided more start-up financing than did venture capitalists in June and July of 2017.13 Catalini and Gans (2018) analyze ICOs where the token on sale may be redeemed for the firm’s product (which is the form the tokens often take) and find that tokens may help entrepreneurs by revealing aspects of consumer demand. Howell, Niessner, and Yermack (2018) analyze post-issuance transaction data for tokens listed on Page 13 of 27

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Technological Change and Financial Innovation in Banking: Some Implica­ tions for FinTech CoinMarketCap and find that liquidity is greater for issuers that engage in voluntary dis­ closure and credibly commit to the project.

9.5 Organizational Innovation New organizational forms for financial institutions have emerged in the United States and other countries over the past few decades. While some of these forms arose from (p. 276) regulatory developments, two related structures—Internet-only banks and marketplace lenders—are directly tied to technological change. Internet-Only Banks. The rapid rise in Internet access and usage during the 1990s cre­ ated the possibility of a new organizational form for intermediaries: the Internet-only (or Internet-primary) banks. Research by Delgado, Hernando, and Nieto (2007) reports that, as of mid-year 2002, there were some thirty-five Internet-only banks operating in Europe and another twenty in the US. In Europe, virtually all of these banks were affiliated with existing institutions, while in the US they tended to be de novo operations. This may ex­ plain why US-based Internet-only banks have disappeared (through acquisition, liquida­ tion, or closure) or established a physical presence to supplement their Internet base. DeYoung (2001, 2005) finds that, as compared with conventional de novo banks, the In­ ternet de novo banks are less profitable due to low business volumes (fewer deposits and lower non-interest income) and high labor expenditures. However, the author also reports that the financial performance gaps narrow quickly over time due to scale effects. Relat­ edly, Cyree, Delcoure, and Dickens (2009) find that Internet-primary banks are larger and have lower net interest margins and loan losses. Delgado, Hernando, and Nieto (2007) re­ port that European Internet banks demonstrate technology-based scale economies. Although Internet-only banks failed to take hold in the early 2000s, new opportunities opened for innovative organizational forms in the 2010s as a result of two developments: (i) the continuing advance of technology; and (ii) the need to recover from the 2007–9 fi­ nancial crisis in the US and from the sovereign debt crisis in the EU that started in 2009. The introduction of the iPhone in 2007 was one marker of the continuing advancement of a broad array of technologies.14 These advances allowed technology firms to enter a wide variety of commercial and financial activities, often providing superior service to that pro­ vided by incumbent firms. Moreover, while technology firms were looking for profitable opportunities to disrupt existing industries, the need to recover from the financial crisis distracted bank management and reduced the resources that banks had to invest in new technology and to make new loans. One of the most well-known sets of new online finan­ cial institutions is marketplace lenders. Marketplace Lenders. Marketplace lenders, which match consumers and small firms as borrowers with lenders/investors using online platforms, have been popping up all over the world. In the United States, these lending arrangements generally work in the follow­ ing way: First, borrowers apply on the platform and are subject to automated underwrit­ ing based on standard criteria (such as a credit score) plus additional information, and as­ Page 14 of 27

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Technological Change and Financial Innovation in Banking: Some Implica­ tions for FinTech signed a proprietary risk rating. Second, institutional investors purchase loans in (p. 277) bulk from the marketplace lenders, principally based on the risk ratings.15 The online marketplaces themselves generally have no direct exposure to the credit risk of the loans through their platforms, as they do not typically hold the loans or otherwise retain an in­ terest in them or guarantee their performance.16 Instead, marketplace lenders principally generate revenue from loan origination and servicing fees. Marketplace lending is grow­ ing rapidly, but it remains a very small part of the $3.3 trillion US consumer lending mar­ ket. Much of what constitutes marketplace lending is actually not new. As discussed above, for many years, larger banks and finance companies have used credit registry data, credit scores, and borrower income information as inputs for statistical models to estimate risk and price consumer loans. However, marketplace lenders appear to be increasingly sup­ plementing their models with additional information. Jagtiani and Lemieux (2018) find that LendingClub’s credit scores had an 80 percent correlation with FICO scores in 2007, but that the correlation drops about 35 percent for loans originated in 2014–15. The au­ thors suggest that the change is likely due to LendingClub using a combination of alterna­ tive data and machine learning as the platform gains more experience with consumer lending.17 In complementary research that uses information from Prosper (which is a prominent marketplace lender), Balyuk and Davydenko (2018) discuss that lender’s use of secondary screening to identify suspicious applications and to verify automatically some borrower-provided information. The authors report that this additional screening has led to the cancellation of 27 percent of the previously accepted loan applications since 2013. Vallee and Zeng (2018) observe that, while the FinTech platforms are using their own models to grade loans and determine credit spreads, informationally sophisticated in­ vestors may be able to differentiate credit quality within these ratings grades. The au­ thors derive a model allowing for such a split in investor sophistication, which results in a trade-off for the platform in terms of the contribution of sophisticated investors in improv­ ing loan quality but also creating adverse selection for less sophisticated investors. The volume-maximizing solution for the platform is to provide intermediate levels of screening and information to investors. Consistent with their model, the authors find that loans pur­ chased by more informationally sophisticated investors were less likely to (p. 278) default for the universe of investments made through LendingRobot from 2014–17.18 They also observe that one marketplace lender, LendingClub, reduced the amount of information it provided to investors and this caused a reduction in the ability of sophisticated investors to “cherry-pick” loans with lower default rates. Beyond marketplace lenders specifically, there has been a general increase in online lend­ ing. According to Fuster et al. (2018), FinTech mortgage lenders have increased their market share from 2 to 8 percent between 2010 and 2016. The authors find the biggest benefit provided by FinTech lenders is an average reduction in the time from application to closing of ten days (20 percent) after controlling for borrower and loan characteristics.

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Technological Change and Financial Innovation in Banking: Some Implica­ tions for FinTech They also find that FinTech lenders can scale up the volume of mortgages they process more readily than can other lenders. The information technology underlying such an automated approach to underwriting is subject to significant scale economies (large fixed costs and very low marginal costs), which provides strong incentives to grow large quickly. This suggests that the consolida­ tion of the marketplace lending industry is very likely. Moreover, as marketplace lenders become more successful, they are likely to find themselves facing increased competition from incumbent consumer lenders.

9.6 Conclusions This chapter reviewed some of the more developed literature relating technological change and financial innovation in banking over the past thirty years. In terms of process and product innovations, the empirical research record provides us with information about the characteristics of users and adopters of technology-driven financial innovations and the attendant welfare implications. Faster computing and widespread adoption of the Internet has resulted in a more efficient payment system with related product innovations quickly diffusing to a large part of the population. Technological change has also trans­ formed consumer lending by moving from human to automated underwriting based on credit scores and other pieces of hard information. This has resulted in expanded credit availability along both intensive and extensive margins. The recent emergence of FinTech has greatly expanded interest in financial innovation as new products, services, production processes, and organizational forms are being created and deployed. Blockchain and distributed ledger technologies are currently being used for the issuance and transfer of widely distributed cryptocurrencies as well as for earlystage funding for technology companies via initial coin offerings. Artificial intelligence and machine learning are being used: in lending environments for (p. 279) marketing and monitoring account activity; to provide low-cost advisement services; and to further im­ prove credit decisions through the use of expanded information. This is a very exciting time to study financial innovation and the continued evolution of the banking business.

References Ackerberg, D. A. and Gowrisankaran, G. (2006). “Quantifying Equilibrium Network Exter­ nalities in the ACH Banking Industry,” RAND Journal of Economics, 37(3), 738–61. Adams, W., Einav, L., and Levin, J. (2009). “Liquidity Constraints and Imperfect Informa­ tion in Subprime Lending,” American Economic Review, 99(1), 49–84. Akhavein, J., Frame, W. S., and White, L. J. (2005). “The Diffusion of Financial Innovations: An Examination of the Adoption of Small Business Credit Scoring by Large Banking Orga­ nizations,” Journal of Business, 78(2), 577–96.

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Technological Change and Financial Innovation in Banking: Some Implica­ tions for FinTech Alan, S. and Loranth, G. (2013). “Subprime Consumer Credit Demand: Evidence from a Lender’s Pricing Experiment,” Review of Financial Studies, 26(9), 2353–74. Anguelov, C. E., Hilgert, M. A., and Hogarth, J. M. (2004). “US Consumers and Electronic Banking: 1995–2003,” Federal Reserve Bulletin, 90(1), 1–18. Arestis, P., Demetriades, P. O., and Luintel, K. B. (2001). “Financial Development and Eco­ nomic Growth: The Role of Stock Markets,” Journal of Money, Credit, and Banking, 33(1), 16–41. Ashcraft, A. and Schuermann, T. (2008). “Understanding the Securitization of Subprime Mortgage Credit,” Federal Reserve Bank of New York Staff Report No. 318, March. Athey, S., Parashkevov, I., Sarukkai, V., and Xia, J. (2016). “Bitcoin Pricing, Adoption, and Usage: Theory and Evidence,” Stanford Working Paper, available at: https:// www.gsb.stanford.edu/gsb-cmis/gsb-cmis-download-auth/423411. Ausubel, L. M. (1991). “The Failure of Competition in the Credit Card Market,” American Economic Review, 81(1), 50–81. Balyuk, T. and Davydenko, S. (2018). “Reintermediation in FinTech: Evidence from Online Lending,” available at SSRN: https://papers.ssrn.com/sol3/papers.cfm? abstract_id=3189236. Bauer, K. and Hein, S. (2006). “The Effect of Heterogeneous Risk on the Early Adoption of Internet Banking Technologies,” Journal of Banking and Finance, 20(10), 1713–25. Bauer, P. W. and Ferrier, G. D. (1996). “Scale Economies, Cost Efficiencies, and Technolog­ ical Change in Federal Reserve Payment Processing,” Journal of Money, Credit, and Bank­ ing, 28(4), 1004–39. Bauer, P. W. and Hancock, D. (1995). “Scale Economies and Technological Change in Fed­ eral Reserve ACH Payment Processing,” Economic Review, Federal Reserve Bank of Cleveland, 31(3), 14–29. Beck, T., Chen, T., Lin, C., and Song, F. M. (2016). “Financial Innovation: The Bright and the Dark Sides,” Journal of Banking and Finance, 72, 28–51. Beck, T. and Frame, W. S. (2018). “Technological Change, Financial Innovation, and Eco­ nomic Development,” in T. Beck and R. Levine (eds.), Handbook of Finance and Develop­ ment (Cheltenham: Edward Elgar), 369–390. Beck, T. and Levine, R. (2004). “Stock Markets, Banks, and Growth: Panel Evidence,” Journal of Banking and Finance, 28(3), 423–42. Beck, T., Levine, R., and Loayza, N. (2000). “Finance and the Sources of Growth,” Journal of Financial Economics, 58(1–2), 261–300.

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Technological Change and Financial Innovation in Banking: Some Implica­ tions for FinTech Berg, T., Burg, V., Gombovic, A., and Puri, M. (2018). “On the Rise of FinTechs— Credit Scoring using Digital Footprints,” available at SSRN: https://papers.ssrn.com/ sol3/papers.cfm?abstract_id=3163781. (p. 280)

Berger, A. N. (2003). “The Economic Effects of Technological Progress: Evidence from the Banking Industry,” Journal of Money, Credit and Banking, 35(2), 141–76. Berger, A. N., Cowan, A., and Frame, W. S. (2007). “The Surprising Use of Credit Scoring in Small Business Lending by Community Banks and the Attendant Effects on Credit Availability, Risk, and Profitability,” Journal of Financial Services Research, 39(1–2), 1–17. Berger, A. N., Espinosa-Vega, M., Frame, W. S., and Miller, N. (2005). “Debt Maturity, Risk, and Asymmetric Information,” Journal of Finance, 60(6), 2895–923. Berger, A. N., Espinosa-Vega, M., Frame, W. S., and Miller, N. (2011). “Why Do Borrowers Pledge Collateral? New Empirical Evidence on the Role of Asymmetric Information,” Jour­ nal of Financial Intermediation, 20(1), 55–70. Berger, A. N., Frame, W. S., and Miller, N. (2005). “Credit Scoring and the Availability, Price, and Risk of Small Business Credit,” Journal of Money, Credit, and Banking, 37(2), 191–222. Berger, A. N. and Udell, G. F. (2006). “A More Complete Conceptual Framework for SME Finance,” Journal of Banking and Finance, 30(11), 2945–66. Bhardwaj, G. and Sengupta, R. (2014). “Subprime Cohorts and Loan Performance,” Jour­ nal of Banking and Finance, 41(2), 236–52. Borzekowski, R. and Kiser, E. (2008). “The Choice at the Checkout: Quantifying Demand Across Payment Instruments,” International Journal of Industrial Organization, 26(4), 889–902. Borzekowski, R., Kiser, E., and Ahmed, S. (2008). “Consumers’ Use of Debit Cards: Pat­ terns, Preferences, and Price Response,” Journal of Money, Credit, and Banking, 40(1), 149–72. Brueckner, J., Calem, P., and Nakamura, L. (2012). “Subprime Mortgages and the Housing Bubble,” Journal of Urban Economics, 71(2), 230–43. Bubb, R. and Kaufman, A. (2014). “Securitization and Moral Hazard: Evidence from Cred­ it Score Cutoff Rules,” Journal of Monetary Economics, 63(1), 1–18. Budish, E. (2018). “The Economic Limits of Bitcoin and the Blockchain,” National Bureau of Economic Research Paper No. 24717. Campbell, T. S. (1988). Money and Capital Markets (Glenview, IL: Scott, Foresman).

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Technological Change and Financial Innovation in Banking: Some Implica­ tions for FinTech Catalini, C. and Gans, J. S. (2017). “Some Simple Economics of the Blockchain,” available at SSRN: https://ssrn.com/abstract=2874598 or http://dx.doi.org/10.2139/ssrn. 2874598. Catalini, C. and Gans, J. S. (2018). “Initial Coin Offerings and the Value of Crypto Tokens,” available at SSRN: https://ssrn.com/abstract=3137213 or http://dx.doi.org/10.2139/ ssrn.3137213. Ciciretti, R., Hasan, I., and Zazzara, C. (2009). “Do Internet Activities Add Value? Evi­ dence from Traditional Banks,” Journal of Financial Services Research, 35(1), 81–98. Cong, L. W. and He, Z. (2018). “Blockchain Disruption and Smart Contracts,” NBER Work­ ing Paper No. w24399, available at SSRN: https://ssrn.com/abstract=3138382. Cyree, K. B., Delcoure, N., and Dickens, R. (2009). “An Examination of the Performance and Prospects for the Future of Internet-Primary Banks,” Journal of Economics and Fi­ nance, 33(2), 128–47. Dandapani, K., Karels, G. V., and Lawrence, E. R. (2008). “Internet Banking Services and Credit Union Performance,” Managerial Finance, 34(6), 437–46. Delgado, J., Hernando, I., and Nieto, M. J. (2007). “Do European Primarily Internet Banks Show Scale and Experience Efficiencies?” European Financial Management, 13(4), 643– 71. DeYoung, R. (2001). “The Financial Performance of Pure Play Internet Banks,” Economic Perspectives, Federal Reserve Bank of Chicago, 25(Q1), 60–75. (p. 281)

DeYoung, R. (2005). “The Performance of Internet-Based Business Models: Evi­

dence from the Banking Industry,” Journal of Business, 78(3), 893–947. DeYoung, R., Frame, W. S., Glennon, D. and Nigro, P. (2011). “The Information Revolution and Small Business Lending: The Missing Evidence,” Journal of Financial Services Re­ search, 39(1–2), 19–33. DeYoung, R., Lang, W. W., and Nolle, D. L. (2007). “How the Internet Affects Output and Performance at Community Banks,” Journal of Banking and Finance, 31(4), 1033–60. Dow, J. P. (2007). “The Adoption of Web Banking at Credit Unions,” Quarterly Review of Economics and Finance, 47(3), 435–48. Einav, L., Jenkins, M., and Levin, J. (2012). “Contract Pricing in Consumer Credit Mar­ kets,” Econometrica, 80(4), 1387–432. Elul, R. (2016). “Securitization and Mortgage Default,” Journal of Financial Services Re­ search, 49(2), 281–309. Foote, C. L., Gerardi, K., and Willen, P. (2008). “Negative Equity and Foreclosure: Theory and Evidence,” Journal of Urban Economics, 64(2), 234–45. Page 19 of 27

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Technological Change and Financial Innovation in Banking: Some Implica­ tions for FinTech Fracassi, C., Germaise, M., Kogan, S., and Natividad, G. (2016). “Business Microloans for U.S. Subprime Borrowers,” Journal of Financial and Quantitative Analysis, 51(1), 55–83. Frame, W. S. (2018). “Agency Conflicts in Residential Mortgage Securitization: What Does the Empirical Literature Tell Us?” Journal of Financial Research, 41(2), 237–51. Frame, W. S., Padhi, M., and Woosley, L. (2004). “The Effect of Credit Scoring on Small Business Lending in Low- and Moderate-Income Areas,” Financial Review, 39(1), 35–54. Frame, W. S., Srinivasan, A., and Woosley, L. (2001). “The Effect of Credit Scoring on Small Business Lending,” Journal of Money, Credit, and Banking, 33(3), 813–25. Frame, W. S. and White, L. J. (2004). “Empirical Studies of Financial Innovation: Lots of Talk, Little Action?” Journal of Economic Literature, 42(1), 116–44. Furst, K., Lang, W., and Nolle, D. (2002). “Internet Banking,” Journal of Financial Services Research, 22(1–2), 95–117. Fusaro, M. (2013). “Why do People Use Debit Cards: Evidence from Checking Accounts?” Economic Inquiry, 51(4), 1986–2001. Fuster, A., Plosser, M., Schnabl, P., and Vickery, J. (2018). “The Role of Technology in Mortgage Lending,” Federal Reserve Bank of New York Staff Report No. 836. Gandal, N., Hamrick, J. T., Moore, T., and Oberman, T. (2018). “Price Manipulation in the Bitcoin Ecosystem,” Journal of Monetary Economics, 95, 86–96. Gennaioli, N., Shleifer, A., and Vishny, R. (2012). “Neglected Risks, Financial Innovation, and Financial Fragility,” Journal of Financial Economics, 104(3), 452–68. Gerardi, K., Lehnert, A., Sherlund, S. M., and Willen, P. (2008). “Making Sense of the Subprime Mortgage Crisis,” Brookings Papers on Economic Activity, 2, 69–159. Goddard, J., McKillop, D., and Wilson, J. O. S. (2009). “Which Credit Unions Are Ac­ quired?” Journal of Financial Services Research, 36(2–3), 231–52. Gowrisankaran, G. and Stavins, J. (2004). “Network Externalities and Technology Adop­ tion: Lessons from Electronic Payments,” RAND Journal of Economics, 35(2), 260–76. Griffin, J. and Maturana, G. (2016). “Did Dubious Mortgage Origination Practices Distort House Prices?” Review of Financial Studies, 29(7), 1671–708. Griffin, J. M. and Shams, A. (2018). “Is Bitcoin Really Un-Tethered?” Available at SSRN: https://ssrn.com/abstract=3195066 or http://dx.doi.org/10.2139/ssrn.3195066. Gross, M., Hogarth, J., and Schmeiser, M. (2012). “Use of Financial Services by the Un­ banked and Underbanked and the Potential for Mobile Financial Services Adoption,” Fed­ eral Reserve Bulletin, 98(4), 1–20.

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Technological Change and Financial Innovation in Banking: Some Implica­ tions for FinTech Hayashi, F. (2016). “Access to Electronic Payments Systems by Unbanked Con­ sumers”, Federal Reserve Bank of Kansas City, Economic Review, 101(3), 5–30. (p. 282)

Hayashi, F. and Klee, E. (2003). “Technology Adoption and Consumer Payments: Evidence from Survey Data,” Review of Network Economics, 2(2), 175–90. Hayashi, F. and Stavins, J. (2012). “Effects of Credit Scores on Consumer Payments Choice,” Federal Reserve Bank of Kansas City Working Paper 2012–13. Henderson, B. J. and Pearson, N. D. (2011). “The Dark Side of Financial Innovation: A Case Study of the Pricing of a Retail Financial Product,” Journal of Financial Economics, 100(2), 227–47. Hernández-Murillo, R., Llobet, G., and Fuentes, R. (2010). “Strategic Online Banking Adoption,” Journal of Banking and Finance, 34(7), 650–1663. Hernando, I. and Nieto, M. J. (2007). “Is the Internet Delivery Channel Changing Banks’ Performance? The Case of Spanish Banks,” Journal of Banking and Finance, 31(4), 1083– 99. Howell, S., Niessner, M., and Yermack, D. (2018). “Initial Coin Offerings: Financing Growth with Cryptocurrency Token Sales,” NBER Working Paper No. 24774. Huberman, G., Leshno, J., and Moallemi, C. C. (2017). “Monopoly without a Monopolist: An Economic Analysis of the Bitcoin Payment System,” available at SSRN: https:// ssrn.com/abstract=3025604 or http://dx.doi.org/10.2139/ssrn.3025604. Jagtiani, J. and Lemieux, C. (2018). “The Roles of Alternative Data and Machine Learning in Fintech Lending: Evidence from the Lending Club Consumer Platform,” Federal Re­ serve Bank of Philadelphia Working Paper No. 18–15. Jiang, W., Nelson, A., and Vytlacil, E. (2013). “Securitization and Loan Performance: Ex Ante and Ex Post Relations in the Mortgage Market,” Review of Financial Studies, 27(2), 454–83. Jiang, W., Nelson, A., and Vytlacil, E. (2014). “Liar’s Loan? Effects of Origination Channel and Information Falsification on Mortgage Delinquency,” Review of Economics and Statis­ tics, 96(1), 1–18. Keys, B., Mukherjee, T., Seru, A., and Vig, V. (2010). “Did Securitization Lead to Lax Screening? Evidence from Subprime Loans,” Quarterly Journal of Economics, 125(1), 307–62. Keys, B., Seru, A., and Vig, V. (2012). “Lender Screening and the Role of Securitization: Evidence from the Prime and Subprime Mortgage Markets,” Review of Financial Studies, 25(7), 2071–108.

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Technological Change and Financial Innovation in Banking: Some Implica­ tions for FinTech Kharpal, A. (2017). “Initial Coin Offerings have Raised $1.2 Billion and Now Surpass Ear­ ly Stage VC Funding,” CNBC website (August 9), available at: https://www.cnbc.com/ 2017/08/09/initial-coin-offerings-surpass-early-stage-venture-capitalfunding.html. Klee, E. (2006). “Families’ Use of Payment Instruments During a Decade of Change in the US Payment System,” Federal Reserve Board, Finance and Economics Discussion Series, #2006-01. Krugman, P. R. (2007). “Innovating our Way to Financial Crisis,” New York Times, Decem­ ber 3, available at: http://www.nytimes.com/2007/12/03/opinion/03krugman.html. Lerner, J. and Tufano, P. (2011). “The Consequences of Financial Innovation: A Counter­ factual Research Agenda,” NBER Working Paper No. 16780, available at: http:// www.nber.org/papers/w16780.pdf. Levine, R. (1997). “Financial Development and Economic Growth: Views and Agenda,” Journal of Economic Literature, 35(2), 688–726. Levine, R. (1998). “The Legal Environment, Banks, and Long-run Economic Growth,” Journal of Money, Credit, and Banking, 30(3), 596–613. Levine, R. (1999). “Law, Finance, and Economic Growth,” Journal of Financial Intermedia­ tion, 8(1–2), 36–67. (p. 283)

Levine, R., Loayza, N., and Beck, T. (2000). “Financial Intermediation and Growth:

Causality and Causes,” Journal of Monetary Economics, 46(1), 31–77. Levine, R. and Zervos, S. (1998). “Stock Markets, Banks, and Economic Growth,” Ameri­ can Economic Review, 88(3), 537–58. Mantel, B. (2000). “Why do Consumers Pay Bills Electronically? An Empirical Analysis,” Economic Perspectives, Federal Reserve Bank of Chicago, 24(4), 32–47. Mantel, B. and McHugh, T. (2001). “Competition and Innovation in the Consumer E-Pay­ ments Market? Considering Demand, Supply, and Public Policy Issues,” Federal Reserve Bank of Chicago, Emerging Payments Occasional Working Paper No. EPS-2001–4. Mayer, C., Pence, K., and Sherlund, S. (2009). “The Rise in Mortgage Defaults,” Journal of Economic Perspectives, 23(1), 27–50. Mayer, C., Piskorski, T., and Tchistyi, A. (2013). “The Inefficiency of Refinancing: Why Pre­ payment Penalties Are Good for Risky Borrowers,” Journal of Financial Economics, 107(3), 694–719. Merton, R. C. (1992). “Financial Innovation and Economic Performance,” Journal of Ap­ plied Corporate Finance, 4(4), 12–22.

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Technological Change and Financial Innovation in Banking: Some Implica­ tions for FinTech Merton, R. C. (1995). “Financial Innovation and the Management and Regulation of Fi­ nancial Institutions,” Journal of Banking and Finance, 19(3–4), 461–81. Miller, M. H. (1986). “Financial Innovation: The Last Twenty Years and the Next,” Journal of Financial and Quantitative Analysis, 21(4), 459–71. Miller, M. H. (1992). “Financial Innovation: Achievements and Prospects,” Journal of Ap­ plied Corporate Finance, 4(4), 4–12. Nakamoto, S. (2008). “Bitcoin: A Peer-to-Peer Electronic Cash System,” available at: https://bitcoin.org/bitcoin.pdf. Piskorski, T. and Tchistyi, A. (2010). “Optimal Mortgage Design,” Review of Financial Studies, 23(8), 3098–140. Piskorski, T. and Tchistyi, A. (2011). “Stochastic House Appreciation and Optimal Mort­ gage Lending,” Review of Financial Studies, 24(5), 1407–46. Piskorski, T., Seru, A., and Witken, J. (2015). “Asset Quality Misrepresentation by Finan­ cial Intermediaries: Evidence from the RMBS Market,” Journal of Finance, 70(6), 2635– 78. Stavins, J. (2001). “Effect of Consumer Characteristics on the Use of Payment Instru­ ments,” New England Economic Review, Federal Reserve Bank of Boston, 3(Q3), 19–31. Stavins, J. and Bauer, P. W. (1999). “The Effect of Pricing on Demand and Revenue in Fed­ eral Reserve ACH Payment Processing,” Journal of Financial Services Research, 16(1), 27–45. Thakor, A. (2012). “Incentives to Innovate and Financial Crises,” Journal of Financial Eco­ nomics, 103(1), 130–48. Tufano, P. (2003). “Financial Innovation,” in G. M. Constantinides, M. Harris, and R. Stulz, (eds.), Handbook of the Economics of Finance: Vol. 1A Corporate Finance (Amsterdam: North-Holland), 307–35. US Federal Reserve (2016). “Federal Reserve Payments Study,” available at: https:// www.federalreserve.gov/newsevents/press/other/2016-paymentsstudy-20161222.pdf. Vallee, B. and Zeng, Y. (2018). “Marketplace Lending: A New Banking Paradigm?” Avail­ able at SSRN: https://ssrn.com/abstract=3102984 or http://dx.doi.org/10.2139/ssrn. 3102984. Van Horne, J. C. (1985). “Of Financial Innovations and Excesses,” Journal of Finance, 40(3), 621–36.

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Technological Change and Financial Innovation in Banking: Some Implica­ tions for FinTech Volcker, P. A. (2009). “Paul Volcker: Think More Boldly,” Wall Street Journal, December 14, available at: http://online.wsj.com/article/ SB10001424052748704825504574586330960597134.html. Wall, L. D. (2018a). “The Initial Coin Offerings Market (Part 1),” Notes from the Vault, Federal Reserve Bank of Atlanta (March), available at: https:// www.frbatlanta.org/cenfis/publications/notesfromthevault/03-the-initial-coin-of­ ferings-market-2018-03-09.aspx. (p. 284)

Wall, L. D. (2018b). “The Initial Coin Offerings Market (Part 2),” Notes from the Vault, Federal Reserve Bank of Atlanta (April), available at: https://www.frbatlanta.org/cenfis/ publications/notesfromthevault/04-the-initial-coin-offerings-marketpart-2-2018-04-20.aspx. Wall, L. D. (2018c). “Some Financial Regulatory Implications of Artificial Intelligence,” Journal of Economics and Business, 100, 55–63. Zinman, J. (2009). “Debit or Credit?” Journal of Banking and Finance, 33(2), 358–66.

Notes: (1) See Levine (1997) for an extensive discussion of the relationship between financial de­ velopment and economic growth in the context of the theoretical and empirical literature at that time. For subsequent empirical evidence, see Levine (1998, 1999); Levine and Zer­ vos (1998); Beck, Levine, and Loayza (2000); Levine, Loayza, and Beck (2000); Arestis, Demetriades, and Luintel (2001); Beck and Levine (2004). (2) Thakor (2012) and Gennaioli, Shleifer, and Vishny (2012) are recent examples of theo­ retical research that attempts to tie financial innovation and financial instability. Both provide models where banks innovate by making new loans or creating new securities; but then altered information or beliefs results in runs or panics. Henderson and Pearson (2011) provide a recent empirical analysis of a welfare-reducing financial innovation. (3) Using a much smaller sample, Bauer and Ferrier (1996) also found support for the ex­ istence of ACH scale economies as well as significant allocative inefficiencies. (4) The blockchain does this by creating a “cryptographic hash,” or unique digital summa­ ry, for each block that includes the hash from the prior block. If any change is made to any given block, it will alter that block’s hash and the change will carry through to every block that is subsequently added to the blockchain. (This occurs because the prior block’s hash is part of each block in the chain.) Thus, if one wants to rewrite the history of one block, then every subsequent block will have to be revised. Otherwise, anyone seeking to verify the blockchain will be able tell that an effort has been made to change one of the blocks.

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Technological Change and Financial Innovation in Banking: Some Implica­ tions for FinTech (5) This finding is consistent with earlier research by Ausubel (1991) describing the “fail­ ure of competition” in the US credit card market. The notion is that the riskiest borrow­ ers have inelastic credit demand owing to liquidity constraints and always intend to use cards to finance purchases. (6) An overview is provided by Gerardi et al. (2008). (7) Related to documentation, the authors describe the concomitant rise in the so-called Alt-A market, which is characterized by lower observed risk (e.g., better credit scores and larger down payments), but little/no documentation/verification of borrower income/as­ sets. (8) Standard FICO credit scores range from 300 to 850. About 70 percent of US con­ sumers have a score greater than 650. Most financial institutions perceive consumers with FICO scores below 620 as definitely being subprime, although some lenders use slightly higher score cut-offs (e.g., 640) for this definition. (9) Nevertheless, subprime borrowers continue to have broad access to mortgage finance through US Government mortgage insurance programs (through the Federal Housing Ad­ ministration, the Department of Veterans Affairs, and the Department of Agriculture)— and such loans have been very popular since the onset of the 2007–9 crisis. (10) See Anguelov, Hilgert, and Hogarth (2004) for the relevant statistics that pertain to these surveys. (11) A potential substitute for cryptocurrency for some uses is government-issued digital currency. Government-issued digital currency could, but need not, use a blockchain for record-keeping. See Chapter 10, this volume, for a discussion of government-issued digi­ tal currency. (12) See Athey et al. (2016) for a theoretical model of Bitcoin pricing and some descriptive analysis of the market. A listing of major cryptocurrency exchanges—along with some vol­ ume and price data—may be obtained from CoinMarketCap at https://coinmarketcap.com/ exchanges/volume/24-hour/. (13) Kharpal (2017) documents the role of ICOs in providing more early-stage financing than did venture capitalists in the early summer of 2017. See Wall (2018a, 2018b) for an overview of the issues raised by ICOs as a funding tool for new ventures. (14) Mobile retail payments using cellular phones are widespread in Africa, most notably in Kenya with Safaricoms’ M-Pesa program. See Beck and Frame (2018) for further de­ tails and a review of the related literature. (15) While marketplace lending originally involved raising funds from individuals, it is in­ stitutional investors who provide the bulk of financing today.

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Technological Change and Financial Innovation in Banking: Some Implica­ tions for FinTech (16) For legal reasons, marketplace loans in the US are actually originated on the balance sheet of a partner bank. This allows the marketplace lender to: (1) purchase the loans without needing to obtain individual state banking/lending licenses; and (2) charge inter­ est rates that are legal in the partner bank’s state but may not be legal in the borrower’s state. The partner bank holds the loan for a few days before selling it to the marketplace lender, which in turn sells it to investors. (17) Berg et al. (2018) discuss the use of alternative data to improve default prediction by a German e-commerce company. The authors identify various pieces of a customer’s digi­ tal footprint as aiding in prediction: access device type, operating system, access chan­ nel, allowing for location tracking, time of day, email service provider, and various cus­ tomer typing conventions. (18) LendingRobot is an automated tool for investors in loans that are originated by Lend­ ingClub and Prosper.

W. Scott Frame

W. Scott Frame is a financial economist and senior advisor on the financial markets team in the research department of the Federal Reserve Bank of Atlanta. His major fields of study are financial institutions, credit markets, real estate, and public policy. He has been with the Bank since 2001, although he spent two years as the Belk Dis­ tinguished Professor of Finance at the University of North Carolina at Charlotte (2012–14). Before joining the Bank, he was a senior financial economist at the US Treasury Department from 1996 to 2000. He also worked at the Federal Reserve Bank of Atlanta as an economic analyst from 1993 to 1995 and as an instructor at the University of Georgia. He was promoted to financial economist and policy advisor in 2007 and assumed his current duties in 2012. Larry Wall

Larry Wall is the research center executive director of the Center for Financial Inno­ vation and Stability (CenFIS) in the research department of the Federal Reserve Bank of Atlanta. He is part of the financial markets team. CenFIS was created to im­ prove knowledge of financial innovation and financial stability and the connection be­ tween the two. He joined the financial structure team of the Bank’s research depart­ ment in 1982 and was promoted to executive director of the CenFIS in 2013. In addi­ tion to pursuing his research agenda, he leads CenFIS’s activities, including its newsletter, Notes from the Vault, and conferences. He has served on the editorial boards of various academic journals. He is also on the Academic Advisory Panel for the International Association of Deposit Insurers. He is currently on the boards of Fi­ nancial Management Association International and the International Banking, Eco­ nomics and Finance Association. He has also been an adjunct faculty member of Emory University and the Georgia Institute of Technology. A native of Grand Forks, North Dakota, he earned a bachelor’s degree in business administration from the

Page 26 of 27

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Technological Change and Financial Innovation in Banking: Some Implica­ tions for FinTech University of North Dakota and a doctoral degree in business administration from the University of North Carolina at Chapel Hill. Lawrence J. White

Lawrence J. White is Robert Kavesh Professor of Economics at New York University’s Stern School of Business. During 1986–9 he served as a Board Member for the Fed­ eral Home Loan Bank Board, in which capacity he also served as Board Member for Freddie Mac. In the period 1982–3, he was on leave to serve as Director of the Eco­ nomic Policy Office, Antitrust Division, US Department of Justice. He is the General Editor of the Review of Industrial Organization and was Secretary-Treasurer of the Western Economic Association International (2006–9). He received the B.A. from Harvard University (1964), the M.Sc. from the London School of Economics (1965), and the Ph.D from Harvard University (1969).

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Payments

Payments   David Humphrey The Oxford Handbook of Banking (3rd edn) Edited by Allen N. Berger, Philip Molyneux, and John O. S. Wilson Print Publication Date: Oct 2019 Subject: Economics and Finance, Financial Economics Online Publication Date: Nov 2019 DOI: 10.1093/oxfordhb/9780198824633.013.11

Abstract and Keywords Payments, paper-based or electronic, are essential for efficient economic exchange. For retail payments, debit and credit cards have been replacing cash and checks for point of sale transactions. Cards and automated clearing house (US) and giro networks (Europe and elsewhere) have replaced cash and checks for bill payments and employee disburse­ ments. Daily retail payments have relatively small average values but number in hun­ dreds of millions of transactions. Daily wholesale wire transfer transactions are in the thousands but their value is in the trillions. They are used to make large-value business, government, and financial market transactions, along with settling payments made over other networks. To be widely adopted, a retail payment instrument has to have lower cost and greater convenience. Cost is also emphasized for wholesale payments but this has generated risk. Reducing risk has raised costs. The issues associated with retail and wholesale payments are quite different; they are discussed separately in this chapter. Keywords: payment instruments, payment systems, payments across countries, Real Time Gross Settlement, sys­ temic risk

10.1 Payments Overview OVER the last 100 years the most important change in payments has been the shift from an essentially cash-based payment system (using gold and silver coins as well as paper currency) to one where checks or paper giro transactions played a dominant role in the value of payments. More recently, paper instruments have been replaced by electronic substitutes. Checks have been increasingly replaced by Automated Clearing House (ACH) payments and debit cards. Paper-based credit card transactions and paper-initiated giro payments have been replaced by electronic versions of the same instruments. For large-value payments, large shipments of currency or gold by rail or boat were re­ placed by accounting entries among correspondent banks and telegraph messages for in­ tercity and regional settlement. Currently, highly secure real-time gross settlement (RT­ GS) networks are used for large-value payments, while interbank, and payments over Page 1 of 40

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Payments card and giro networks, are settled using central bank balances. These changes lowered transaction costs and improved security. It also eliminated US domestic exchange rates that reflected the cost (and risk) of physically transporting gold, and later currency, among regions for interbank settlement (Garbade and Silber, 1979). The many different retail payment instruments are best distinguished by their average transaction value. This largely determines the type of transaction they are used for and the cost and risk issues associated with their use. Smaller value retail transactions in­ clude cash, checks, and debit and credit cards (some tied to a mobile phone) and are used at the point of sale. Another type of retail payment concerns medium value consumer and business bill payments using checks and electronic ACH transfers in the US, or postal and bank giro networks in Europe. This includes direct debits for consumer bill payments (with cards used on the Internet) along with credit transfers for business and employee disbursements. Large-value or wholesale payments primarily use wire transfers (in the US, Europe, and elsewhere). These represent large-value transactions among businesses, between (p. 286) business and government, and importantly lay behind almost all large-value financial transactions in foreign exchange, government security, corporate bond, equity, and deriv­ ative markets. A country’s payment system is comprised of the payment instruments used, and the bank­ ing institutions directly involved, in offering transaction services. There are also bank and non-bank firms that process the payments, transportation firms (for cash), and telecom­ munications facilities (for electronic payments) needed to move the payment information between individual and business deposit accounts at banks. Telecommunication facilities are also needed to transfer funds between individual bank reserve accounts at central banks for final settlement of retail and wholesale transactions. Cash does not require fi­ nal settlement—the transfer of good and final funds between accounts or persons—since coin and currency already represent final payment. Central banks are used for final set­ tlement, rather than private banks, due to their low cost and the presumption that they cannot fail (as governments could print money or tax to support them if needed). In the US and Europe, banks have an effective monopoly in offering retail and wholesale payment services since deposit accounts contain the funds needed for almost all types of transactions. This is enforced by the legal definition of what a bank is and does as only banks are typically allowed access to central bank payment settlement accounts. Some countries (e.g., Canada, Australia) allow non-bank financial firms to have limited access to central bank settlement services and in many countries non-bank institutions may offer limited payment services outside of usual banking channels (e.g., money order firms, money transmitters of inter-country remittances). Even so, almost all payments go through banks and are an important source of revenue. The contribution of payment-re­ lated activities to bank operating revenues was estimated to be 42 percent at the twentyfive largest US bank holding companies. Most of this revenue is associated with the de­

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Payments posit function (service charges, card revenues, transaction fees) with the remaining amount coming from fiduciary (trust) and trading activities (Radecki, 1999). Banks also provide large-value payment services to the public. In the US (and similarly in Europe) large-value payment volumes are around 0.1 percent of all non-cash retail trans­ actions but over six times the value of retail payments. Due to the importance of these transactions underpinning financial markets, central banks are typically a primary suppli­ er of wire transfers to banks (Fedwire in the US, Target 2 in Europe, and BOJ-NET in Japan). However, in some specialized financial markets, bank-owned organizations initi­ ate and process large-value transactions among their members for themselves and their customers (CHIPS in the US, Euro1 and CLS Bank for Europe, CHAPS in the UK, and sim­ ilar entities in other countries). In this process they use a portion of central bank reserve account funds for initial funding (in the US) or post collateral for intraday exposures (in the UK and Europe) with later final net settlement in good funds. This is an improvement over practices some forty years ago when there was almost no cover for intraday credit exposures on these large-value net settlement networks. International payments are made via SWIFT, a message transfer network. Here funds are “moved” using accounting entries to interbank correspondent accounts at banks in sending and receiving countries. As there is no world central bank, there is no fi­ nal settlement in the usual sense: banks in different countries carry as an asset (liability) (p. 287)

the various “due from” (“due to”) deposit amounts of other banks in their interbank corre­ spondent accounts. This enables them to provide foreign exchange for customers paying for imports, receive foreign exchange from customers selling exports, or facilitate foreign investment and other capital flows for their customers (all for a fee).

10.1.1 Payment Theory Current payment instruments evolved from earlier forms, such as seashells, peppercorns, or precious metals. The main attributes of money have always been that it is easily divisi­ ble for transactions; has an agreed upon stable nominal value; is easy to transfer and store; and (importantly) has scarcity value. When money is not scarce, due to gold discov­ eries when gold was money or when countries print too much currency after currency re­ placed gold, inflation resulted and the purchasing power of money was markedly re­ duced. Using simplified models for mathematical tractability, payment theory largely focuses on how different payment arrangements evolved among transactors as a substitute for barter and how they trade off with one another today. These analyses offer insights on the reasons behind the development and (slow) adoption of different types of retail payment instruments over time. This involves the use of cash versus different types of debit or credit instruments (checks, cards) due to their attributes of transferability and finality (Kahn and Roberds, 2007). In contrast, most empirical payment analyses rely on well-ac­ cepted microeconomic theory dealing with payment pricing principles; demand estima­

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Payments tion; payment instrument substitution; analysis of payment cost; scale economies; and as­ sessing competition among payment suppliers. Perhaps the most important recent development in payment theory concerns recasting traditional demand theory into a two-sided market framework (Rochet and Tirole, 2003; Rochet and Wright, 2010). It is applied to credit and debit card pricing arrangements (the interchange fee), as well as to other markets, and forms the basis for recent theoretical work in the retail payments area (a survey is provided by Chakravorti (2003) and numer­ ous models are outlined and criticized in Katz (2001)). Most other theoretical develop­ ments in this field are related to antitrust and competition issues that have dominated policy debates, regulatory actions, and legal cases. Papers on these topics can be found in the Review of Network Economics (2005 and 2006).

10.1.2 Differences in Payment Structure The current transition from paper (checks, paper-based giros) to electronic non-cash pay­ ments (cards, electronic giros, and ACH) is mostly due to technical change allowing greater convenience and lower costs in making payments. Often, an electronic transac­ tion (p. 288) costs only one-third to one-half as much as the all-in social or private cost of a paper-based one for the same purpose. While individual consumer payment transactions are not usually priced, businesses can face a fee for each transaction made. Consumer payments do not differ markedly across users, so a minimum balance requirement or monthly fee is charged based on the average number of transactions to cover most of the cost. The volume of business transactions is much more variable across firms. Using an average here would not be appropriate and a fee per transaction plus a monthly deposit account fee are common. In Europe, checks (except for France) and paper-based giro transactions have been effec­ tively eliminated and replaced with electronic giro payments and cards. In contrast, checks markedly reduced cash use in the US after WWII but only relatively recently has check use been falling (about 5 percent a year) with the expansion of cards and the ACH. This is occurring even as checks are now being collected electronically (via Check 21), substantially lowering the resource and float cost of check use in the US. Demographic as well as technical change plays an important role here since new generations grow up without having any experience in using a particular payment instrument and are more open to change compared to their parents. Differences in the intensity of payment instrument use across countries are often associ­ ated with historical institutional “accidents” rather than any clear plan to shape payment use. One major institutional difference was the development of a paper-based postal giro system in Europe before 1900 but never in the US. Another was the low cost of obtaining a US banking charter over 125 years ago compared to a very high charter cost in Canada and a history of royal or state monopolies in most European countries. These two institu­ tional differences resulted in many thousands of small banks in the US compared to a far more concentrated banking structure in Europe and Canada. In turn, Europe was able to Page 4 of 40

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Payments offer nationwide paper-based giro payments using postal banks (and now also commer­ cial banks) while the US had no alternative but to rely on checks for transactions among thousands of small banks since no national payment service supplier existed. And when technology made electronic payments possible, Europe—with a national giro network al­ ready in place—was able to shift more rapidly to electronics for bill payments and busi­ ness disbursements than was the US. Similarly, the heavy use of cash in Japan compared to either Europe or the US was facilitated by the fact that Japan was, and still is, consid­ ered to be a safer country. While this remains the case for retail payments in Japan, bill payments are largely electronic. Another institutional development concerned the early US practice of discounting the face value of a check to cover the cost of collection (non-par banking). In attempting to reduce collection costs, checks were often routed using cheaper (and slower) paths for collection. This resulted in payment delays that were at times inordinately long and dis­ rupted commerce. One reason the Federal Reserve was established was to transport and process checks at face (par) value and at no charge. This eliminated circuitous routing of checks, which hindered commerce. Today, alone among central banks, the Federal Re­ serve processes about one-half of all check and ACH payments (now for a fee). (p. 289) Eu­ rope, not having an overabundance of checks (debit transfers) to begin with, due to a re­ liance on cash and giro (credit transfer) payments, instead covered payment costs by deb­ iting accounts prior to the value date to earn float revenues. This helps to explain why Eu­ ropean central banks are not involved in processing retail transactions in competition with banks but do provide final settlement for interbank giro and other transactions.

10.2 Retail Payments The main issue related to retail payments has been the substitution of electronic payment instruments for cash and/or checks over the last forty years. While cash use has fallen in the past, this has slowed recently (except in Scandinavia) while the replacement of checks is still progressing and has been almost eliminated in many countries. The use of cash is approximated by the ratio of cash in circulation to GDP or the value of cash to population. The countries shown in Table 10.1 are ordered by their use of cash, both as a percent of GDP (column 1) and as a value held per person (column 2). This is shown in US dollars for comparison. The ranking of cash use by country is basically the reverse of that for per-person use of non-cash payment instruments shown in the last col­ umn. Using the ratio of cash to GDP, European countries in the Euro Area in 2016 used close to three times as much cash as do the US, UK, or Canada.1 In contrast, Japan uses close to twice as much as Europe. The ratios of cash to GDP have only changed slightly in the last five years, in some cases rising slightly (US and the Euro Area) or the reverse (UK, Canada, and Japan). Some have attributed the recent slowing of cash use to very low interest rates so the opportunity cost of continuing to use cash has been almost zero for the last decade. And before that, the cost of acquiring cash was significantly reduced as (p. 290)

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Payments banks progressively augmented branch networks with networks of ATMs for more conve­ nient cash acquisition. Indeed, in some countries the number of expensive stand-alone bank offices has fallen absolutely, a process only starting in the US. There has been little solid information on the number or value of cash transactions in a country. One new way to estimate cash use in a country involves adding the value of cash withdrawn from ATMs (which is usually available) to the value of cash withdrawn over the counter at banks. The latter, based on survey information, is only available for some Euro­ pean countries and is approximated for others using a matching procedure (see the ap­ pendix in Payments.com, 2018b). As well, some information is available from diaries of consumer payments where the use of cash and other payment instruments is noted for small groups of individuals over a number of days. A comparison of payment diary results across countries is contained in Bagnall et al. (2014). Focusing on diary information on consumer cash use of adults in the US (those over 18 years of age), Greene and Schuh (2017) found that consumers made an average of 14 cash payments per month with an average value of $22. As there are some 250 mil­ lion adults in the US, a rough approximation for cash transactions for the nation as a whole could be 42 billion cash transactions worth $931 billion over a year.2 If this is cor­ rect, then one would expect that a similar extrapolation of debit card diary information (giving 37 billion transactions at the national level) would be close to that from an actual national survey of debit card use in Gerdes, Hamburg, and Liu (2016). Unfortunately, it does not. The survey data estimate debit card volume at 61 billion, suggesting that the simple extrapolation of diary cash use may severely underestimate both cash and debit card use at the national level. This is unfortunate since diary information seems like a reasonable way to approximate cash use in a country.

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Payments Table 10.1 Payment Instrument Use, 2016 Cash/GDP

Cash/Popu­ lation

Annual Transactions Per Person:

Percent

Value Held

Check

Card

Giro/ACH

Total NonCash

US1

3.4

$1,980

51

326

83

460

UK

3.5

$1,408

7

249

127

383

Canada

3.8

$1,664

14

276

60

350

Euro Area2

10.7

$3,756

–

–

–

–

Germany

–

–

0, whereas both efficiency hypotheses imply that α2 > 0. Most stud­ ies find a positive and statistically significant α2, but an α1 close to zero and insignificant. These findings support both efficiency hypotheses, that is, larger market shares go to­ gether with higher profitability.6 Berg and Kim (1994) argue that conduct has an important effect on both (in)efficiency and scale measurements and therefore the estimation of such should not be carried out independently of market structure and conduct. Berger (1995) goes one step further than the standard bank efficiency study and aims to further differentiate between the SCP and efficiency hypotheses by including direct measures of both X-efficiency and scale efficien­ cy into the regression specification (as additional variables in the Xk,ijt vector). He argues that after controlling for efficiency, MSijt only captures the relative market power of banks. Berger derives both efficiency measures from the estimation of a translog cost function. X-efficiency is separated from random noise by assuming that X-efficiency differ­ ences will persist over time while random noise will not. The X-efficiency measure for bank i then equals the ratio of the predicted costs for the most efficient bank in the sam­ ple to the predicted costs for bank i for any given vector of outputs and inputs. Berger (1995) estimates a cost function using data from 4,800 US banks during the 1980s. Including both computed efficiency measures in the performance equation that al­ so contains market share and concentration, Berger finds that in 40 out of 60 regres­ sions, market share actually retains its positive sign. However, the economic significance (p. 781) of market share seems very small: a 1 percent increase in market share boosts re­ turn on assets by less than 0.1 percent. Nevertheless, Berger interprets these findings as evidence in favor of the relative market power hypothesis: market share does represent market power of larger banks, and their market power may be grounded in advertising, local networks, or business relationships. Results further show that X-efficiency also con­ tributes positively in explaining profits, whereas the results on scale efficiency are mixed and never economically important. Similarly, De Jonghe and Vander Vennet (2008) aim to discriminate between theories es­ tablishing a link between market structure and bank performance and alternative expla­ nations based on efficiency considerations. They argue that the effects of competition and efficiency take time to materialize. Therefore, they analyze the competition–performance relationship using a longer-term concept of firm rents, the franchise value. They find that banks with better management or production technologies possess a long-run competi­ tive advantage. They also find that bank market concentration does not affect all banks equally. Only the banks with a large market share in a concentrated market are able to generate non-competitive rents. For more on X-efficiency studies analyzing financial insti­ Page 6 of 45

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Competition in the Banking Sector tutions, we refer the reader to surveys by Allen and Rai (1996), Molyneux, Altunbas, and Gardener (1996), Berger and Humphrey (1997), or work by Turati (2001). Another tradi­ tional method corresponds to studies of economies of scale and scope,7 which address the question whether financial institutions produce the optimal output mix both in terms of size and composition. Literature on this method can be found in Kim (1986), Allen and Rai (1996), Berger and Humphrey (1997), Cavallo and Rossi (2001), Hughes and Mester (2013) and Davies and Tracey (2014).

24.2.2 New Empirical Industrial Organization A fundamental criticism leveled against the SCP and the efficiency hypotheses relates to the embedded—assumed—one-way causality from market structure to performance. In other words, most SCP studies do not take into account the conduct of the banks in the market and the impact of performance of the banks on market structure. In fact, studies that have attempted to determine the degree of competition relying on various indexes of concentration such as the C3, the HHI, and the like, reach conflicting and troublesome results. Carbo et al. (2009) document that the coefficients of determination among these various indexes for both the within and between countries are very weak (most 1,800 as “highly concentrated” (Salop, 1987).

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Competition in the Banking Sector (5) As control variables they include time dummies, the one-year growth in market de­ posits, the proportion of bank branches in total number of branches of financial institu­ tions (including S&L branches), a wage rate, per capita income, and a Metropolitan Sta­ tistical Area dummy variable. (6) Hannan and Prager (2009), for example, interact market concentration with the mar­ ket share of large (small) (not) primarily-out-of-market banks to account for the impact in the market of large banking organizations on the profitability of small single-market banks. (7) Degryse, Morales-Acevedo, and Ongena (2014) review in more detail this method. (8) Consistently, using the H-statistic as a measure of competition, Schaeck, Cihák, and Wolfe (2009) find that concentration and competition have independent effects on the likelihood and timing of systemic crisis, suggesting that these two measures describe dif­ ferent characteristics of banking systems. (9) The conjectural variations approach has been subject to a number of important criti­ cisms. Corts (1999) for example argues that the conduct parameter λ may not only hinge on the firm’s static first-order condition, but also on the dynamics, that is, the incentive compatibility constraints associated with collusion. In the dynamic case, the estimated λ may be biased when the incentive compatibility constraints are a function of demand shocks. (10) For an earlier application of the conjectural variations method, see Spiller and Favaro (1984). (11) In certain specifications, researchers also include the price of capital, since this price may vary over time. (12) See also Molnár, Nagy, and Horvath (2007) and Molnár (2007), for example. (13) The idea in the nested logit model is that consumer tastes are correlated across bank products i. Making a priori groups G, a product i belonging to one of the groups then pro­ vides a utility to consumer c equal to ucij ≡ δij + ςcg + [1 − σ]εcij, where ςcg denotes the group specific component for individual c. (14) Carbo Valverde, Rodríguez Fernández, and Udell (2009) compare the “performance” of the HHI and Lerner index for the Petersen and Rajan (1995) credit availability hypothe­ sis. (15) The effect of concentration on credit availability may further depend on how the bank–firm transactions are mediated, as in De Mello (2007) and Montoriol Garriga (2006). (16) Rosen (2007) finds that having more large banks in a market generally increases de­ posit rates at all banks but also increases their sensitivity to changes in the concentration ratio. Page 43 of 45

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Competition in the Banking Sector (17) Kashyap, Rajan, and Stein (2002), for example, link lending and deposit-taking at the bank level, while Berg and Kim (1998) connect behavior in retail and corporate banking markets. (18) Magri, Mori, and Rossi (2005), for example, document that foreign banks successfully entered the Italian banking market following the lowering of the regulatory barriers un­ der the Second Directive enacted in 1992. (19) This issue is related to the so-called “Zombie lending” phenomenon (Caballero, Hoshi, and Kashyap, 2008).

Hans Degryse

Hans Degryse is Professor of Finance at the Department of Accountancy, Finance and Insurance of the KU Leuven. He is a research fellow at the CEPR, CESIfo, the Euro­ pean Banking Center (EBC), and TILEC. He is a member of the Group of Economic Advisers of ESMA. Before joining Leuven in 2012, he was Professor of Finance at Tilburg University. His research focuses on financial intermediation, including theo­ retical and empirical banking as well as market microstructure. He has published in many journals including the American Economic Review, Journal of Finance, Journal of Financial Economics, Review of Financial Studies, Management Science, Review of Finance, Journal of Financial Intermediation, and the Economic Journal, and has been presented in leading international conferences such as the American Finance Association, the Western Finance Association, the European Finance Association, and the Financial Intermediation Research Society. He co-authored, with Moshe Kim and Steven Ongena, the graduate textbook Microeconometrics of Banking: Methods, Ap­ plications and Results (Oxford University Press, 2009). Paola Morales-Acevedo

Paola Morales-Acevedo is a Researcher at the Central Bank of Colombia, Banco de la República. Prior to that, she was an Economist at the Applied Research and Model­ ling Division of the Sveriges Riksbank. Her research focuses on empirical banking, fi­ nancial intermediation, monetary policy, behavioral finance and corporate finance. She holds a Ph.D in Finance from the CentER graduate school of Tilburg University (Netherlands). During her Ph.D studies, she has been a Visiting Scholar at the De­ partment of Banking and Finance of the University of Zurich, as well as an intern at the Research Department of the Sveriges Riksbank and at the Monetary Capital Mar­ kets Department (Financial Crisis) of the International Monetary Fund. She has also been a Junior Fellow of the European Banking Center. Paola received a M. Phil. in Fi­ nance from Tilburg University in 2011, an M.Sc. in Industrial Engineering in 2009, a B.A. in Economics in 2009 and a B.Sc. in Industrial Engineering in 2007 from Univer­ sidad de los Andes (Colombia). After finishing her first bachelor degree, she worked for three years at the Financial Stability Department of the Central Bank of Colom­ bia.

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Competition in the Banking Sector Steven Ongena

Steven Ongena is a Professor of Banking at the University of Zurich, a senior chair at the Swiss Finance Institute, a research Professor at KU Leuven, and a research fel­ low in financial economics of CEPR. He is also a research Professor at Deutsche Bun­ desbank. He has published more than sixty-five papers in refereed journals, including in the American Economic Review, Econometrica, Journal of Finance, Journal of Fi­ nancial Economics, Journal of International Economics, Journal of Political Economy, Management Science, and Review of Finance. In 2017, he received an ERC Advanced Grant and in 2012 a NYU-Fordham-RPI Rising Star in Finance Award.

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Behavioral Economics, Financial Literacy, and Consumers’ Financial Deci­ sions

Behavioral Economics, Financial Literacy, and Con­ sumers’ Financial Decisions   Gregory Elliehausen The Oxford Handbook of Banking (3rd edn) Edited by Allen N. Berger, Philip Molyneux, and John O. S. Wilson Print Publication Date: Oct 2019 Subject: Economics and Finance, Financial Economics Online Publication Date: Nov 2019 DOI: 10.1093/oxfordhb/9780198824633.013.26

Abstract and Keywords This chapter reviews research in behavioral economics and financial literacy that raises concerns that consumers lack competence to make complex financial decisions. Con­ sumers do not collect comprehensive information or extensively evaluate alternatives. They rely on heuristics that cause them to make systematic errors in judgment, and many individuals lack an understanding of basic financial principles, which arguably would hamper individuals’ ability to manage their finances effectively. Decisions are generally purposive, however, and individuals tend to be deliberative and thoughtful when the situ­ ation warrants. Outcomes may not be optimal but such decision processes nevertheless may be an economical means for achieving desired goals. The extent to which these phe­ nomena impair actual decisions in markets is not at all clear. At this time, neither existing behavioral evidence nor conventional economic evidence supports a general conclusion that consumers’ financial decisions are not rational or that markets do not work reason­ ably well. Keywords: behavioral economics, bounded rationality, fast and frugal heuristics, financial decision-making, finan­ cial literacy, heuristics and biases, household finance

25.1 Introduction RESEARCH in the areas of behavioral economics and financial literacy has raised con­ cerns that consumers lack competence to make complex financial decisions. In behavioral economics, much of the literature argues that consumers rely on heuristics that cause them to make systematic errors in judgment. The literature on financial literacy suggests that many individuals lack an understanding of basic financial principles, which arguably would hamper individuals’ ability to manage their finances effectively. This chapter re­ views findings from a broad literature in economics and psychology on individuals’ eco­ nomic decision processes.

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Behavioral Economics, Financial Literacy, and Consumers’ Financial Deci­ sions The review discusses whether optimality is the appropriate basis for judging behavior as rational; whether use of heuristics invariably results in harmful decisions; whether mea­ sures of financial literacy reflect ability to manage finances; and whether individuals hav­ ing incomplete information and using heuristics inevitably lead to market failure. Evidence indicates that individuals do not collect comprehensive information. They take shortcuts, use rules of thumb, and do not carefully consider all alternatives available in the marketplace. Financial literacy, whether it be the ability to answer correctly test questions on financial concepts or the participation in financial education programs, ap­ pears to have little effect on outcomes of financial decisions. As such, decision processes fall far short of what neoclassical economic models would seem to require. Decisions are generally purposive, however; and individuals tend to be delibera­ tive and thoughtful when the situation warrants. Outcomes may not be optimal but such decision processes nevertheless may be an economical means for achieving desired goals. While most economists and psychologists agree that cognitive errors and time inconsis­ tent behavior occur, the extent to which these phenomena impair actual decisions in mar­ kets is not at all clear. At this time, neither existing behavioral evidence nor conventional economic evidence supports a general conclusion that consumers’ financial decisions are (p. 815)

not rational or that markets do not work reasonably well.

25.2 Psychology and Economic Behavior Around the mid-twentieth century, researchers were developing information-processing models of decision-making (Miller, 2003; Fiori, 2005). The work of Herbert Simon con­ tributed significantly to this effort. Simon proposed that cognitive and time limitations prevent individuals from obtaining full information and evaluating all possible alterna­ tives to achieve optimal outcomes. Instead, he argued, individuals simplify using heuris­ tics, that is, shortcuts that simplify decision processes. Heuristics enable them to limit the decision process, ending the process as soon as a satisfactory alternative is achieved. De­ cision processes are rational if they lead consumers to achieve desired goals. He called this process “satisficing” and this concept of rationality “bounded rationality.” Bounded rationality has stimulated research in several areas. In one area, researchers used surveys to question consumers about the extensiveness of their decision process when making economic choices. Findings indicate that consumers simplify and take shortcuts in the decision process but tend to be purposive and deliberate. Another area is concerned with biases in behavior arising from the use of heuristics. Researchers rely pri­ marily on experiments to detect deviations from rationality as defined by statistics or logi­ cal rules. Frequent deviations are attributed to a faulty application of heuristics to solve problems. A third area, also concerned with heuristics, views heuristics as specialized tools guiding decisions in specific environments. Such heuristics are argued to allow fast decisions with limited information in uncertain environments.

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Behavioral Economics, Financial Literacy, and Consumers’ Financial Deci­ sions

25.2.1 Extensiveness of Decision Processes The decision process that emerged from the literature can be described as a series of steps consisting of recognition of problem, acquisition of pertinent information, develop­ ment of possible solutions, evaluation of alternatives using relevant criteria, choice of an alternative, and assessment of the decision. Influences that affect the process include consumer resources, motivation and involvement, knowledge, attitudes, personality, val­ ues, lifestyle, culture, family, and situation.1 This model provided a framework for (p. 816) questioning consumers about their decision processes. Much of the survey research on the extent of decision processes for saving, household investment, and borrowing was carried out from the 1950s through the mid-1970s by George Katona and his colleagues at the University of Michigan Institute for Social Research.2

25.2.1.1 Household Investment and Borrowing Katona and Mueller’s “A Study of Purchase Decisions” (1954) provides an especially com­ prehensive analysis of processes leading to the purchase and financing of household durables. They found that many decisions were not based on an extensive search for in­ formation and an evaluation of alternatives. Consumers tended to simplify by contacting a few sellers and focusing on only one or a few attributes of the transaction. In some cases, they depended on information from past experience or experiences of friends and rela­ tives. When financing their purchases, they did little credit shopping, often relying on the seller to provide financing. Their research identified factors that tend to lead to more or less deliberation. The extent of deliberation depended on the situational factors. Delibera­ tion tended to be limited when buyers perceived a special opportunity (an especially fa­ vorable sale price, for example), felt an urgent need, or experienced satisfaction with a similar item previously used. Greater deliberation was found for purchases that are con­ sidered expensive or particularly important, associated with a new or unfamiliar product, or involve an unsatisfactory experience with previous purchases. The Michigan surveys questioned consumers about their knowledge and decision criteria for financial products. Responses suggested a widespread lack of financial knowledge and the use of heuristics. Most consumers were not well informed about interest rates for consumer credit, for example. Many respondents reported that they did not know the in­ terest rate one has to pay on an auto loan. A substantial fraction of respondents reported rates that were unreasonably low.3 Only about 20 to 30 percent of respondents provided a rate that suggested awareness of actual market rates. Evidence collected in the surveys indicated that many consumers based their borrowing decisions on the dollar amount they could afford to pay after meeting their monthly con­ tractual obligations. This finding suggests a monthly payment heuristic for assessing credit cost. Comparison of the size of monthly payments is a useful measure for credit cost when the number of payments is the same for a given amount of credit (Mors, 1965). Also, when an alternative credit opportunity with the same term to maturity offers a low­ er product price but a higher finance charge, the monthly payment directly reveals the lower cost alternative (Durkin and Elliehausen, 2010). In this situation, the joint purchase Page 3 of 35

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Behavioral Economics, Financial Literacy, and Consumers’ Financial Deci­ sions of product and credit, a monthly payment heuristic provides a simple and effective deci­ sion rule. Day and Brandt’s (1973) survey for the National Commission on Consumer Fi­ nance provides further evidence on consumers’ decision processes for durable purchase and credit use decisions. Day and Brandt found that by far most consumers planned for large purchases for several weeks or more. The lengthy planning period suggests that few purchases were truly urgent, a condition that was associated with less extensive search in the Michigan surveys. Planning periods for replacement of items that were no longer usable tended to be longer than those for other items. Apparently, consumers in such situations recognized the condition of the present item and took steps to prepare for the eventual breakdown. Well more than half shopped for at least a few days and consid­ ered more than one brand or seller. That shopping was not more extensive may be ex­ plained at least in part by previous experience with similar items that were already owned. (p. 817)

Day and Brandt found that consumers were less deliberative in their credit decisions than their product decisions. A little more than a quarter of consumers using credit searched for information about credit sources, and only about one in five considered alternative types of credit. Many consumers apparently simplified their decision process by relying on the seller to arrange for credit. Credit choices were rarely considered among the most difficult part of the decision and often were considered as the least important part of the process when purchasing durable goods. Consumers simplified, focusing instead on the product decision. Consumers most often reported that the amount to spend and product characteristics were most frequently mentioned as the most difficult parts of the decision process. Day and Brandt, whose surveys were conducted fifteen months after Truth in Lending mandated disclosure of an effective annual rate of interest (the annual percentage rate), found greater awareness of interest rates for consumer credit than the earlier Michigan surveys. Still, fewer than half of Day and Brandt’s respondents were able to report rea­ sonably accurate effective interest rates. Consumers generally were aware of differences in credit costs among types of lenders, however. For instance, they knew that finance company and retail credit were more expensive than bank or credit union credit. Day and Brandt’s survey explored respondents’ understanding of installment mathemat­ ics, specifically the relationship between an effective interest rate and the dollar finance charge. Respondents were first asked for an estimate of the total of payments (interest and principal) for a one-year $500 installment loan and then asked to estimate the inter­ est rate associated with this loan. A large percentage of respondents reported plausible values for interest rates. Finance charges computed from responses to the first question asking for the finance charge, however, were unrealistically high for most respondents. Further examination of responses suggests that many respondents applied an interest rate to the original balance, not recognizing that the outstanding balance declined over the term of the loan.4 Page 4 of 35

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Behavioral Economics, Financial Literacy, and Consumers’ Financial Deci­ sions Over time, required disclosures appear to have increased consumers’ awareness of interest rates. Recent survey data on awareness are available for bank cards, which to a great extent have replaced closed-end retail credit for financing non-auto durables.5 A little more than half of bank card holders in Day and Brandt’s time reported reasonably accurate rates (Durkin and Elliehausen, 1978). In 2012, nearly all bank card holders re­ ported rates that can be deemed as accurate (Canner and Elliehausen, 2013). In contrast, understanding of installment mathematics does not appear to have increased. Similar findings to those of Day and Brandt were found for 1977 (Durkin and Elliehausen, 1978) and 1983 (Stango and Zinman, 2011). Whether understanding of installment mathematics is needed for effective decision-making is unclear, as required Truth in Lending disclo­ sures provide both the finance charge and effective interest rate.6 (p. 818)

25.2.1.2 Saving Behavior Survey evidence suggests that saving can be grouped into three categories—contractual, discretionary, and residual savings—based on motivation and situation (Katona, 1975). Contractual saving results from committing to fixed contractual obligations, such as debt repayments, life insurance premiums, and pension contributions. Consumers typically do not consider all of these obligations as saving. Debt repayments are considered part of purchase decisions. Debt is a prevalent source of funding household investment in durables by consumers, especially in early life cycle stages. Life insurance premiums are commonly viewed as fees paid for protection against adversity, even if the insurance has a savings feature. Consumers also generally do not consider social security taxes or em­ ployer contributions to pension plans as savings, but they do consider their own contribu­ tions to pension plans as savings. Contractual saving may be a form of pre-commitment, a method to enforce compliance with long-term plans (Strotz, 1955–1956).7 In recent years, availability of tax-deferred retirement, education, and medical savings plans has in­ creased the possibilities for conscious decision-making for contractual saving. Discretionary saving involves a conscious decision to set aside funds for specific purpos­ es. The most common purpose is precautionary, to provide funds for expenses in emer­ gencies. Such funds tend to be held in highly liquid assets such as bank accounts. Other common purposes for discretionary spending include retirement, education, and purchas­ es of homes or expensive durables. Discretionary saving is most common among middleaged consumers with substantial income and wealth. These consumers may continue sav­ ing into retirement because wealth tends to raise levels of aspiration and because estab­ lished habits tend to continue. Precautionary motives may help explain why some con­ sumers simultaneously have savings in bank accounts and owe higher rate credit card debt. Because of strong precautionary motives to have available funds for emergencies, such funds provide a high subjective rate of return (Katona, 1975). Finally, residual saving consists of funds that individuals fail to spend. Residual saving is saved by default rather than planning. This type of saving typically would in­ clude funds held in bank accounts and used for paying monthly expenses. (p. 819)

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Behavioral Economics, Financial Literacy, and Consumers’ Financial Deci­ sions Saving decisions are influenced by affordability and circumstances. Greater uncertainty heightens the precautionary savings motive. Individuals may reduce withdrawals from discretionary savings. They may postpone new purchases or replacement of durables or expenditures for travel and vacations. By postponing the replacement of durables they may also complete repayment of existing debts, resulting in smaller deductions from in­ come for debt servicing. A stimulus may have different outcomes depending on circumstances. For example, re­ sponses to uncertainty arising from inflation were generally increases in precautionary saving in liquid assets even if inflation tended to reduce the value of assets. The percep­ tion of special opportunity in an inflationary environment led on occasion to different out­ comes. The price freeze in August 1971 was accompanied by a rollback of prices. Individ­ uals perceived prices to be low and that expected government efforts to hold down prices would not be successful. Consumers perceived that low prices were temporary and that it was a good time to purchase goods in advance of higher prices.

25.2.1.3 Rationality of Consumers’ Economic Decision-Making Whether consumers are informed depends on the type of information. Knowledge of spe­ cific economic facts and numerical data is not widespread. Survey findings suggest that most consumers are aware of major changes in the economy, increases or decreases in prices, unemployment, stock market prices, and interest rates, for example. They are not generally aware of the precise magnitude of such changes, however, and may overlook small changes. Katona (1975) summarized his conclusions about rationality of consumers’ economic deci­ sions based on over twenty-five years of research as follows: If careful deliberation were defined as comprising all the features of decision mak­ ing … the conclusion would emerge that almost all people proceed in a careless way in purchasing large household goods. This conclusion is, however, not justi­ fied. Deliberation may be strongly focused on one aspect of the purchase to the exclusion of other aspects. Therefore, it may be considered as careful deliberation if some, but by no means all, of the features of problem solving and thinking are present. (p. 220) In reaching this conclusion, Katona focuses on the process rather than the outcome in as­ sessing rationality. For Katona, rational behavior involved choosing appropriate means for achieving improvements in one’s well-being.8 (p. 820)

25.2.2 Heuristics and Biases and Other Systematic Errors

Psychologists Daniel Kahneman and Amos Tversky’s research in the 1970s on individual’s decision-making under risk and uncertainty has strongly influenced a branch of econom­ ics known as behavioral economics. Kahneman and Tversky observed that many individu­ als’ responses to questions involving risk or uncertainty violated statistical or logical

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Behavioral Economics, Financial Literacy, and Consumers’ Financial Deci­ sions rules. They attributed errors to the use of specific heuristics that biased reasoning or val­ ued gains and losses inconsistently (Tversky and Kahneman, 1974, 1981).

25.2.2.1 Heuristics and Biases Focusing on decision-making under risk and uncertainty, Kahneman and Tversky identi­ fied heuristics that, if followed, cause individuals to make logical or statistical errors or otherwise obtain suboptimal outcomes (Tversky and Kahneman, 1974). They gathered empirical evidence mostly from small-scale experiments in which subjects responded to test problems. Their findings indicated that a large percentages of subjects’ responses vi­ olated logical or statistical rules. They attributed errors to the use of specific heuristics that biased reasoning. For example, one well-known study (Tversky and Kahneman, 1983), presented subjects with the following problem: “Linda is 31 years old, single, outspoken, and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of dis­ crimination and social justice, and also participated in anti-nuclear demonstrations. Which is more probable? (1) Linda is a bank teller, or (2) that Linda is a bank teller and is active in the feminist movement.” By far most subjects in this experiment failed to recog­ nize that the probability of any one of two events is greater than or equal to the probabili­ ty of both events occurring together (a conjunction fallacy). The error was attributed to a representativeness heuristic, which caused subjects to ignore logic and judge the likeli­ hood of an event by its similarity to a known event. The heuristic apparently caused sub­ jects to view Linda as more typical of someone who is active in the feminist movement than someone who is a bank teller. Other heuristics that have been studied include availability, anchoring, recognition, and “take the best.” The availability heuristic assesses the likelihood of an event by how easily an example can be brought to mind. For example, an individual may assess the likelihood of price rises for a particular stock, based on information recalled from a newspaper arti­ cle reporting recent changes in stock market indices. The anchoring heuristic relates to an initial value as a reference point in making subsequent judgments about value. For ex­ ample, the first house shown by a real estate agent may influence a buyer’s perceptions whether subsequent houses are inexpensive or expensive. The recognition heuristic holds that if one of two objects is recognized and the other is not, then the recognized object has the higher value with respect to some criterion. Thus, individuals might judge the stock of a recognized company to be less risky than the stock of a company they never heard of. The take the best heuristic estimates which, of two alternatives, has a higher value on a criterion, by choosing the alternative based (p. 821) on the first attribute that discriminates between the alternatives, where attributes are ordered by attributes’ ability to distinguish best among the alternatives. As mentioned, heuristics are shortcuts that may help simplify decision-making and short­ en the decision process. Taking shortcuts is not necessarily harmful, but heuristics and bi­ ases research, and behavioral economics that has been influenced by this research, focus on logical or statistical errors that arise from the use of heuristics. Individuals are capa­ Page 7 of 35

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Behavioral Economics, Financial Literacy, and Consumers’ Financial Deci­ sions ble of overriding heuristic biases, but the heuristics and biases literature argues that, due to limitations on cognitive ability and motivation, they often fail to do so (Kahneman and Frederick, 2005). Other research discussed in the next section focuses on heuristics that may be effective in certain environments.9

25.2.2.2 Framing Beyond heuristics and biases, Tversky and Kahneman (1981) pointed to inconsistencies arising from how risky options are framed and proposed prospect theory as a model of choice under risk. Framing is the manner in which an option is presented. They found that framing options as losses elicits different preferences than framing equivalent prospects as gains. For example, individuals tend to prefer a prospect that saves 90 out of 100 lives to a prospect that loses 10 out of 100 lives, even though the prospects are equivalent. Loss aversion generally causes individuals to avoid risky choices when they evaluate possible gains, since they prefer avoiding losses to making gains. However, in some situations, individuals may prefer a risky option if the riskier option provides the possibility of mitigating a loss.

25.2.2.3 Prospect Theory and Mental Accounting Prospect theory describes the process of simplifying complex problems involving losses and gains (Kahneman and Tversky, 1979). Underlying prospect theory is an assumption that individuals perceive outcomes relative to a reference point rather than an absolute value. That is, they perceive outcomes as gains or losses. Individuals organize and refor­ mulate options to simplify evaluation and choice. Kahneman and Tversky suggested several rules for simplifying choices: Probabilities of identical outcomes may be simplified by combining probabilities; sometimes prospects can be segregated into riskless and risky outcomes; common components of different prospects can be ignored; and outcomes or probabilities associated with a prospect may be simplified by rounding. Individuals evaluate prospects by considering the monetary value of each simplified out­ come of a prospect and the decision weight that reflects the likelihood of an outcome but is not a probability.10 Low probabilities are overweighted, and moderate and high proba­ bilities are underweighted. The latter effect is more pronounced than the former. (p. 822) The overweighting of low probabilities may contribute to the attractiveness of both insur­ ance and gambling. Kahneman and Tversky’s research strongly influenced behavioral economics. This branch of economics seeks to provide a more realistic description of individual decisions than standard neoclassical economics. Economist Richard Thaler (1980, 1985) adapted prospect theory to develop a model of mental accounting comprising a set of cognitive op­ erations to organize, evaluate, and manage budgets. Building on Kahneman and Tversky’s findings on risk aversion and rules for simplification of prospects, Thaler proposed addi­ tional rules for further simplifying prospects that involved separating, combining, inte­ grating, or segregating gains and losses to obtain the greatest utility from a set of Page 8 of 35

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Behavioral Economics, Financial Literacy, and Consumers’ Financial Deci­ sions prospects. Specifically: evaluate gains separately (because utility increases less than pro­ portionately with the amount of gain); combine losses (because the disutility of two small­ er losses is greater in absolute value than the sum of two losses); integrate smaller losses with larger gains (to offset disutility arising from loss aversion); and segregate small gains from larger losses (because the utility of a gain may be greater than the utility from a small reduction in the amount of a loss). Prospects that are so organized are then evalu­ ated on the basis of two types of utility, acquisition utility and transaction utility. Acquisi­ tion utility arises from the consumption of an item. Transaction utility reflects the outlay required to pay for the item. To simplify further, Thaler argued that prospects are grouped into categories, which he called mental accounts. Purchase decisions take place within mental accounts. Each men­ tal account is subject to a budget constraint, which typically is based on current income flows (perhaps augmented by credit that the income can service). Individuals normally re­ strict expenditures in each category to the income allocated to the category. Thaler’s mental accounting requires less information and knowledge of financial concepts than neoclassical economic models, which maximize the present value of lifetime wealth. Mental accounting is a heuristic that simplifies decision-making and may facilitate selfcontrol. It likely works well in most circumstances but is not optimal. Mental accounting may help explain many consumers’ focus on monthly payments in making credit decisions (facilitates budgeting of debts) and their simultaneous holding of substantial liquid assets and owing credit card debt (prevents depletion of funds held for emergencies). In restrict­ ing expenditures to income allocated to the category, the mental accounting heuristic pre­ vents shifting of income from one category to another to equalize marginal consumption across categories. Shefrin and Thaler (1988) applied mental accounting to intertemporal choice. They pro­ posed that consumers allocate their resources to one of three mental accounts: (1) cur­ rent income, (2) current assets, and (3) future income. They assume that consumers have self-control problems, which causes consumers to use various devices such as participat­ ing in pension plans and employing heuristics to curb current spending. Different mental accounts have different vulnerability to temptation. Current assets (saving for emergen­ cies, for example) and future income (saving for retirement) are more vulnerable to selfcontrol problems than current income. Allocation of income to an account depends on how the income is framed (lump-sum bonus or regular income, for example). Prelic and Loewenstein (1998) adapted the mental accounting framework to ana­ lyze individuals’ decisions to pay by cash or credit. Analogous to acquisition and transac­ tion utility, Prelic and Loewenstein define net utility from consumption (utility of con­ sumption less disutility of associated payments) and net disutility of payments (disutility of consumption less utility of associated consumption). When these values occur over time, they are discounted, not necessarily at a constant rate. (p. 823)

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Behavioral Economics, Financial Literacy, and Consumers’ Financial Deci­ sions They further posit that past events are largely written off (prospective accounting) and that individuals allocate future payments to consumption or allocate consumption over fu­ ture payments (that is, individuals try to match consumption to payments), but that indi­ viduals do not necessarily fully link payments and consumption (which they called “de­ coupling”). The extent to which payments and income are coupled, they suggested, varies according to the situation, payment method, and individual. Prelec and Loewenstein argued that prepayment enhances the utility from consumption. The prospect of future consumption diminishes the pain of prepayment, while the prospective accounting assumption would largely write off past payments at the time of consumption. In contrast, debt financing tends to diminish the utility of consumption. Fu­ ture payments are discounted for current consumption, but past consumption is written off when future payments are made. Thus, consumers would tend to be averse to owing debt. However, an installment purchase of a durable good may be attractive if the durable good provides a series of surpluses of consumption over the periodic payments. Prelec and Loewenstein suggested that debt aversion resulting from mental accounting may help explain why individuals with temporarily low incomes fail to borrow sufficiently against future income to maintain a constant consumption profile over their lifetime. Thoughts of future debt repayments diminish the utility of the additional present con­ sumption while in the future no benefits diminish the disutility of the debt repayments. They also suggested that mental accounting might prevent consumers from paying off credit card debts. The pain of repaying a credit card debt immediately would be relatively large and possibly greater than the discounted disutility of making relatively small mini­ mum payments in the future to repay the debt. Additionally, if expenditures financed by credit cards provide little or no stream of future consumption, any benefits experienced in the past would tend not to be recalled and therefore be available to offset the pain of current full repayment. In some cases, however, they suggested that credit cards may ac­ tually enhance consumption paid by credit card if payment is associated with the monthly credit card payment rather than signing the credit card slip. This possibility arises be­ cause mental accounting enables the consumer to decouple the consumption from thoughts about paying.

25.2.2.4 Hyperbolic Discounting Individuals’ tendency to discount proximate utilities more heavily than distant utilities is among the cognitive biases that have raised significant concerns for financial decisionmaking. When discount rates decline over time, the choice between two options closer in time are discounted more than options more distant in time. Such preference reversals are called “time inconsistent behavior.” In economists’ expected utility model, individuals maximize the sum of all future utilities. Future utilities are reduced to comparable magnitudes by discounting. For sim­ plicity, individuals are assumed to discount by a single constant discount rate, which is the same across all time periods and also for all types of consumption. Assuming the same rate across all time periods precludes time inconsistent behavior.11 Time inconsis­ tent behavior may lead individuals to deviate from prior optimal intertemporal allocations (p. 824)

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Behavioral Economics, Financial Literacy, and Consumers’ Financial Deci­ sions in future time periods. Assuming the same discount rate across all types of consumption precludes different discount rates for different items, such as gains being discounted more heavily than losses (that is, loss aversion, discussed earlier in this section).12 A declining rate of time preference is often termed “hyperbolic discounting” because a hyperbolic function provides a better fit to experimental data than a constant, exponen­ tial function. Many researchers have observed behavior consistent with hyperbolic or oth­ er non-constant rates of time discounting (see Frederick, Loewenstein, and O’Donoghue (2002) for a comprehensive list). Available evidence from many different studies suggests that discount rates decline sharply during the short run and then level off and become practically constant. Frederick, Loewenstein, and O’Donoghue (2002) examined the rela­ tionship between estimated discount rates and the time horizon from different studies. They found that the discount rate was inversely related to the length of the time horizon. The highest discount rates were for time horizons of one year or less. Discount rates de­ creased with the length of the time horizon. After a year, the discount rate was nearly constant, on average about 25 percent. This relationship is quite imprecise, however. Es­ timates from the individual studies varied quite substantially. Hyperbolic discounting leads individuals to deviate from prior optimal intertemporal allo­ cations in future time periods. For example, individuals might postpone or abandon earli­ er plans for setting aside money in savings. As a consequence, those individuals might not save enough for future expenses or retirement. Hyperbolic discounting has also been be linked to behavior that can be, or is, harmful, such as procrastination and addiction (O’Donoghue and Rabin, 1999), for instance. Whether or not hyperbolic discounting is irrational is not clear. Individuals make numer­ ous intertemporal choices, in most cases apparently without suffering great harm. In some circumstances, choosing a smaller proximate reward may be sensible, such as when future prospects, preferences, and resources are uncertain or when the proximate reward ensures survival (Becker and Mulligan, 1997; Smith, 2005). (p. 825)

In addition, individuals may exercise self-control to prevent impatience jeopardizing longterm plans. Individuals may also enter into contractual arrangements that obligate them to carry out long-term plans (pre-commit). Individuals have cognitive self-control struc­ tures that provide them with the ability to direct thought and action to achieve internal goals. Activation of these cognitive control structures enables individuals to inhibit auto­ matic processes that are susceptible to impulses.13 Benhabib and Bisin (2005) model such a structure for a consumption/saving decision. The structure trades off impulsive immedi­ ate consumption with a saving rule requiring self-control for its implementation. Self-con­ trol requires actively maintaining attention to the saving rule. An individual facing temp­ tations might yield to a temptation only if it does not perturb the saving plan too much and does not have large permanent effects on the prescribed wealth accumulation pat­ tern. To be effective, the saving rule requires that the internal inhibitions become stronger as the awareness of the cost of impulsive consumption increases.

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Behavioral Economics, Financial Literacy, and Consumers’ Financial Deci­ sions To enforce previous decisions, individuals sometimes pre-commit to future actions, such as having automatic contributions from pay to tax-deferred savings accounts or using in­ stalment credit to purchase relatively expensive household durables (see Strotz, 1955– 1956; or Laibson, 1997, for example). Casual observation and empirical evidence indi­ cates that individuals exercise self-control through pre-commitment. Ariely and Werten­ bach (2002) provide experimental evidence that, in circumstances where time-inconsis­ tent behavior is costly, many individuals self-impose binding constraints to overcome per­ ceived self-control problems. In two experiments, participants were assigned to groups with either self-imposed deadlines or mandatory deadlines. Participants who failed to meet deadlines were penalized. In both experiments, the performance of participants with evenly spaced deadlines was similar, regardless of whether mandatory or self-im­ posed. Performance of participants with end of period deadlines was worse than the per­ formance of participants with evenly spaced deadlines. When given a choice, most partici­ pants chose evenly spaced deadlines. This choice suggests that individuals self-imposed deadlines to overcome procrastination and improve performance.

25.2.2.5 Robustness of Evidence of Cognitive Biases Evidence on the existence of cognitive biases arising from the use of many common heuristics is mostly from small-scale experimental studies using convenience samples (of­ ten students). In these studies, biases are elicited from responses to test-type problems. Biases are deviations from statistical or logical rules. When similar experimental proce­ dures are followed, findings of these studies have been replicated. However, results are sensitive to changes in the format, context, or content of the problem. Changing the format of the question or implementing different procedures can make cog­ nitive biases disappear. No generally accepted theory explains why cognitive biases (p. 826) occur or what causes them to disappear, although some psychologists have sug­ gested hypotheses. These hypotheses, along with empirical evidence, will be discussed in the next subsection. Economists also noticed inconsistent findings and questioned the robustness of experi­ mental evidence of cognitive biases. In an especially thorough study, Plott and Zeiler (2005) investigated differences in preferences attributed to an endowment effect, which is hypothesized to cause individuals’ willingness to pay for an item to differ from their willingness to accept payment to do without the item. The endowment effect is attributed to loss aversion. Individuals’ value an item that they own much more than an identical item that they do not own. Hence, they demand much more to do without the item than they would pay to obtain it. Plott and Zeiler examined in detail previous experimental studies of the endowment ef­ fect. They noted that the different studies employed various procedures to avoid partici­ pant misunderstanding of the nature of the problem. The procedures included ones that (1) explained the nature of the experiment and optimal response; (2) provided an opportu­ nity to practice and experience the consequences of their decisions; (3) offered incentives to provide true valuations rather than respond strategically; (4) elicited valuations in a Page 12 of 35

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Behavioral Economics, Financial Literacy, and Consumers’ Financial Deci­ sions market environment with incentives for optimal responses; and (5) measured differences based on actual trades rather than willingness to pay and willingness to accept respons­ es. Previous studies did not agree on the nature of misunderstanding, and no study included all of the procedures to avoid participant misunderstandings that Plott and Zeiler identi­ fied. Participant misunderstanding may have influenced the results of any of these experi­ ments. Also notable is that the evidence is not robust, despite beliefs to the contrary.14 Twelve of thirty-nine experiments examined by Plott and Zeiler reported no significant difference in willingness to pay and willingness to accept. Evidence of an endowment ef­ fect is not conclusive. In the absence of a theory of how perceptions might influence experimental results, Plott and Zeiler developed an experimental design to avoid all possible sources of misunder­ standing identified in previous studies. They initially chose the experimental design re­ ported in Kahneman, Knetsch, and Thaler (1990) and replicated Kahneman, Knetsch, and Thaler’s results, finding that median willingness to accept was significantly greater than median willingness to pay. Plott and Zeiler then modified the survey procedures to avoid possible participant misunderstandings identified in the literature. To elicit valuations, they used a market mechanism that provides incentives for participants to provide “true” valuations. They explained to participants how providing true valuations maximizes earn­ ings and provided practice rounds for both selling (willingness to accept) and buying (willingness to pay) valuations. Participants kept any earnings from the practice rounds. Participants were told that strategic behavior was not optimal, (p. 827) and practice rounds allowed participants to learn that such behavior reduced earnings. Plott and Zeil­ er also ensured that decisions and payments were anonymous so that participants would not be tempted to consider how others (experimenters or other participants) would view their valuations. Results of the modified experiment indicated that participants’ willingness to accept was not significantly different from willingness to pay. Based on their findings, Plott and Zeil­ er concluded that the observed differences in willingness to accept and willingness to pay do not reflect a fundamental feature of preferences and do not support the endowment ef­ fect hypothesis: The fact that the gap [between willingness to pay and willingness to accept] can be turned on and off demonstrates that interpreting gaps as support for endow­ ment effect theory is problematic. The mere observation of the phenomenon does not support loss aversion—a very special form of preferences in which gains are valued less than losses. That the phenomenon can be turned on and off while hold­ ing the good constant supports a strong rejection of the claim that WTP–WTA [will­ ingness to pay-willingness to accept] gaps support a particular theory of prefer­ ences posited by prospect theory. (p. 542)

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Behavioral Economics, Financial Literacy, and Consumers’ Financial Deci­ sions Plott and Zeiler did not advance a theory explaining participants’ perceptions but did speculate about possible explanations for their findings. One explanation is that the valu­ ations reflect motivations to announce a value other than the true value. Experimental procedures sought to eliminate motivations based on strategic considerations or concern about how others might judge their valuations, but other motivations might still exist. Ex­ planations that the procedures removed any attitudes in which ownership plays a role, or suggested that a value other than participants’ valuations was desired, are possible but Plott and Zeiler’s experimental data suggest that these explanations are unlikely. Other explanations included that participants perceived they were expected to remove any spe­ cial value of ownership from their valuation and that the willingness to pay-willingness to accept gap reflects a learning process. Plott and Zeiler’s experimental results provided no evidence regarding these latter explanations.15

25.2.2.6 Fast and Frugal Heuristics Researchers in the field of evolutionary psychology have proposed hypotheses to explain why cognitive biases are observed in some situations and not in others. Evolutionary psy­ chologists approach the problem on the basis of a theory that humans have many special­ ized cognitive processes that underlie their reasoning and that responses to stimuli are adaptations to humans’ natural environment.16 For example, they argue that human cog­ nition of statistical processes occurs naturally through observation of a series of events. As a consequence, human cognitive processes have adapted to process (p. 828) frequency information rather than probabilities. Experimental studies that frame problems in terms of probabilities, therefore, may not adequately replicate the situations in which individu­ als make decisions under uncertainty. Based on this theory, some researchers have hypothesized that presenting statistical problems in terms of frequencies would produce fewer errors than problems presented in terms of probabilities. In one study, Fiedler (1988) replicated Kahneman and Tversky’s experiment using the original formulation of the Linda problem. He found that 91 percent of participants responded that the feminist bank teller option was more probable than the bank teller option. He conducted a second experiment in which he asked which option is more frequent rather than which is more probable.17 In this experiment, only 22 percent of participants responded that the feminist bank teller option was more probable than the bank teller option. Similarly, Hertwig and Gigerenzer (1993), reported in Gigerenzer (1994), found that 88 percent of participants made cognitive errors for the probability format, but only 20 percent made errors for the frequency format. The frequency format reduced cognitive errors in other experimental problems as well. Gigerenzer and Hoffrage (1995) and Cosmides and Tooby (1996) conducted experiments comparing responses to probability and frequency formats in medical diagnosis prob­ lems. In both studies, participants were considerably more likely to provide correct re­ sponses to frequency formats than probability formats.

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Behavioral Economics, Financial Literacy, and Consumers’ Financial Deci­ sions Such results support the hypothesis that frequency formats facilitate statistical inference under some circumstances. They do not indicate that cognitive biases do not exist, but they do refute the notion that all statistical reasoning is biased. The context of the problem may also influence how individuals respond. Hertwig and Gigerenzer (1999) investigated this possibility, again using Kahneman and Tversky’s Lin­ da problem. Hertwig and Gigerenzer pointed out that the opening statements in the prob­ lem (that Linda is 31 years old, single, outspoken, and very bright; that she majored in philosophy; and that as a student, she was deeply concerned with issues of discrimination and social justice, and also participated in anti-nuclear demonstrations) are not needed to answer the statistical problem. They hypothesized that these statements can be interpret­ ed as asking for a typicality judgment. In that case, a representativeness heuristic might well be an efficient process for producing an appropriate judgment. Hertwig and Gigerenzer’s empirical analyses supported this hypothesis. In a small-scale experiment, they found that by far most participants chose (2) as the correct answer. When asked about their understanding of the word “probable,” most provided responses suggesting a non-statistical understanding. In a second experiment, Hertwig and Gigeren­ zer presented the problem in the original format to half of the participants and a modified format asking for both typical and statistical judgments. Participants (p. 829) responding to the modified, two-part, format provided correct answers to the statistical problem much more frequently than participants responding to the original format. Hertwig and Gigerenzer conducted a similar analysis of participants’ understanding of the question in a frequency format. When participants were asked about their under­ standing of “frequently,” only one of fifty-five responses was non-statistical. Thus, it seems that findings of considerably lower cognitive error rates for the frequency format than the probability format are not surprising, regardless of the validity of evolutionary psychologists’ theories about frequency data. Krynski and Tenenbaum (2003) proposed another potential cause of observed cognitive errors in experimental studies. They argued that human reasoning under uncertainty nat­ urally operates over causal mental models, rather than purely statistical representations. Typically, individuals make correct statistical inferences only when the data can be incor­ porated into a causal model consistent with individuals’ theories of the environment. The problem focused on predicting the incidence of cancer, given a false positive test re­ sult. The possible cognitive error for this problem arises from failure to consider the over­ all base rate of cancer in the population. They hypothesized that, lacking an explanation for a false positive test result, individuals will tend to believe the test and focus only on the information from the test. Krynski and Tenenbaum conducted two experiments. In the first experiment, they tested whether describing false positive test results as uncertain would lead participants to be­ lieve the false positive rate and incorporate that information in their estimates. In the sec­ ond test, they compared responses to a statistical question with those to a question that Page 15 of 35

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Behavioral Economics, Financial Literacy, and Consumers’ Financial Deci­ sions attributed false positive results to benign cysts. In both experiments, they found that pro­ viding a way for participants to make sense of false positive results improved estimates. The number of participants who failed to consider the low base rate (high false positive rate) was lower, and the number of correct or near-correct estimates was higher for the causal format. They interpreted these findings as evidence that human probabilistic rea­ soning operates over causal mental models. These findings suggest that failing to consid­ er or misunderstanding causal structure may be an important source of error in experi­ mental studies of problem-solving involving uncertainty. In order to construct such causal models, theories of cognitive processes for specific environments are needed. Even without accepting the theories of evolutionary psychologists, the sensitivity of ex­ perimental results to the format, context, and content of the problem suggests that some skepticism about the extent and impact of cognitive biases is warranted. Beyond ques­ tioning the robustness of the heuristics and biases program’s findings, the fast and frugal heuristics program argues that heuristics may be effective for making choices in situa­ tions where information is limited and consequences of actions are uncertain (Gigerenzer, Todd, and the ABC Group, 1999; Gigerenzer, 2008; or Gigerenzer and Brighton, 2009).18 (p. 830)

For example, DeMiguel, Garlappi, and Uppal (2009) compared a heuristic portfo­

lio diversification rule with fourteen mean-variance optimization rules. The heuristic rule (called the 1/N rule) divides assets equally across assets available for investment at each rebalancing date. They found that none of the mean-variance optimal portfolios’ out-ofsample performance consistently exceeded that of the 1/N heuristic.19,20 This finding does not indicate that the 1/N heuristic is generally better than mean-variance rules. Three en­ vironmental conditions tend to favor use of a 1/N heuristic: (1) high uncertainty, (2) a large number of assets, and (3) a short estimation period (Gigerenzer, 2008). The influ­ ence of environmental conditions on performance is consistent with environmental psy­ chologists’ hypotheses that heuristics are specialized to certain environments. Monti et al. (2012) found evidence of heuristic use in their investigation of decision processes for investment products. They recruited fifteen non-expert investors at an Ital­ ian bank and fifty-six university students who had no investment experience but had tak­ en courses in economics or finance. The experimental setup was designed to reflect the information environments investors commonly encounter when making investment deci­ sions. Information on features of seven investment products (bank accounts, bonds issued by the bank, bonds issued by the government, insurance products, a corporate bond mu­ tual fund, a large-company stock mutual fund, and a balanced mutual fund of stocks and bonds) was provided. The investment features were risk, time horizon, cost, liquidity, cost before redemption, and coupon. Participants generally considered a small subset of the information provided despite search costs that were minimal. Participants neither looked at all available data nor fully compared the available choices, which would be expected from a rational choice model. Observing the predominant behavior of participants modeled investment choices with a lexicographic decision tree that ordered risk first among the various investment features. Page 16 of 35

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Behavioral Economics, Financial Literacy, and Consumers’ Financial Deci­ sions That is, risk was most important and non-compensatory. If risk was unacceptable, the in­ vestment product was discarded. The decision tree model then used a tallying rule for the remaining investment features. Positive features were assigned a weight of one. For each product, the number of ones is counted, and the product with the highest number of ones is chosen.21 Some of the same qualifications apply to evidence from the fast and frugal heuristics pro­ grams as those that apply to the evidence from the heuristics and biases program. Much of the evidence is from experimental studies that do not involve actual market choices. Samples are often convenience samples, and sample sizes are small. Again, results are imprecise and cannot confidently be generalized.

(p. 831)

25.3 Rationality of Credit Card Use

Credit card use is often suggested to be vulnerable to cognitive biases. Prelec and Loewenstein’s (1998) mental accounting model is just one of a number of studies that raise behavioral issues regarding credit card use. Many other studies have hypothesized that consumers are prone to making errors when using credit cards.22 Much of the evi­ dence supporting these studies’ hypotheses is based on experimental studies using re­ sponses to hypothetical choices. This section reviews findings of using data on the actual behavior of consumers using credit cards. Gross and Souleles (2002) analyzed the monthly panel data of several thousand individual bank card accounts from several different lenders in 1995. They found that increases in credit limits produce immediate increases in debt. The response was strongest for ac­ counts starting near their limit, but increases were also observed for accounts starting well below their credit limit. Increases in debt for accounts starting near their limit can be explained by binding liquidity constraints (credit rationing). The increases in debt for accounts starting well below their limit cannot, however. Looking at utilization rates (the ratio of debt to the credit limit), Gross and Souleles found a plausible explanation for increases in debt. After an initial drop in utilization following an increase in the credit limit, consumers quickly increased borrowing, returning to their original utilization within a relatively short period of time. That this behavior was true for accounts starting near their limits, as well as accounts starting well below their limits, suggests that consumers may have target utilization rates, which may arise from behav­ ioral rules of thumb about appropriate amounts of borrowing or from precautionary mo­ tives for maintaining a reserve of available credit. Evidence exists showing that outcomes are largely consistent with predictions of economic theory. Results of regressions for changes in interest rates indicate that borrowing was sensitive to interest rates. Increases in the interest rate produce nearly proportionate declines in borrowing within a short period of time and eventually greater than proportionate de­ clines in borrowing. Furthermore, they find that consumers shift balances to other ac­ counts when the interest rate on an account rises, but the rise in balances on other ac­ Page 17 of 35

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Behavioral Economics, Financial Literacy, and Consumers’ Financial Deci­ sions counts is less than half the decline in the balance on the account whose interest rate has risen. Thus, while some balances are shifted to other accounts, an increase in the interest rate still causes a large decrease in debt overall. Gross and Souleles also examined responses to temporary teaser rates for new accounts and for balance transfer offers, which have become a ubiquitous part of competition in the bank card market since the 1990s. They found that large decreases in interest rates, such as those typically occurring when a teaser rate is taken, have stronger effects than small decreases. They also found that large decreases in rates had greater effects than the (p. 832) large increases, which follow upon the expiry of teaser rates. Thus, temporary teaser rates would produce a rise in debt, a result that helps explain card issuers’ wide­ spread use of teaser rates. In an experimental study using bank card solicitation data, Ausubel (1999) found that more consumers responded to lower price bank card offers than higher price offers which is consistent with downward sloping demand curves and rational behavior. Consumers do not always act in a fully optimal manner, however. Ausubel (1999) found that consumers may be more responsive to teaser rates than equivalent reductions in post-introductory rates or the duration of the introductory rate. These results certainly suggest that con­ sumers do not calculate precisely and may respond differently when price changes are framed in different ways. Results of a large-scale experiment undertaken by a bank produce further evidence that consumers are sensitive to credit card interest rates in choosing credit card offers (Agar­ wal et al., 2005). A large bank credit card issuer offered consumers a choice between credit card contracts, one with a fee but a low fixed interest rate and another with no fee but a higher fixed rate. The offer included an option to switch contracts after the initial choice. These authors found that the majority of consumers chose the lower cost choice based on their subsequent card use behavior, suggesting that most consumers under­ stood the likelihood of their future use of the card to add debt. Consumers who chose to pay an annual fee in order to obtain a lower interest rate (perhaps because they planned to use the card for debt purposes) more frequently revolved balances and borrowed greater amounts than consumers who chose a higher interest rate and no fee. Sixty percent of the consumers who remained with their initial choice made an optimal choice.23 The likelihood of making an optimal choice was much greater for consumers who did not pay a fee (79.0 percent) than for consumers who paid a fee (44.5 percent). That the frequency of errors was much higher for those who paid an annual fee can be ex­ plained by the magnitude of the potential cost of the mistake. The potential cost is limited to the amount of the fee, which was a small dollar amount (on average about $20) for con­ sumers who paid the fee.24 In contrast, the potential cost for borrowers who did not pay a fee depends on the amount of borrowing. Thus, the cost of making an error could become quite large with frequent or large amounts of debt. These findings suggest that many bor­ rowers who could not or did not want to estimate future borrowing very precisely may have chosen contracts that limited the cost of mistakes to a small dollar amount. Those Page 18 of 35

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Behavioral Economics, Financial Literacy, and Consumers’ Financial Deci­ sions who chose contracts with potentially large costs, being much more likely than not to have chosen the right contract, apparently were aware of their (limited) future borrowing. Consumers who initially chose not to pay an annual fee were more likely to switch as the net savings from paying the fee increased, and consumers who initially chose to pay (p. 833) the fee were less likely to switch as net savings increased. Of the small percent­ age (3.4 percent) of consumers who eventually switched accounts, nearly all made a sub­ optimal choice initially and had corrected their mistake by switching. Agarwal, Chomsisengphet, Liu, and Souleles concluded that most consumers made cost minimizing choices of credit card contracts. Further, they reported that the probability of making the wrong choice declines with the size of the potential error, and “those who made a larger error in their initial contract choice were more likely subsequently to switch to the optimal contract” (Agarwal et al., 2005, p. 5). It is hard to reconcile these results with the hypothesis of consumer insensitivity toward rates. These authors do note, however, that a “small minority of consumers persists in holding substantially suboptimal contracts without switching” (Agarwal et al., 2005, p. 5). In another study Agarwal et al. (2008) provide evidence that credit card holders’ behavior is sensitive to late, over limit, and cash advance fees. In their data, which were obtained from a large bank, they observed that when consumers incurred these fees, they incurred the fees most commonly soon after opening an account. Subsequently, the incidence of these fees declined, falling by 75 percent during the first four years of account life. To ex­ plain this behavior, Agarwal, Driscoll, Gabaix, and Laibson suggested that consumers of­ ten learn about fees by incurring them, and that having incurred a fee, consumers are more careful in managing their accounts. Consumers learn from their mistakes and take steps in the future to avoid making a mistake again. In the case of late payments, for ex­ ample, they found that incurring a late payment fee reduced the probability of a late pay­ ment in the next month by 44 percent. They also found that a recent fee payment had a larger effect than more distant fee payments. The findings of Agarwal, Driscoll, Gabaix, and Laibson suggest that consumers may not consider all available information in opening accounts or they may not always manage their accounts carefully. That alone does not indicate that consumers’ behavior is not ra­ tional. That consumers learn from experience and correct their behavior after mistakes is consistent with rationality, where rationality is viewed as taking actions to achieve objec­ tives. In sum, evidence from analyses of actual credit card behavior indicates that consumers are sensitive to price, consistent with the predictions of economic theory. When a credit card company increases the interest rates on an account, consumers reduce new charges, reduce existing balances, and shift charges to other credit card accounts; and over the course of a year, they reduce total credit card balances from the level before the price in­ crease. Based on subsequent account use, consumers generally make cost-minimizing

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Behavioral Economics, Financial Literacy, and Consumers’ Financial Deci­ sions choices, trading off interest rates and annual fees when choosing new credit card ac­ counts. When they make mistakes, the mistakes are usually relatively small. If mistakes are large, consumers generally correct the mistakes. Although some consumers do not correct large mistakes, persistent large mistakes are not the rule. Analyses of credit card behavior based on survey data also suggest that consumers are sensitive to cost and do not incur costly mistakes. Survey data indicate that by far most consumers believe that credit cards provide a useful service (Canner and Elliehausen, 2013). Consumers whose (p. 834) choic­ es are inconsistent with their interests are unlikely to evaluate a product positively. Analy­ ses of actual behavior in the credit card market do not support a hypothesis that credit market failures arising from behavioral biases are large and persistent.

25.4 Financial Literacy Researchers have written numerous papers examining individuals’ knowledge of financial concepts and the effects of such knowledge on financial decisions.25 These studies can broadly be classified in one of two groups, measured financial literacy studies or financial education intervention studies (Fernandes, Lynch, and Netemeyer, 2014). Measured fi­ nancial literacy is defined as the percentage of correct answers on test questions on fi­ nancial knowledge.26 These studies correlate financial literacy with different indicators of the financial management of behavior. Financial education intervention studies compare outcomes of individuals who participated in various financial education programs. Finan­ cial education intervention studies are generally experimental or quasi-experimental as­ sessments of the effects of financial education on subsequent financial outcomes. Out­ comes consist of behavior that is generally considered good financial practice, such as ac­ cumulating savings, planning for retirement, budgeting expenses, investing in stocks, having a diversified asset portfolio, avoiding late fees, improving credit bureau scores, paying credit card statement balances in full, and avoiding high-rate credit products. Research on financial literacy often starts with a formal economic life-cycle model of in­ tertemporal consumption (see Lusardi and Mitchell, 2014). The details differ, but the ba­ sic structure of the various models is similar. Individuals receive an income stream and seek to achieve an optimal time pattern or consumption over their lifetimes. They may borrow when young, when returns on household investment in durables are high, pay down debts and save during high earning years, and rely on social security and savings to support consumption in retirement. Decisions may be influenced by borrowing con­ straints, mortality risk, demographic factors, stock market returns, tax considerations, and earnings and health shocks. In some models, individuals may incur costs for acquir­ ing financial knowledge to improve the financial outcomes, which allow them to obtain a higher-valued distribution of intertemporal consumption. An important implication (p. 835) of allowing individuals to choose the amount of financial knowledge is that they will choose different types and amounts depending on their circumstances. For example, Lusardi and Mitchell hypothesize that individuals with limited education might rationally Page 20 of 35

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Behavioral Economics, Financial Literacy, and Consumers’ Financial Deci­ sions choose not to incur the costs required to increase financial knowledge because, having few assets or discretionary income to invest and anticipating receipt of substantial social security income in old age, they would obtain little benefit from such knowledge. Lusardi and Mitchell (2014) argue that knowledge of several concepts is fundamental to making saving and investment decisions in a life-cycle framework. Key concepts include effects of interest compounding, inflation, and risk diversification. They developed three test questions for these concepts to measure individuals’ understanding of the concepts, with correct answers being interpreted as the individuals’ being financially literate. They developed an expanded set of test questions on financial knowledge for savings and in­ vestment decisions (Lusardi and Mitchell, 2010) to assess knowledge relevant for borrow­ ing decisions (Lusardi and Tufano, 2009). Lusardi and Mitchell’s three test questions were included in the 2004 Health and Retire­ ment Study, which surveyed a representative sample of individuals in the US aged fifty years or older. Large percentages of respondents provided incorrect answers or said that they did not know the correct answer to each of the test questions (33, 25, and 48 per­ cent for interest compounding, inflation, and risk diversification, respectively).27 Responses to these questions by other population groups produced similar large percent­ ages of individuals who were unable to provide correct answers (see, for example, Lusar­ di, Mitchell, and Curto, 2014; Lusardi and Mitchell, 2010). These findings led Lusardi and Mitchell to conclude that the level of financial literacy is quite low.

25.4.1 Evidence on the Effects of Financial Literacy on Behavior Simply knowing facts, such as knowing correct answers to test questions, however, does not ensure that an individual is capable of making sound financial decisions. Individuals must be able to use their knowledge effectively. A large number of papers have examined whether financially literate individuals achieve better financial outcomes than financially illiterate individuals. In a meta-analysis, Fernandes, Lynch, and Netemeyer (2014) re­ viewed the findings of 168 such papers containing 201 non-redundant studies, which were systematically selected to produce a representative sample.28 They also conducted original analyses. Fernandes, Lynch, and Netemeyer examined two types of studies assessing the ef­ fects of financial knowledge on outcomes of financial decisions. One type assessed out­ comes of the financial literacy of individuals defined by the percentage of correct answers on test questions on financial knowledge, such as the test questions of Lusardi and Mitchell. These studies Fernandes, Lynch, and Netemeyer called measured financial liter­ acy studies. The other type of study compared outcomes of individuals who participated in various financial education programs, which they called financial education interven­ tion studies. Financial education intervention studies are experimental or quasi-experi­ mental assessments of the effects of financial education on subsequent financial deci­ sions. (p. 836)

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Behavioral Economics, Financial Literacy, and Consumers’ Financial Deci­ sions Their review indicated that financial education intervention studies have statistically sig­ nificant but inconsiderable effects on behavior. Measured financial literacy studies have larger significant effects than financial education intervention studies, but the effects of measured financial literacy are still very small. Results varied by the studies’ research de­ sign, with stronger designs estimating smaller effects than weaker designs. Experimental studies of financial education interventions produced smaller effects than quasi-experi­ mental studies, and studies of measured financial literacy using instrumental variables produced smaller effects than studies using ordinary least squares.29 Studies of measured financial literacy have used instrumental variables in efforts to ac­ count for possible bias from omitted variables, which may occur if an omitted variable is correlated with both financial literacy and financial behavior. For example, personal char­ acteristics (such as confidence in information search, propensity to plan, willingness to take financial risks, and numeracy) might be correlated with financial literacy but also with positive financial behavior (such as saving for emergencies, planning for retirement, and avoiding overdraft or late fees). In their original analyses, Fernandes, Lynch, and Netemeyer found that measured financial literacy was significantly related to positive fi­ nancial behavior after accounting for individuals’ demographic characteristics. However, when they added the personal characteristics to the model, measured financial literacy was statistically insignificant. These personal characteristics quite plausibly are related to the acquisition of financial knowledge and positive financial behavior, a conclusion that is consistent with these findings. Fernandes, Lynch, and Netemeyer found that effects of manipulated financial literacy de­ cay with delay. The decay over time is greater for larger interventions (measured by hours of instruction) than for smaller interventions. After twenty-four months, the effect of the intervention is about the same regardless of the size of the intervention. (p. 837)

25.4.2 Implications of Behavioral Studies for Financial Literacy

Fernandes, Lynch, and Netemeyer offered possible explanations for the weak effects of fi­ nancial education. They noted that financial education competes for consumers’ attention with other information available in the market. Without a ready expected use, consumers’ motivation to acquire knowledge may be weak. This argument favors just-in-time finan­ cial education tied to a particular decision over youth financial education interventions in­ tended to affect behavior in the distant future. Their finding that knowledge decays over time suggests that imminent use of acquired in­ formation aids retention. Time-sensitive content knowledge is especially likely to be for­ gotten. Over time, consumers are likely to forget information that is not used. The content of a given financial education intervention may be useful in some situations but not in other situations. For example, teaching budgeting skills might be useful to con­ sumers with limited resources. In contrast, consumers with significant surpluses in their budgets may not need to budget their expenses very carefully and therefore may obtain little benefit from such education (Xiao and O’Neill, 2018). Uncertainty also may affect Page 22 of 35

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Behavioral Economics, Financial Literacy, and Consumers’ Financial Deci­ sions the usefulness of financial education interventions. Stating normative behavior is difficult when neither instructors nor consumers can anticipate future circumstances. Multiple-skill, multiple-behavior programs may be less effective than single-behavior pro­ grams. Consumers may perceive less relevance and give less attention to broad-based programs that address some future, as yet unanticipated, decisions than single-behavior programs addressing a specific known and imminent decision. Some studies suggest that attitudes and personal traits such as propensity to plan, confidence to be proactive, and willingness to take financial risks may be more effective than content knowledge about fi­ nancial mathematics or financial markets, and instruments for achieving utility increasing outcomes (Hadar, Sood, and Fox, 2013). Further study of decision processes and outcomes is needed to resolve differences in im­ plications of behavioral analyses for financial literacy and education. The heuristics and biases literature does not find much of a role for financial education to improve financial decisions. According to this literature, systematic errors are hardwired in the brain. Con­ sumers use heuristics that are error-prone and often do not realize their mistakes. Educa­ tion can have little effect on behavior under this circumstance. In contrast, the fast and frugal literature views heuristics as experience-based decision-making shortcuts for spe­ cific environments. Actual choice environments are characterized by asymmetric, incom­ plete, and even false information. Financial education interventions informed by under­ standing decision processes can improve outcomes by facilitating information acquisition and improving choice environments. Public policy implications of the heuristics and biases program differ from those of the fast and frugal heuristics program. Heuristics and biases suggest that experts know de­ sirable financial outcomes better than consumers. Regulation of products and nudges (p. 838) into decisions that are deemed in the best interest of consumers are the preferred policies. Fast and frugal heuristics generally respects differences in individuals’ circum­ stances and preferences. The fast and frugal approach favors disclosure and financial ed­ ucation interventions that improve decision-making environments and facilitate achieve­ ment of better financial outcomes.30

25.5 Limited Information and Heuristic Deci­ sion-Making in Market Environments Limited theoretical evidence indicates that a satisficing heuristic produces long-run opti­ mal outcomes in some circumstances. Empirical evidence from experimental economics supports this theoretical conclusion.31 The studies consistently indicate that individual de­ cisions based on limited information in experimental markets produce prices and alloca­ tions that converge quickly to the neighborhood of optimal equilibrium values.32 The re­ sults occur even though participants do not engage in extensive weighing of alternatives.

Page 23 of 35

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Behavioral Economics, Financial Literacy, and Consumers’ Financial Deci­ sions The behavior of participants using various heuristics with limited information produces efficient market outcomes. Experimental studies have also found that market environments reduce the incidence of preference reversals for risky prospects and losses from failure to recognize sunk costs and opportunity costs. Smith (1991) argued that the findings of these studies suggest that markets reinforce or even induce individual rationality, although the manner in which markets promote rationality is not well understood. In a later paper, Smith (2005) specu­ lated on how markets promote rationality. Market prices provide stimuli that cause indi­ viduals to take actions that better their situations. These actions move prices and alloca­ tions to competitive equilibrium.33 Focusing on whether or not individual decisions are optimal misses the point (Smith, 2005, p. 146). Consistent with the findings in experimental markets, evidence of the existence of behav­ ioral biases in equity markets does not lead to the conclusion that market outcomes are not efficient. Shiller (1999) in a review of behavioral finance describes various anomalies and departures from rationality in financial markets. He concludes: (p. 839)

Because of its focus on anomalies and departures about conventional notions of rationality, I worry that the reader of this paper can get a mistaken impression about the place of behavioral finance and the importance of conventional theory. … The lesson from the literature surveyed here, is not that “anything can happen” in financial markets. … I could have, had that been the goal of this paper, found very many papers that suggest that markets are impressively efficient in certain respects. (p. 1333) Reviewing studies of stock return anomalies attributed to behavioral biases, Malkiel (2003) noted that, although statistically significant, the anomalies are generally quite small and that the anomalies sometimes persist for short periods but usually disappear quickly. Malkiel argued that while market participants clearly do make mistakes and the actions of some market participants are demonstrably less than rational, the preponder­ ance of evidence suggests that the market is remarkably efficient. Whatever evidence of anomalies in the pricing of equities have been found, he concluded, do not persist and provide few opportunities for investors to obtain extraordinary returns. Fama (1998) and Schwert (2003) provide similar assessments of the evidence on behavioral anomalies in stock market returns.

25.6 Conclusions Behavioral research indicates that consumers do not always make the cognitive efforts required for an extensive decision process. Individuals often take shortcuts, simplify, and use heuristics. Cognitive effort tends to be reserved for situations where commitments in money and duration are great, past experience and information are insufficient or obso­ Page 24 of 35

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Behavioral Economics, Financial Literacy, and Consumers’ Financial Deci­ sions lete, and outcomes of previous decisions are regarded as unsatisfactory. In situations where consumers have previous experience and are satisfied with past decisions, con­ sumers often make choices with little further deliberation. That cognitive biases and time inconsistent discounting exist is well established in the be­ havioral literature. Some research suggests that these psychological considerations influ­ ence consumers’ credit behavior. The extent to which cognitive biases and time inconsis­ tent discounting affect actual credit decisions is not known at this time. The experimental evidence supporting cognitive biases and time inconsistent discounting is sensitive to the format, content, and context of the problems presented to study partici­ pants. When problems are framed differently the results sometimes contradict previous findings. Experimental problems often appear more similar to test questions than choices that consumers actually face in the markets. Hypothetical situations are likely perceived as such by study participants. And it seems unlikely that participants in experimental studies view the consequences of their choices as very important even when they are paid or their course grade may be affected. Individuals may be predisposed to (p. 840) impul­ sive behavior but they also have the capacity to exert self-control to implement forwardlooking plans. Self-control requires actively maintaining attention to the plan. An individual facing an impulse might yield to the impulse if it does not perturb the plan too much. To be effec­ tive, self-control requires that the internal inhibitions become stronger as awareness of the cost of impulsive behavior increases. It is not clear that participants exert the same cognitive efforts in experimental situations that they exert in actual situations where com­ mitments in money and duration are great, past experience and information are insuffi­ cient or obsolete, and outcomes of previous decisions are regarded as unsatisfactory. Em­ pirical evidence indicates that consumers generally use credit to finance purchases of rel­ atively expensive consumer-durable goods, not to smooth consumption. In doing so, be­ havioral concepts such as pre-commitment and mental accounts may be used to manage behavior. Such concepts may not be optimal in the sense of global utility maximization, but they may be sensible when future prospects, preferences, and resources are uncer­ tain. Evidence indicates that many consumers have little knowledge of basic financial princi­ ples or financial institutions and markets. Greater knowledge or participation in financial education interventions is generally associated with positive financial outcomes, but the effects are small. Behavioral studies suggest different implications for this finding. The heuristics and biases literature suggests that education has little effect because systemat­ ic cognitive errors are frequent and hardwired in the brain. The fast and frugal heuristics literature suggests that consumers use experience-based decision-making heuristics ap­ propriate for specific environments. As these heuristics may not require the extensive col­ lection of information and evaluation of alternatives, consumers may not need the same knowledge of financial principles or financial institutions and markets that underlie tests for financial literacy and financial education interventions. Further study of decision Page 25 of 35

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Behavioral Economics, Financial Literacy, and Consumers’ Financial Deci­ sions processes and outcomes is needed to resolve differences in implications of behavioral analyses for financial literacy and education. Analyses of actual credit card behavior indicate that consumers are sensitive to price, consistent with the predictions of economic theory. When a credit card company increas­ es the interest rates on an account, consumers reduce new charges, reduce existing bal­ ances, and shift charges to other credit card accounts; and over the course of a year, they reduce total credit card balances from the level before the price increase. Based on sub­ sequent account use, consumers generally make cost minimizing choices, trading off in­ terest rates and annual fees when choosing new credit card accounts. When they make mistakes, the mistakes are usually relatively small. If mistakes are large, consumers generally correct the mistakes. Although some consumers do not correct large mistakes, persistent large mistakes are not the rule. Analyses of credit card behavior based on survey data also suggest that consumers are sensitive to costs and do not incur costly mistakes. And by far most consumers believe that credit cards provide a useful ser­ vice and are satisfied with their dealings with credit card companies. Thus, neither be­ havioral nor conventional evidence provides much support for the conclusion that market failure is pervasive.

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Behavioral Economics, Financial Literacy, and Consumers’ Financial Deci­ sions Bendor, J.B., Kumar, S., and Siegel, D.A. (2009). “Satisficing: A ‘Pretty Good’ Heuristic,” The B.E. Journal of Theoretical Economics, 9, 1–36, available at: https:// www.bepress.com/bejte/vol9/iss1/art9. Benhabib, J. and Bisin, A. (2005). “Modeling Internal Commitment Mechanisms and SelfControl: A Neuroeconomic Approach to Consumption-Saving Decisions,” Games and Eco­ nomic Behavior, 52, 460–92. Blackwell, R.D., Mineard, P.W., and Engel, J.F. (2006). Consumer Behavior, 10th edn (Stamford, CT: Thompson South Western). Bloomfield, T., Leftwich, R., and Long, Jr., J.B. (1977). “Portfolio Strategies and Perfor­ mance,” Journal of Financial Economics, 5(November), 201–18. Camerer, C., Loewenstein, G., and Prelec, D. (2005). “Neuroeconomics: How Neuro­ science Can Inform Economics,” Journal of Economic Literature, 43(March), 9–64. Canner, G.B. and Elliehausen, G. (2013). “Consumer Experiences with Credit Cards,” Fed­ eral Reserve Bulletin, 99(December), 1–36. Cosmides, L. and Tooby, J. (1996). “Are Humans Good Intuitive Statisticians After All? Re­ thinking Some Conclusions from the Literature on Judgment Under Uncertainty,” Cogni­ tion, 58(1), 1–73. Day, G.S. and Brandt, W.K. (1973). “A Study of Consumer Credit Decisions: Implications for Present and Prospective Legislation,” in National Commission on Consumer Finance: Technical Studies, Vol. 1. (Washington, DC: US Government Printing Office). DellaVigna, S. and Malmendier, U. (2004). “Contract Design and Self-Control: Theory and Evidence,” Quarterly Journal of Economics, 119(May), 353–401. DeMiguel, V., Garlappi, L., and Uppal, R. (2009). “Optimal versus Naïve Diversification: How Inefficient is the 1/N Portfolio Strategy?” Review of Financial Studies, 22(May), 1915–53. Durkin, T.A. and Elliehausen, G. (1978). 1977 Consumer Credit Survey (Washington, DC: Board of Governors of the Federal Reserve System). Durkin, T.A. and Elliehausen, G. (2010). Truth in Lending: Theory, History, and a Way For­ ward (New York: Oxford University Press). Durkin, T.A., Elliehausen, G., Staten, M.E., and Zywicki, T. (2014). Consumer Credit and the American Economy (New York: Oxford University Press). Fama, E.F. (1998). “Market Efficiency, Long-Term Returns, and Behavioral Fi­ nance,” Journal of Financial Economics, 49, 283–306. (p. 842)

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Behavioral Economics, Financial Literacy, and Consumers’ Financial Deci­ sions Fernandes, D., Lynch, J.G., and Netemeyer, R. (2014). “A Meta-Analytic and Psychometric Investigation of the Effect of Financial Literacy on Downstream Financial Behaviors,” Management Science, 60(August), 1861–83. Fiedler, K. (1988). “The Dependence of the Conjunction Fallacy on Subtle Linguistic Fac­ tors,” Psychological Research, 50, 123–9. Fiori, S. (2005). “Simon’s Bounded Rationality: Origins and Use in Economic Theory,” De­ partment of Economics, Università di Torino, Torino, Working Paper No. 09/2006. Forbes, W., Hudson, R., Skerratt, L., and Soufian, M. (2015). “Which Heuristics Can Aid Financial Decision-Making?” International Review of Financial Analysis, 42, 199–210. Frederick, S., Loewenstein, G., and O’Donoghue, T. (2002). “Time Discounting and Time Preference: A Critical Review,” Journal of Economic Literature, 40(June), 351–401. Gabaix, X. and Laibson, D. (2006). “Shrouded Attributes, Consumer Myopia, and Informa­ tion Suppression in Competitive Markets,” Quarterly Journal of Economics, 121(May), 505–40. Gigerenzer, G. (1994). “Why the Distinction Between Single-Event Probabilities and Fre­ quencies is Important for Psychology (and Vice Versa),” in G. Wright and P. Ayton (eds.), Subjective Probability (New York: John Wiley). Gigerenzer, G. (2008). “Why Heuristics Work,” Perspectives on Psychological Science, 3 (January), 20–9. Gigerenzer, G. and Brighton, H. (2009). “Homo Heuristicus: Why Biased Minds Make Bet­ ter Inferences,” Topics in Cognitive Science, 1, 107–43. Gigerenzer, G. and Hoffrage, U. (1995). “How to Improve Baysian Reasoning Without In­ struction: Frequency Formats,” Psychological Review, 102, 684–704. Gigerenzer, G., Todd, P.M., and the ABC Group (1999). Simple Heuristics that Make Us Smart (New York: Oxford University Press). Gross, D.B. and Souleles, N.S. (2002). “Do Liquidity Constraints and Interest Rates Mat­ ter for Consumer Behavior? Evidence from Credit Card Data,” Quarterly Journal of Eco­ nomics, 117(February), 149–85. Hadar, L., Sood, S., and Fox, C.R. (2013). “Subjective Knowledge in Consumer Financial Decisions,” Journal of Marketing Research, 50(June), 303–16. Hertwig, R. and Gigerenzer, G. (1993). “Frequency and Single-Event Judgments,” unpub­ lished manuscript. Hertwig, R. and Gigerenzer, G. (1999). “The ‘Conjunction Fallacy’ Revisited: How Intelli­ gent Inferences Look Like Reasoning Errors,” Journal of Behavioral Decision Making, 12, 275–305. Page 28 of 35

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Behavioral Economics, Financial Literacy, and Consumers’ Financial Deci­ sions Jorion, P. (1991). “Bayesian and CAPM Estimators of the Means: Implications for Portfolio Selection,” Journal of Banking and Finance, 15, 717–27. Kahneman, D. (2011). Thinking Fast and Slow (New York: Farrar, Straus and Giroux). Kahneman, D. and Frederick, S. (2005). “A Model of Heuristic Judgment,” in K.J. Holyoak and R.G. Morrison (eds.), The Cambridge Handbook of Thinking and Reasoning (New York: Cambridge University Press). Kahneman, A. and Tversky, D. (1979). “Prospect Theory: An Analysis of Decision Under Uncertainty,” Econometrica, 47(March), 263–92. Kahneman, D., Knetsch, J.L., and Thaler, R.H. (1990). “Experimental Tests of the Endow­ ment Effect and the Coase Theorem,” Journal of Political Economy, 98, 1325–48. Kahneman, D., Knetsch, J.L., and Thaler, R.H. (1991). “Anomolies: The Endowment Effect, Loss Aversion, and Status Quo Bias,” Journal of Economic Perspectives, 5(Winter), 193– 206. Katona, G. (1975). Psychological Economics (New York: Elsevier Scientific Pub­ lishing). (p. 843)

Katona, G. and Mueller, E. (1954). “A Study of Purchase Decisions,” in L.H. Clark (ed.), Consumer Behavior: The Dynamics of Consumer Reaction (New York: New York Universi­ ty Press). Krynski, T.R. and Tenenbaum, J.B. (2003). “The Role of Causal Models in Reasoning under Uncertainty,” in Proceedings of the 25th Annual Conference of the Cognitive Science So­ ciety, available at: https://escholarship.org/uc/item/82d1f0wr. Laibson, D. (1997). “Golden Eggs and Hyperbolic Discounting,” Quarterly Journal of Eco­ nomics, 112(May), 443–77. Loomes, G., Starmer, C., and Sugden, R. (2003). “Do Anomalies Disappear in Repeated Markets,” Economic Journal, 113(March), C153–C166. Lusardi, A. and Mitchell, O.S. (2010). “How Ordinary Consumers Make Complex Econom­ ic Decisions: Financial Literacy and Retirement Readiness,” Center for Financial Studies, Goethe University, Frankfurt, CFS Working Paper No. 2010/11. Lusardi, A. and Mitchell, O.S. (2014). “The Economic Importance of Financial Literacy: Theory and Evidence,” Journal of Economic Literature, 52(March), 5–44. Lusardi, A. and Tufano, P. (2009). “Debt Literacy, Financial Experiences, and Overindebt­ edness,” Center for Financial Studies, Goethe University Frankfurt, CFS Working Paper No. 2009/08.

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Behavioral Economics, Financial Literacy, and Consumers’ Financial Deci­ sions Lusardi, A., Mitchell, O.S., and Curto, V. (2014). “Financial Literacy and Financial Sophis­ tication in the Older Population,” Journal of Pension Economics and Finance, 13(October), 347–66. Malkiel, B.G. (2003). “The Efficient Market Hypothesis and Its Critics,” Journal of Eco­ nomic Perspectives, 17(Winter), 59–82. Miller, E.K. and Cohen, J.D. (2001). “An Integrative Theory of Prefrontal Cortex Function,” Annual Review of Neuroscience, 24, 167–202. Miller, G.A. (2003). “The Cognitive Revolution: A Historical Perspective,” Trends in Cogni­ tive Sciences, 7(March), 141–4. Monti, M., Boero, R., Berg, N., Gigerenzer, G., and Martignon, L. (2012). “How Do Com­ mon Investors Behave? Information Search and Portfolio Choice Among Bank Customers and University Students,” Mind Science, 11, 203–33. Mors, W.P. (1965). Consumer Credit Finance Charges: Rate Information and Quotation (New York: National Bureau of Economic Research). O’Donoghue, T. and Rabin, M. (1999). “Doing It Now or Doing It Later,” American Eco­ nomic Review, 89(March), 103–24. Plott, C.R. (1996). “Rational Individual Behavior in Markets and Social Choice Processes: The Discovered Preference Hypothesis,” in K.A. Arrow, E. Colombatto, M. Perlman, and C. Schmidt (eds.), Rational Foundations of Economic Behavior (New York: St. Martin’s Press). Plott, C.R. and Zeiler, K. (2005). “The Willingness to Pay–Willingness to Accept Gap, the ‘Endowment Effect,’ Subject Misconceptions, and Experimental Procedures for Eliciting Validations,” American Economic Review, 95(June), 530–45. Prelec, D. and Loewenstein, G. (1998). “The Red and the Black: Mental Accounting of Savings and Debt,” Marketing Science, 17, 4–28. Samuels, R., Stich, S., and Faucher, L. (2004). “Reason and Rationality,” in I. Niiniluoto, M. Sintonen, and J. Wolenski (eds.), Handbook of Epistemology (Dordrecht: Kluwer). Samuelson, P.A. (1937). “A Note on Measurement of Utility,” Review of Economic Studies, 4, (February), 155–61. Schwert, G.W. (2003). “Anomalies and Market Efficiency,” in G.M. Constantinides, M. Harris, and R.M. Stulz (eds.), Handbook of the Economics of Finance (New York: Else­ vier). (p. 844)

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Behavioral Economics, Financial Literacy, and Consumers’ Financial Deci­ sions Shiller, R.J. (1999). “Human Behavior and the Efficiency of the Financial System,” in J.B. Taylor and M. Woodford (eds.), Handbook of Macroeconomics, Vol. 1, Part C (Amsterdam: Elsevier), 1305–40. Shui, H. and Ausubel, L.M. (2005). “Time Inconsistency in the Credit Card Market,” Uni­ versity of Maryland Working Paper, January 30. Smith, V.L. (1991). “Rational Choice: The Contrast Between Economics and Psychology,” Journal of Political Economy, 99(August), 877–97. Smith, V.L. (2005). “Behavioral Economics Research and the Foundations of Economics,” Journal of Socio-Economics, 34, 135–50. Soman, D. (2001). “Effects of Payment Mechanism on Spending Behavior: The Role of Re­ hearsal and Immediacy of Payments,” Journal of Consumer Research, 27(March), 460–74. Soman, D. and Gourville, J.T. (1998). “Transaction Decoupling: How Price Bundling Af­ fects the Decision to Consume,” Journal of Marketing Research, 38(February), 30–44. Stango, V. and Zinman, J. (2011). “Fuzzy Math, Disclosure Regulation, and Market Out­ comes: Evidence from Truth-in-Lending Reform,” Review of Financial Studies, 24, 507– 34. Strotz, R.H. (1955–1956). “Myopia and Inconsistency in Dynamic Utility Maximization,” Review of Economic Studies, 23, 165–80. Thaler, R.H. (1980). “Toward a Positive Theory of Consumer Choice,” Journal of Economic Behavior and Organization, 1, 39–60. Thaler, R.H. (1985). “Mental Accounting and Consumer Choice,” Marketing Science, 4(Summer), 199–214. Tversky, A. and Kahneman, D. (1974). “Judgment Under Uncertainty: Heuristics and Bias­ es,” Science, 185, 1124–31. Tversky, A. and Kahneman, D. (1981). “The Framing of Decisions and the Psychology of Choice,” Science, 211, 453–8. Tversky, A. and Kahneman, D. (1983). “Extensional versus Intuitive Reasoning: The Conju­ gation Fallacy in Probability Judgment,” Psychological Review, 90, 293–315. Xiao, J.J. and O’Neill, B. (2018). “Mental Accounting and Behavioral Hierarchy: Under­ standing Consumer Budgeting Behaviour,” International Journal of Consumer Studies, 42(April), 448–59.

Notes: (1) See Blackwell, Mineard, and Engel (2006). Page 31 of 35

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Behavioral Economics, Financial Literacy, and Consumers’ Financial Deci­ sions (2) For a summary of three decades of research at the Institute for Social Research, see Katona (1975). (3) Much of the Michigan survey research took place before Truth in Lending mandated disclosure of an effective annual rate (the annual percentage rate). At that time, three dif­ ferent types of rates were quoted—add-on, discount, and percent per month—depending largely on the institutional type of lender. The add-on and discount methods produce rates that are considerably lower than an effective annual rate. See Mors (1965). (4) Applying the interest rate to half the initial balance provides an approximation of the finance charge for a one-year loan. Had respondents used this procedure to estimate fi­ nance charges, their reported finance charges would have been consistent with estimated interest rates. (5) More recent data are not available for closed-end credit. (6) As mentioned, three types of interest rates were in use before Truth in Lending. Famil­ iarity with installment mathematics might have been useful for comparing credit costs across institution types at that time. See Mors (1965) for discussion. (7) See discussion on hyperbolic discounting below for discussion of pre-commitment. (8) Katona (1975) argued that the predominant alternative to rational behavior is habitual behavior, not irrational behavior. Habitual behavior occurs when consumers are satisfied with previous decisions and do not experience any stimulus to change. (9) For discussion of other common heuristics that have been linked to cognitive biases, see Kahneman (2011). For heuristics that have been found to perform well, see Gigerenz­ er, Todd, and the ABC Group (1999), Gigerenzer (2008), or Gigerenzer and Brighton (2009). (10) Probability weights may be influenced by ambiguity or vagueness. (11) See Samuelson (1937). Samuelson did not claim that individuals actually discounted using a single constant rate. Instead he maintained that a single constant rate was a hy­ pothesis, subject to refutation by the observable facts. (12) Besides a constant discount rate, the expected utility model involves several addition­ al assumptions: (1) When evaluating new prospects, individuals consider how new prospects will affect consumption in all future periods. (2) Aside from discounting, the distribution of utility across time does not matter, ruling out preferences for a flat or im­ proving utility profile over a highly uneven utility profile. (3) Utility of consumption in any period is unaffected by consumption in any other period, which does not allow for a pref­ erence for variety in consumption. (4) An individual’s well-being in any time period is con­ stant regardless of the time at which utility is evaluated, precluding changes in prefer­ ences. Empirical evidence indicates that individuals do not behave in accordance with these assumptions either (see Frederick, Loewenstein, and O’Donoghue, 2002). Depar­ Page 32 of 35

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Behavioral Economics, Financial Literacy, and Consumers’ Financial Deci­ sions tures from these assumptions of the expected utility model generally have not been viewed as problematic. (13) See Miller and Cohen (2001) or Camerer, Loewenstein, and Prelec (2005) for a neuro­ biological description of cognitive control structures. (14) For example, “After more than a decade of research on this topic we have become convinced that the endowment effect, status quo bias, and the aversion to losses are both robust and important” (Kahneman, Knetsch, and Thaler, 1991, p. 205). (15) See Plott (1996) and Loomes, Starmer, and Sugden (2003) for further discussion and evidence of learning in repeated markets. (16) For a brief description of the theory, see Samuels, Stich, and Faucher (2004). (17) Recall that participants were asked whether it was more probable that (1) Linda is a bank teller or that (2) Linda is a bank teller and active in the feminist movement. The fre­ quency format is “There are 100 people who fit the description above. How many of them are (1) … bank tellers? (2) … bank tellers and active in the feminist movement? (18) For a discussion of differences between the Kahneman/heuristics and biases program and the Gigerenzer/fast and frugal heuristics program, see Forbes et al. (2015). (19) Performance was measured by the ratio of mean excess portfolio return to the portfo­ lio standard deviation, the certainty equivalent return for an expected utility mean-vari­ ance investor, and trading volume for each portfolio. (20) Earlier studies by Bloomfield, Leftwich, and Long (1977) and Jorion (1991) also found that mean-variance portfolios did not outperform 1/N portfolios. (21) For further discussion of fast and frugal heuristics in financial decision-making, see Forbes et al. (2015). (22) For example, Shefrin and Thaler (1988), Ausubel (1991, 1999), Shui and Ausubel (2005), Soman (2001), Soman and Gourville (1998), DellaVigna and Malmendier (2004), Gabaix and Laibson (2006). See Durkin et al. (2014, chapters 5 and 7) for further discus­ sion. (23) A choice that turns out to be a mistake ex post may not be a mistake ex ante. Con­ sumers may experience unexpected expenses or shortfalls in income that cause them to borrow when they initially had not intended to borrow. (24) The annual fees on cards ranged from $10 to $24. (25) Fernandes, Lynch, and Netemeyer (2014) identified 10,650 studies published be­ tween 1987 and 2013 that were empirical tests of the effect of financial literacy on finan­ cial behavior.

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Behavioral Economics, Financial Literacy, and Consumers’ Financial Deci­ sions (26) Some questions test knowledge of basic financial concepts such as compound inter­ est: For example, “Suppose you had $100 in a savings account and the interest rate was 20 percent per year. After 5 years how much do you think you would have on this account in total? [More, exactly or less than 200].” Other questions require knowledge of basic concepts and institutional features: For example, “Buying a company stock usually pro­ vides a safer return than a stock mutual fund [True or false?].” Correctly answering this question requires an understanding of risk diversification and knowing the definition of a stock mutual fund. See Lusardi and Mitchell (2010) for a list of the full set of financial lit­ eracy questions. (27) Sixty-six percent gave incorrect answers or said that they did not know the correct answer for two or more questions. Ten percent gave incorrect answers or said that they did not know the correct answer for all three questions. (28) If two papers analyzed the same data, they included the paper with the more inclu­ sive sample. Pre-test/post-test studies were included only if the post-test was at least two weeks later than the pre-test. They excluded studies that did not provide sufficient infor­ mation to calculate effect size. (29) This finding is in sharp contrast to Lusardi and Mitchell (2014), who point to selected studies that report larger effects for instrumental variable regressions than OLS regres­ sions. As mentioned, Fernandes, Lynch, and Netemeyer’s results are based on a systemat­ ically selected set of all studies, which includes more studies, and likely is more represen­ tative of such studies than that of Lusardi and Mitchell. Also, Fernandes, Lynch, and Netemeyer report standardized effects (partial correlation coefficients) to facilitate com­ parisons of effects across models. (30) See Altman (2012) for further discussion. (31) Experimental economics is a field of economics that applies experimental methods to study how markets and other exchange systems work. (32) See Smith (1991) for references and a summary of the findings of various studies. (33) In a theoretical study, Bendor, Kumar, and Siegel (2009) found that a satisficing heuristic (choose an action again if it previously satisfied aspirations; search otherwise) often produces optimal long-run outcomes and improved but not optimal outcomes in oth­ ers).

Gregory Elliehausen

Gregory Elliehausen is Principal Economist in the Consumer Finance Section of the Division of Research and Statistics at the Board of Governors of the Federal Reserve System. His current research focuses on consumer financial behavior, regulation of financial markets and services, and markets for high-rate credit products. His re­ search has been published in numerous professional journals. Recent work includes Truth in Lending: Theory, History, and a Way Forward (co-authored with T.A. Durkin), Page 34 of 35

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Behavioral Economics, Financial Literacy, and Consumers’ Financial Deci­ sions which analyzes the purposes, strengths, and weaknesses of disclosures as consumer protections in financial transactions, and Consumer Credit and the American Econo­ my (co-authored with T.A. Durkin, M.S. Staten, and T.J. Zywicki), which examines the economics, psychology, law, and regulation of consumer credit in the United States. Previously, he held research positions at George Washington University (2006–9), Georgetown University (1998–2005), and the Board of Governors of the Federal Re­ serve System (1981–98). He has a Ph.D degree in business administration from the Pennsylvania State University.

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Systemic Risk in Banking after the Great Financial Crisis

Systemic Risk in Banking after the Great Financial Cri­ sis   Olivier De Bandt and Philipp Hartmann The Oxford Handbook of Banking (3rd edn) Edited by Allen N. Berger, Philip Molyneux, and John O. S. Wilson Print Publication Date: Oct 2019 Subject: Economics and Finance, Financial Economics Online Publication Date: Nov 2019 DOI: 10.1093/oxfordhb/9780198824633.013.27

Abstract and Keywords In this chapter we present a comprehensive review of systemic risk in banking, as the pri­ mary ingredient for understanding financial crises that have severe adverse effects on the macroeconomy (such as the Great Depression or the recent Great Financial Crisis). The first part of the chapter develops a conceptual framework that distinguishes three main forms of systemic risk: contagion, aggregate shocks, and the endogenous build-up and unraveling of widespread financial imbalances (such as credit booms leading to debt overhangs). Ex ante (preventive) policies, notably macroprudential regulation and super­ vision, and ex post (crisis management and resolution) policies to contain systemic risks and financial crises are also discussed. The second and third parts of the chapter review the existing theoretical and empirical literature about systemic risk, using the previously described conceptual framework and making reference to features of the systemic crisis that started in the summer of 2007. Keywords: bank resolution, contagion, crisis management, financial crises, financial imbalances, macro-financial linkages, macroprudential policy, systemic risk

The Fed will work closely and actively with the Treasury and other authorities to minimize systemic risk. Ben Bernanke, Chairman of the Federal Reserve (October 2008)1 The failure of Lehman Brothers in September triggered an unprecedented deterio­ ration in the degree of confidence in the banking sector which ran the risk of un­ dermining its fundamental function of financial intermediation. Jean-Claude Trichet, President of the European Central Bank (December 2008)2

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Systemic Risk in Banking after the Great Financial Crisis

26.1 Introduction FINANCIAL instability and crises are a recurrent, albeit infrequent, phenomenon in histo­ ry (Kindleberger, 1996 [1978]; Reinhart and Rogoff, 2009). The crisis that broke out (p. 848) in August 2007 reached systemic dimensions in September 2008, with the demise of Lehman Brothers in conjunction with a number of other events. This was one of the clearest illustrations in history of the fact that financial systems are subject to “systemic risk,” in which banks and credit play a particularly important role. Other examples in­ clude the banking crises of the Great Depression during the 1930s and of Japan and the Nordic countries during the 1990s. While the earlier and the present episodes both share some common features and are characterized by specific factors, systemic risk is now widely accepted as a fundamental underlying concept for the study of such severe finan­ cial instabilities, with strong real effects for the economy at large, and possible public pol­ icy responses. The two chapter epigraphs, observations which were made at the height of the crisis by the leaders of the two most important central banks in the world, illustrate the policy rel­ evance of systemic risk. In fact, one widely shared lesson from it was that financial super­ vision and regulation needed to become much more “macroprudential” (rather than re­ maining “microprudential”), that is, they should be geared toward containing systemic risks (rather than the risks of individual intermediaries or markets).3 To this effect many countries have created new bodies that should exercise such macroprudential policies. In Europe, also the European Systemic Risk Board has been created and, through the Single Supervisory Mechanism, the European Central Bank received some macroprudential competencies (Council of the European Union, 2013). In the United States, the Financial Stability Oversight Council has been established. In this chapter we provide a comprehensive analysis of systemic risk in banking, as the primary ingredient in understanding financial crises that cause severe negative effects for the real sector, and as a main rationale for banking regulation, prudential supervision, and crisis management.4 First, we bring together the most important analytical elements of systemic risk and integrate them into a coherent working concept, which can be used as a baseline for policies for ensuring the stability of financial systems, and distinguish three sources of systemic risk: contagion effects; aggregate shocks (exogenous to the fi­ nancial system); and that emerging from the endogenous build-up and unraveling of wide­ spread financial imbalances (ECB, 2009). We then analyze ex ante (preventive) and ex post (crisis management) public policy to contain systemic risk and crises (including macroprudential policy). Second, we also review the existing theoretical and empirical lit­ erature about systemic risk in light of the previously developed general concept. This could also help in identifying areas in which future research is needed. Finally, we offer some concluding remarks.

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Systemic Risk in Banking after the Great Financial Crisis (p. 849)

26.2 The Concept of Systemic Risk

Systemic risk in a very general sense is by no means a phenomenon limited to economics or the financial system. Maybe the most natural illustration of the concept is in the area of health and epidemic diseases. For example, widespread contamination as a result of disease could wipe out a significant portion of a population. In the area of economics, it has been argued that systemic risk is a special feature of financial systems, in particular the banking system. While contamination effects may also occur in other sectors of the economy, they are often regarded as more likely and severe in financial systems, partly because of the adverse effects they may have on the economy at large. One comprehen­ sive definition of systemic risk in an economy is when the risk that financial instability be­ comes so widespread that it impairs the functioning of a financial system to the point where economic growth and welfare suffer materially (ECB, 2009). A “systemic crisis” is the materialization of this risk. This section first provides a framework for the economic analysis of systemic risk that is based on both the research literature and practical experience.5 Second, it explains the reasons why financial systems can be regarded as being more vulnerable to systemic risk than other parts of economic systems. Third, we discuss to which extent some systemic events may be regarded as “efficient” and others as “inefficient.” Fourth, the relevance of systemic risk in banking for public policy is briefly examined.

26.2.1 Systemic Events and Crises Starting from the above definition, one can first distinguish “horizontal” from “vertical” systemic risk. The “horizontal” perspective is limited to understanding what makes insta­ bility widespread within the financial system. The “vertical” perspective also takes into account the two-way interaction between the financial system and the macroeconomy, which would be needed to assess growth and welfare effects. Until recently, standard macroeconomic models did not possess well-developed financial sectors, let alone charac­ terizations of financial stability, so that the research literature did not cover the “vertical” perspective very well. This is why most of this chapter focuses on the “horizontal” per­ spective of systemic risk, although we now also include some macro models with financial instability and some empirical evidence on the importance of financial shocks for the real economy.6 A key question is what makes financial instability widespread, that is, what makes an in­ stability event widespread in the banking system or the whole financial system? This (p. 850) can happen in three ways. First, instability can be transmitted in a sequential way from one financial intermediary to another (or from one financial market to another, often in the form of an externality), even though the instability of these intermediaries (or mar­ kets) has no common origin. We denote this form of systemic risk as contagion risk if cer­ tain further conditions are fulfilled, such as that the transmission is particularly violent, leading, for example, to bank defaults (or market crashes), or is in other ways different from the regular transmission of shocks (it differs from simple interdependence across in­ Page 3 of 43

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Systemic Risk in Banking after the Great Financial Crisis stitutions in normal times, as opposed to crisis periods, and it cannot be explained by eco­ nomic fundamentals; see Hartmann, Straetmans, and de Vries, 2006). Second, the system can be hit by a severe exogenous aggregate shock, which adversely affects a wide range of banks (markets) simultaneously and potentially leads to their default (crash). Third, widespread financial imbalances that have built up endogenously over time may unravel. For example, when a credit boom breaks down a number banks might collapse at the same time. Although these three “forms” of systemic risk are theoretically distinct, they are not unrelated and, in practice, can happen in conjunction with each other. For exam­ ple, in the 2007–8 crisis, the endogenous build-up of a strong credit and leverage boom, in conjunction with contagion effects through financial linkages, fire sales, market and funding liquidity problems, were key. Since systemic risk refers to the risk of very severe problems and not regular financial or business cycles, it is useful to also distinguish “strong” from “weak” systemic events. The former means events that lead to bank failures—although the banks have been fundamen­ tally solvent ex ante—or at least to losses that are so severe that they cause drastic trans­ missions in the financial system or to the real economy. A systemic event can range be­ tween a few banks—accounting for a significant share of banking assets or deposits—and all banks of a financial system. A “systemic crisis” usually affects a considerable number of banks covering a large and significant share of banking assets/liabilities in a “strong” sense.

26.2.2 The “Financial Fragility Hypothesis” Why is it, then, that systemic risk is of special concern in the financial system? Many of the traditional market imperfections play a role, notably externalities and asymmetric or imperfect information, incomplete markets and financial contracts, the public good char­ acter of financial stability, and multiple equilibria. But many of these market imperfec­ tions are also present in other sectors of the economy. Therefore, they alone do not seem to be sufficient for justifying the special “fragility” of financial systems. The “financial fragility hypothesis” becomes supported when three interrelated features are also taken into account. (1) The structure of banks’ balance sheets matters, in particular the conjunction of matu­ rity/liquidity mismatches, the highly (short-term dispersed) leverage, and the opacity of banking assets/liabilities. As a result of liquidity and maturity transformation activities, (p. 851) traditional commercial banks have short-term dispersed liabilities that are liquid and long-term assets that are illiquid. Moreover, banks tend to be highly leveraged in that a large share of their liabilities is in the form of debt. For example, the fact that commercial banks take fixed value deposits that can be with­ drawn (unconditionally and at fixed value) at very short notice, even though loans can usually not be sold at short notice, exposes them to the risk of bank runs (Bryant, 1980; Diamond and Dybvig, 1983). In addition, bank loans are difficult to value; more generally, banking assets are opaque, potentially contributing to asymmetric information between Page 4 of 43

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Systemic Risk in Banking after the Great Financial Crisis creditors and bank managers. In fact, the 2007 credit-market crisis is an illustration that the valuation of bank assets remains a challenge and that the expansion of securitization activity in the preceding years may have masked this fact. Therefore, the health of a bank depends not only on its success in picking profitable projects for lending and investment but also on the “confidence” of (retail and wholesale) depositors in the value of the loan and asset book and, importantly, in their confidence that “other” depositors will not run on the bank (Chari and Jagannathan, 1988). In fact, such coordination problems among depositors may sometimes cause solvent but illiquid banks to fail (Goldstein and Pauzner, 2005).7 This “special” character of banks does not apply to many other financial intermediaries, such as insurance companies, securities houses, and the like. However, if banks and other intermediaries belong to the same financial entity, or the former are exposed to the latter, non-bank intermediaries’ problems might still become a source of bank fragility. Some­ thing like this happened with special purposes vehicles to which banks had transferred some of their structured credit business before the crisis. Their design was not “balancesheet remote” and many banks decided to repatriate them on their balance sheets rather than to liquidate them when they got in trouble. The phenomenon of “shadow banking” is also of broader concern. For a variety of reasons, including regulatory arbitrage, some of banks’ business has migrated to other intermediaries, such as broker–dealers, money market funds,8 hedge funds or even some insurance companies. While legally not being banks (“credit institutions”), these entities have still acquired a significant role in the process of credit creation or some of them have balance-sheet structures very similar to banks (e.g., collateralized loans in the assets and short-term commercial paper in the lia­ bility), making them relevant for systemic risk assessments.9 Despite the fact that they look like banks, they are not subject to the same regulation and deposit insurance and, until recently, to liquidity support, thus they can be more fragile than banks. (p. 852)

Another important feature of the financial crisis that began in 2007 is the role

that short-term wholesale funding structures played. Most major investments banks, for example, acquired a large share of their high leverage through such funding structures and, as some main assets and hedging instruments became illiquid or turned out to be much less liquid than previously thought, effectively faced substantial maturity and liq­ uidity mismatches. As market stresses deepened, wholesale financiers became unwilling to roll over short-term debt, in ways reminiscent of depositor runs. This affected not only investment banks, but also other banks with undiversified funding structures and off-bal­ ance-sheet vehicles used for funding structured finance investments.10 The deleveraging process during a crisis usually requires fire sales of assets, pushing instability through the system and thereby deepening the crisis (Adrian and Shin, 2008). Market illiquidity and funding illiquidity reinforce each other and cause negative externalities to financial intermediaries (Brunnermeier and Pedersen, 2009). Finally, perverse incentives and behavioral biases may explain systemic risk. Because banks and other intermediaries are highly leveraged financial institutions which can also pass on their losses to taxpayers (in bailouts, for example), they may take excessive corre­ Page 5 of 43

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Systemic Risk in Banking after the Great Financial Crisis lated risks, the so-called moral hazard problem as, for instance, in Acharya and Yorulmaz­ er (2007, 2008b) and Farhi and Tirole (2012). Moreover, behavioral biases as, for exam­ ple, neglecting tail risk, as in Gennaioli, Shleifer, and Vishny (2013), may also lead to sys­ temic risk in financial markets. (2) Financial intermediaries and markets are highly interconnected among each other and with the real economy. Thinking of the “horizontal” perspective of systemic risk, there is a complex network of exposures among banks (and other financial intermediaries), for ex­ ample, through exposures in interbank money markets, derivative markets and large-val­ ue (wholesale) payment and security settlement systems. The Great Financial Crisis illus­ trated that malfunctioning wholesale markets have immediately systemic effects due to the extensive participation of most major banks in them.11 Policy and market initiatives over the last decades have significantly improved the safety of wholesale and retail pay­ ment and settlement systems, so that they played no specific role in the Great Financial Crisis. Badly designed payment and settlement systems, however, imply substantial sys­ temic risk. However, in the Great Financial Crisis, the dense network of financial claims among banks (and other intermediaries) played an important role. Concerning the “vertical” perspective of systemic risk, the financial sector constitutes a central component of a modern economy. All other sectors tend to be strongly connected to it, either as net borrower (e.g., the government and corporate sectors) or as net lender (e.g., the household sector). When the financial system malfunctions, then savings cannot be efficiently allocated to private or public investment and the borrowing (p. 853)

sectors suffer. For example, a banking crisis can create strong negative results for the economy at large through a reduction of the supply of credit (a credit crunch).12 (3) The information and control intensity of financial contracts, which rely on promises and expectations about future payments (e.g., Stiglitz, 1993). For example, the willing­ ness of agents to extend credit depends on their confidence that borrowers reimburse them in the future. When asymmetric information emerges, uncertainty increases, or the credibility of a financial commitment starts to be questioned, market expectations may shift substantially and, in an “individually rational” way, in short periods of time, lead to equally volatile investment and disinvestment decisions. For example, after the failure of Lehman Brothers and other negative events in September 2008, a general loss of confi­ dence emerged in which many banks preferred to hoard liquidity rather than lend it out. Or, in the summer of 2007, significant doubts emerged about the viability of structured fi­ nance products, so that investors—who could not distinguish good from bad products—in general stopped rolling over asset-backed commercial paper financing the investments of off-balance-sheet vehicles.13 These actions, in spite of being rational from an individual fi­ nancial intermediary point of view, are very negative for the financial system as a whole as they cause severe negative externalities. The combination of traditional market imperfections and these three special features in an environment of incomplete financial markets and contracts make financial systems subject to systemic risk, because it can give rise to particularly violent adjustments of be­ Page 6 of 43

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Systemic Risk in Banking after the Great Financial Crisis havior, powerful feedback and amplification mechanisms that make financial problems spread widely and in non-linear ways.

26.2.3 “Efficient” versus “Self-Fulfilling” Systemic Events Some bank failures are efficient, whereas many can be inefficient. General uncertainty and agents’ awareness of potential asymmetries of information highlight the role that ex­ pectations can play in systemic events. In fact, systemic events driven by expectations can be individually rational but not socially optimal. If the information about bank losses is released in full, and the bank is insolvent, it is indi­ vidually rational for depositors to withdraw their funds and force those banks into liquida­ tion. In the absence of external costs of liquidation this outcome would be “efficient”. If, instead, the information about bank losses is not revealed in full but depositors receive only a bad “noisy” common signal, it might still be rational for them to withdraw their funds early and thereby force the default of those banks. Whether the signal has been “right” or “wrong” would determine, ceteris paribus, whether this outcome is “efficient” ex post or not. As it is triggered by imperfect information on fundamentals, this type of event could be denoted as “information-based.” Signals can also coordinate depositors in their strategies to run or not in one or multiple banks. If the signals are not related to the health of banks and are common, as in the sunspot mechanism à la Cass and Shell (1983), multiple equilibria—bank failures stemming from sunspots—are inefficient. On the other hand, private signals to depositors that convey information about general bank fundamentals help them to predict how good the health of a bank is, and also what other depositors might predict about the health of the bank (see Goldstein and Pauzner, 2005). Depending on the noise structure, the unique equilibrium could be that depositors run if the private signal regarding bank fundamen­ tals is below a threshold. In particular, if the bank is close to insolvency but still solvent, there may be failure as a consequence of the combination of uncertainty in fundamentals and strategic uncertainty among depositors about their behavior—illiquidity due to bad fundamentals causes insolvency. This implies an ex post inefficiency that should be con­ trasted with the ex ante disciplining incentives provided by short-term debt such as de­ posits (Calomiris and Kahn, 1991; Diamond and Rajan, 2001; Rochet and Vives, 2004). (p. 854)

The presence of asymmetric information also illustrates how banking problems can build up over an extended period of time before an “efficient” or “inefficient” crisis occurs. That is, the systemic event is only the manifestation of a fundamental underlying financial imbalance (e.g., reckless lending) that was hidden from investors or policymakers for some time or remained unaddressed by either of them. The general repricing of risk that triggered the Great Financial Crisis started only around summer 2007, although it is widely believed nowadays that mortgage-lending and complex forms of securitizations had been on an unsustainable path for some years and imbalances had built up undetect­ ed for a while.14

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Systemic Risk in Banking after the Great Financial Crisis

26.2.4 Systemic Risk and Public Policy Given the market failures involving systemic risk and the potentially high costs of sys­ temic crises,15 there are public policies designed to contain systemic risk and crises—no­ tably macroprudential policy. These policies can be divided into ex ante (pre-emptive—try­ ing to contain systemic risks before they materialize as instability), and ex post (reactive —crisis management policies trying to stem instability that has broken out).16 The ex ante policies against systemic risk mean that banks (and other parts of the financial system) need to be supervised to identify emerging systemic risks early, and reg­ ulated so as to contain systemic risk or create buffers against it. One of the widely shared policy conclusions from the recent financial crisis was that this macroprudential branch of financial supervision and regulation needed to be developed properly. Before the crisis, most supervision and regulation was “microprudential” in nature. The main difference is that macroprudential policies have the objective to contain systemic risk, whereas micro­ prudential policies have the objective to contain the risks of individual banks or markets (Borio, 2003). While at present both policies continue to draw on a similar set of regulato­ ry instruments (with an important role for various capital and liquidity requirements), and long-term objectives are aligned, it is important to recognize that their short-run objec­ tives may sometimes differ, for example in the case of a downturn.17 In this case, micro­ prudential policy could be aimed at banks increasing their capital and liquidity buffers, whereas this may be very negative for the economy. Macroprudential policy, however, would build up buffers in good times and release them in the downturn. (p. 855)

The ex post policies against systemic instability are often denoted as crisis management. Crisis management typically involves central banks, bank supervisors and fiscal authori­ ties. Through its role as lender of last resort (LOLR), central banks often play a crucial role in crisis management. In principle, central banks can provide emergency liquidity as­ sistance (ELA) to individual banks, provide liquidity to the banking system as a whole (“lending to the market”) or more generally conduct an expansionary monetary policy to help stabilize the financial system, thereby supporting the economy as a whole. ELA may be justified if an individual bank is in liquidity trouble (but solvent) or is so large or interconnected that its failure could cause significant contagion effects. But it is only a temporary policy until the liquidity stress is over or the bank is either recapitalized or liq­ uidated. Individual emergency loans can be sterilized through opposite transactions vis-àvis the market as a whole, so that they do not interfere with the implementation of mone­ tary policy. “Lending to the market” is, by definition, not sterilized, but any surplus liquid­ ity could normally be taken out of the banking system at a later stage, when the crisis is over. For various reasons, the literature about the LOLR has shown much more controver­ sy regarding ELA than regarding “lending to the market” (see Goodfriend and King, 1988; and Goodhart and Huang, 1999 for two opposite views).18 Central banks could also relax monetary policy—lower short-term interest rates—in order to counter the effects of a cri­ sis on the banking system and the economy at large. While this risks mixing monetary policy and financial stability objectives, most severe financial crises are associated with Page 8 of 43

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Systemic Risk in Banking after the Great Financial Crisis economic downturns and downward risks (p. 856) to price stability, so that monetary poli­ cy may often go in the same direction as financial stability policies and a conflict may not materialize. Recently, central banks have also adopted a wide range of non-standard mon­ etary policies, either to compensate for the fact that short-term interest rates reached the zero lower bound or in order to repair a malfunctioning transmission of monetary policy in times of severe financial instability. In a crisis the difference between LOLR activities and non-standard monetary policies may blur. Recovering from a crisis it is therefore im­ portant to take care that accommodative monetary policies do not lead to excessive liq­ uidity or risk-taking by banks. In order to stabilize the macroeconomy in a systemic crisis, fiscal policy could also help. During the Great Financial Crisis, both accommodative monetary policy and substantial fiscal stimuli happened in many countries. In fact, given the central bank balance-sheet risks and long-term maturity involved in some non-standard monetary policy actions, the dividing line between monetary policy and fiscal policy may become less clear-cut. A policy with clear fiscal implications is a public bailout of financial intermediaries, in particular, large and complex banks. This also serves to avoid the destabilizing contagion or confidence effects that may emanate from their failure. In order to preserve the finan­ cial health and monetary policy independence of central banks, their LOLR activity tends to be limited to various forms of liquidity support. As soon as solvency support is required to ensure systemic stability, fiscal authorities need to be involved. Since, however, the fis­ cal costs of such bailouts can be enormous, sometimes even endangering the solvency of the sovereign (as highlighted in the Eurozone sovereign crisis), efforts are underway to limit them as much as possible. These efforts not only include more effective macropru­ dential regulations but also resolution policies involving bail-ins. It is now widely recognized that public and private safety nets, whether they take the form of public bailouts, LOLR facilities or deposit insurance, bear the risk of creating moral hazard. For example, if deposit insurance premiums do not reflect the banks’ rela­ tive portfolio risks, then the protection may incite banks to take on higher risks (Merton, 1978). Moreover, market expectations could be created whereby systemically large banks, with substantial market, clearing, and settlement links, are too-big-to-fail (TBTF) or “too complex to fail.”19 Such effects may be countered by very effective financial regu­ lation and prudential supervision, as, for example, suggested by Kareken and Wallace (1978), Buser, Chen, and Kane (1981) and Furlong and Keeley (1989) for the case of de­ posit insurance. They also create a case for “constructive ambiguity” vis-à-vis the poten­ tial use of public emergency lending (see Rochet and Vives, 2004). In a fragile situation, however, “constructive ambiguity” could also have destabilizing effects if markets lose confidence that public authorities will act decisively when needed.20 If the (p. 857) mea­ sures to control moral hazard are not successful, then the insured institutions could take on excessive risk ex ante. This could contribute to the accumulation of endogenous imbal­ ances, enhancing the likelihood of financial instability in the future. Also, too expansion­ ary macro-policies can fuel credit booms or asset price bubbles and excessive risk-taking

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Systemic Risk in Banking after the Great Financial Crisis and, thereby, contribute to the emergence of financial imbalances.21 This latter scenario would imply a higher level of systemic risk through inadequate safety net provisions. The complications in making ex ante policies effective and in containing unintended side effects of ex post policies has increased interest in ensuring market discipline and the re­ solvability of banks. Three approaches are prominent: First, living wills and “structural regulation” (such as the Volcker or, Vickers rules22) are intended to ensure that banks are not too complex to be resolved and that excessive risk-taking in investment is not subsi­ dized with deposit insurance or other public safety nets; second, the creation of resolu­ tion authorities with special powers to deal notably with systemic institutions in the case of the Dodd–Frank Act in the US (granted to the FDIC), or the Bank Recovery and Resolu­ tion Directive (BRRD) in the European Union (and the Single Resolution Board in the Eu­ rozone), which includes “bail-in” provisions intended to give investors greater incentives to impose discipline on bank management ex ante and relieve public budgets from heavy bailout costs through cost sharing; and third, building extra cushions to cover losses with various types of junior liabilities beyond capital, as in the Total Loss-Absorbing Capacity (TLAC) requirements for Global Systemically Important Banks (GSIBs), and generalized to all banks in the European Union. A related approach is the introduction of some form of Pigou tax on the total, or some parts, of banks’ liabilities, as in several EU countries in the 2010–15 period (see Buch, Hilberg, and Tonzer, 2016, for Germany). These taxes were designed to close the gap between marginal private and social costs of fragile financial structures (see IMF, 2010). However, bail-in may also have ex post costs in terms of con­ tagion, as investors in other banks may take them as a signal for an increased likelihood of being bailed-in in the future.

26.3 Theoretical Models of Systemic Risk in Banking (p. 858)

We now consider in greater detail the forms that systemic risk may take in banking. The theoretical literature in this area is surveyed in the light of the concept discussed in sec­ tion 26.2. The summary of theoretical (and, in section 26.4, empirical) papers is not ex­ haustive and the reader should go into de Bandt and Hartmann (2000) and de Bandt, Hartmann, and Peydró (2010) to get more extensive explanations of some papers. We start in the next subsection with the bank contagion literature, and then, systemic bank­ ing risk as a consequence of macroeconomic shocks and lending booms.

26.3.1 Contagion The banking literature in the last thirty years has developed sophisticated models of “sin­ gle” banks’ fragility starting from their balance-sheet structure (see section 26.2.2). How­ ever, with regard to systemic risk, this is only part of the story. One should distinguish be­ tween a “run” which involves only a single bank and a “banking panic” where more than one bank is affected (Calomiris and Gorton, 1991; Bhattacharya and Thakor, 1993). One can distinguish two main channels through which contagion in banking markets can Page 10 of 43

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Systemic Risk in Banking after the Great Financial Crisis work: the “real” or exposure channel and the informational channel. In principle, these two fundamental channels can work in conjunction as well as quite independently.

26.3.1.1 Interactions of Retail Depositors across Banks Chen (1999) combines an extension of the bank run models to multiple banks with the ra­ tional herding approach. There are two externalities in this model that cause contagious bank runs: a payoff externality through the first-come-first-served rule for servicing with­ drawing depositors, and an information externality through the Bayesian updating of be­ liefs about the macroeconomic situation as a function of observed bank failures. There is a critical number of early failures above which a run on the remaining banks in the sys­ tem will always be triggered. Finally, Chen shows that there also exists a deposit insur­ ance scheme that could eliminate any contagious bank runs in this model.

26.3.1.2 Interbank Markets A further important step is provided by theories of crises transmitted through the inter­ bank market. Rochet and Tirole (1996) present a model of the interbank market, where peer monitoring among banks in this market solves the “moral hazard” problem between bank debt-holders and bank shareholder–managers, but also induces contagion risk. The authors show that, for certain parameter values of the model, a small increase in the size of the liquidity shock hitting any of the banks can lead to the closing down of the entire banking system, a particularly severe case of contagion. A substantial part of this literature explains contagion by the structure of the banking network. Allen and Gale’s (2000) model focuses on the “physical exposures” of banks in different regions and on the “real” linkages between regions, as represented by the correlation of liquidity needs of the respective depositors. In their model, both deposi­ tors and banks choose deposits to insure against liquidity shocks. Liquidity shocks across regions fluctuate randomly, with aggregate liquidity staying constant with no bank fail­ ures. However, in an unexpected state of the world, to which all agents assign a probabili­ ty of zero ex ante, one bank faces additional withdrawals, so that aggregate liquidity is not sufficient to serve all depositors. The authors show that contagion can occur in this situation. Whether and how much propagation of failures emerges depends on the struc­ ture of the banking system: with more “complete” markets (each bank has lending rela­ tionships with all the other regions) the system is likely to be more stable. In a related pa­ per, Freixas, Parigi, and Rochet (2000) also show inefficient and contagious bank runs through fear of insufficient reserves in the system. (p. 859)

Following the above, there is literature that uses “network theory” to model the different possible sources of connections between financial institutions, stemming from both the asset and the liability side of their balance sheet. By providing means to model the specifics of interbank linkages, network analysis is well designed to explain interbank linkages and contagion through the interbank system. In this type of model, narrow shocks can lead to strong and widespread systemic events (see, e.g., Babus, 2016).

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Systemic Risk in Banking after the Great Financial Crisis Leitner (2005) studies the tradeoff between risk sharing and the potential for contagion in a network model. More interbank linkages imply better risk sharing among banks but also a higher potential for contagion with the possibility of multiple bank failures (sys­ temic event). In the model, the return of a bank depends on the investments of the other banks it is linked to. Banks, therefore, may be willing to bail out other banks, in order to prevent the collapse of the whole network. Conversely, Acharya, Gromb, and Yorulmazer (2012) suggest that surplus banks in the interbank market may strategically under-pro­ vide lending to cash-stricken banks and, thereby, induce inefficient sales of assets that transmit a crisis. This provides a rationale for the provision of emergency liquidity assis­ tance to individual banks by the central bank (see also section 26.3.1.4). Brusco and Castiglionesi (2007) extend Allen and Gale (2000) by modeling contagion in the interbank deposit market as an endogenous phenomenon, and introducing moral haz­ ard problems in banks. Banks establish interbank links to insure against liquidity prob­ lems and accept the risk of contagion only when the risk is not too large. The main impli­ cation is that contagion is a rare phenomenon, since otherwise the banks would avoid es­ tablishing financial linkages. In addition, in their model, the extent of contagion is the greater the larger the number of interbank deposit cross-holdings since more banks will get affected by the initial failure. In consequence, the more interbank links banks have, the higher the potential for contagion. Battiston et al. (2012a, 2012b) as well as Haldane and May (2011) also challenge the usu­ al view that increasing interconnection is always beneficial to financial stability. The argu­ ment raised by Haldane is derived from a parallelism with life sciences and, in (p. 860) particular, food cycles: complexity of species may imply more fragility. As a consequence, and completing Allen and Gale’s (2000) result, the negative relationship between inter­ connection and systemic risk may 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 interconnect­ ed may create more contagion. Acemoglu, Ozdaglar, and Tahbaz-Salehi (2015) show that when shocks are small enough, more interconnections increase the stability of the finan­ cial system, but beyond a certain point, they lead to a more fragile financial system. Mishkin (1991) and Davis (1994, 1995) argued that “adverse selection” plays an impor­ tant role in the transmission of financial crises. Flannery (1996) sketched a model of in­ terbank market crises due to asymmetric information among competing banks. Banks re­ ceive imperfect signals about the quality of prospective borrowers. Following a large shock in the financial system, banks may become more uncertain about their rivals’ screening ability. As they feel less able to distinguish between banks exposed to more or less risky borrowers, lenders raise interest rates across the board. If the loan rate be­ comes too high, “good” banks might not be able to repay their interbank loans any more, so that illiquid but solvent banks may go bankrupt. Ferguson et al. (2007) and Cassola et al. (2008) argue that adverse selection problems also played an important role in the transmission of the subprime crisis. Heider, Hoerova, and Holthausen (2015) develop a

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Systemic Risk in Banking after the Great Financial Crisis theoretical model on this idea and show the possible breakdown of the (unsecured) inter­ bank market. There are some applications of global games theory to interbank contagion. The advan­ tage of using this technique is to analyze at the same time coordination problems among depositors (panics) with depositor disciplining based on the health of the banking system (see Rochet and Vives, 2004). In fact, the level of (rational) panics depends in equilibrium on the level of banks’ fundamentals and the equilibrium is unique. Dasgupta (2004) ana­ lyzes crossholding of deposits among banks as a source of contagious breakdowns. He shows that failure in one bank reduces the value of creditor banks, thereby increasing its probability of failure. In Iyer and Peydró’s (2007) model, depositors may start running when there are bank shocks, forcing banks to unwind their positions in the interbank market to pay back the depositors, thus generating a strong systemic event. Fecht, Grüner, and Hartmann (2007) discuss the relationships between financial integra­ tion and systemic risk. They compare segmentation with three forms of inter-regional risk sharing: (1) integration through the secured interbank market; (2) integration through the unsecured interbank market; and (3) integration of retail markets. The secured inter­ bank market is an optimal risk-sharing device when banks report liquidity needs truthful­ ly. It allows diversification without the risk of cross-regional bank contagion. However, free-riding on the liquidity provision in this market restrains achievable risk sharing as the number of integrated regions increases. This can make the moral hazard problem be­ come so severe that either unsecured interbank lending implies contagion (p. 861) risk or, ultimately, the penetration of retail markets is preferable. Financial integration can also promote specialization in lending (and therefore production), which enhances risk shar­ ing but also increases cross-border contagion risk, even though this may be optimal from a welfare perspective (Fecht, Grüner, and Hartmann, 2012).

26.3.1.3 Payment and Settlement Systems By providing the technical infrastructure through which wholesale bank market transac­ tions are settled, large-value payment systems determine the physical exposures among financial institutions. Beyond explicit interbank lending, one needs to take into account the implicit lending that may arise in a payment system. In a way, looking at payment sys­ tems is like looking at the network of interbank exposures with a magnifying glass. Hence, depending on their internal organization they also influence how shocks may propagate through the financial system, in particular how severe bank contagion can be. There are three main types of interbank payment systems: net settlement systems, gross settlement systems, and correspondent banking. We just note here that the risks of net­ ting systems explain the spreading of real-time gross settlement (RTGS) systems across the world (Bech and Hobijn, 2007). Most real-life systems have specific additional institu­ tional features in order to reduce systemic risk or liquidity costs (and “gridlock” risk) in both net and gross systems, so that the two types that are very different in theory can be­ come quite similar in practice (“hybrid” systems).

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Systemic Risk in Banking after the Great Financial Crisis 26.3.1.4 “Fire Sales,” Liquidity Problems, and Endogenous Risk Diamond and Rajan (2005) argue that banks are characterized by specific knowledge about borrowers, which make their assets particularly illiquid. So, if a bank fails, the com­ mon pool of liquidity shrinks creating or exacerbating aggregate liquidity shortages, which in turn may cause further failures. Carletti, Hartmann, and Spagnolo (2007) link in­ dividual bank and aggregate interbank market liquidity with competition in the loan mar­ ket. When interbank markets are relatively efficient, bank concentration can exacerbate aggregate liquidity fluctuations. If a central bank does not offset them through liquidity provision, then system-wide liquidity shortages can become more severe and frequent. Unfortunately, liquidity and solvency problems interact and can cause each other, making it hard to determine the cause of a crisis. In Acharya and Yorulmazer (2008a), as the num­ ber of bank failures increases, the set of assets available for acquisition by the surviving banks expands but the total amount of available liquidity within the surviving banks falls. Since financiers not belonging to the banking system do not have the specific knowledge characterizing banks, the previous results imply “cash-in-the-market” pricing (below the “fair value”) for liquidation of banking assets. Fecht (2004) asks whether an individual bank run has more severe systemic conse­ quences in bank- or market-oriented financial systems. He finds that a bank run on a sin­ gle bank causes contagion via the financial market only in moderately bank-dominated fi­ nancial systems where “fire sales” of long-term financial claims by a distressed bank cause a sudden drop in asset prices, which hurts other banks. Cifuentes, Shin, and Fer­ rucci (2005) present a model where financial institutions are connected via common port­ folio holdings. Contagion is mainly driven here by changes in asset prices through forced sales of assets by some banks that depress the market price, inducing further distress to other banks. In Allen and Carletti (2008), asset prices in some markets may reflect the amount of liquidity available in the market rather than the future earning power of the as­ set. Mark-to-market accounting is not a desirable way to assess the solvency of a financial institution in such circumstances since it can lead to contagion where none would occur with historic cost accounting.23

26.3.2 Macroeconomic Fluctuations, Aggregate Shocks, and Lending Booms Systemic risk may be associated with large exogenous macroeconomic shocks or the widespread accumulation of endogenous financial imbalances, such as credit booms. The former is an ex post argument in the sense that many banks may get into trouble at the same time when economic downturns or widespread financial market crashes occur. The latter is an ex ante argument in the sense that there are mechanisms in financial systems that encourage similar forms of risk-taking being pursued by many banks at the same time. So, widespread imbalances can accumulate over time, which may unravel violently only much later, be it through a macroeconomic shock or other events. Given their differ­ ent nature we discuss the two sources of systemic risk in separate subsections.

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Systemic Risk in Banking after the Great Financial Crisis 26.3.2.1 Aggregate Shocks to the Banking Sector It has been observed that many banking crises have occurred in conjunction with cyclical downturns or other aggregate shocks, such as interest rate increases, stock market crashes, or exchange rate devaluations (see, e.g., Gorton, 1988). Why is it that banks si­ multaneously get in trouble in those events (included in the concept of systemic risk in the “broad” sense, according to the terminology given above), even in the absence of di­ rect interbank contagion, and why are prudent banks not better protected than impru­ dent ones? One answer could be given on the basis of the individual bank run models. News about a cyclical downturn, for example, could provide the negative signal about banks’ loans to all or a subset of depositors. Allen and Gale (1998) take issue with the in­ terpretation of bank runs as random phenomena, because of their historical association with severe “business cycle fluctuations.” They argue that if depositors make their with­ drawal decisions based on a leading indicator for business cycles, the first-best outcome can occur in spite of the non-contingent character of the deposit contract. However, the result breaks down when early withdrawals are costly, so that a public intervention is nec­ essary to restore the first-best outcome.24 Another source of systematic shocks to the banking sector can be “financial mar­ ket crashes” or “market liquidity crises”—in particular when they concern any of the ma­ jor markets and when they are contagious across markets (see, e.g., Morgenstern, 1959; King and Wadhwani, 1990; Hartmann, Straetmans, and de Vries, 2004). Commercial and universal banks have become more involved in financial market trading (as opposed to traditional lending). Moreover, as part of the securitization trend before the crisis and more active credit risk management, banks had invested a lot in asset-backed securities and structured credit products, using also credit derivatives very actively. As a conse­ quence, their trading books had grown significantly, exposing them more to shocks origi­ nating in financial markets. This implied that systemic risk in banking markets was more dependent on market risk, (supposedly) tradable credit risk, and liquidity in those mar­ kets than had previously been the case. (p. 863)

Various negative events in financial markets may increase uncertainty and the ability and willingness to trade in these markets. Imperfect information about asset valuations can lead to significant credit spreads even at shorter maturities or even credit rationing (Duffie and Lando, 2001; Tirole, 2008a, 2008b). Market makers might increase bid–ask spreads to reduce the likelihood of being hit by a transaction (“price rationing”) or even “refuse” to trade at all (“quantity rationing”). Such a liquidity “freeze” could involve a systematic shock on all those banks and non-bank financial institutions whose risk man­ agement strategies depend on the ability to trade in these markets. During the Great Fi­ nancial Crisis, valuation uncertainties for credit products had these effects and led to illiquidity in structured product and major money markets (Cassola et al., 2008). One key question is how banks deal with aggregate shocks to the banking sector. Allen and Gale (2004, 2007) develop a general equilibrium framework for analyzing the norma­ tive aspects of financial crises with a more significant emphasis on the relationships be­ tween asset prices and banking crises. They consider the interaction of banks and mar­ Page 15 of 43

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Systemic Risk in Banking after the Great Financial Crisis kets and focus on fundamental shocks (as opposed to coordination problems among de­ positors) as the driver of financial crises. Financial intermediaries provide liquidity insur­ ance to consumers against idiosyncratic liquidity shocks. Markets allow financial interme­ diaries and their depositors to share aggregate liquidity and return shocks. The authors show that, when markets are incomplete, asset prices must be volatile to provide incen­ tives for liquidity provision (otherwise, agents would not find liquidity holdings valuable). This asset price volatility can lead to costly and inefficient crises. There is a market fail­ ure that potentially provides a justification for regulation and other kinds of intervention to improve the allocation of resources.25 (p. 864)

26.3.2.2 Credit Booms and Unraveling of Imbalances

Two different types of contributions need to be mentioned. First, the literature on credit booms, then the integration of fragility in macroeconomic models, the shift from “tran­ quil” to crisis periods, and their aggregate effect. First, an issue related to the real macroeconomic shocks discussed above is why banks expand so much credit, implying risks that can bring many of them into trouble at turning points, even though they know they cannot pass on the risk to depositors. The lending boom literature has addressed this question. Minsky (1977, 1982) believed that the postWorld War II free-market economy has a natural tendency toward financial instability at the aggregate level. In good times agents consume and invest, generating more income. As “euphoria” and “gregarious behavior” pick up, more speculative or even “Ponzi” fi­ nance is undertaken, as opposed to safer “hedging” finance.26 The boom is fed by an over­ expansion of bank credit until some exogenous outside shock to the macroeconomic sys­ tems (“displacement”) brings it to an end. Kindleberger (1996 [1978]) shares the basic idea, although perhaps being more moderate in pointing out that the market system “oc­ casionally” faces such bubbles, leading to financial crises. These early writers empha­ sized the role of uncertainty (of the “Knightian” type as opposed to risk) and the inability of banks to take the appropriate decisions in some circumstances. For example, Gut­ tentag and Herring (1984) develop a simple model of credit expansion and discuss the consequences of “Knightian” uncertainty about catastrophic shocks on investment re­ turns and default risk premiums. On the basis of results from psychology, they also argue that the subjective probabilities attached to catastrophic events will decline as time elaps­ es after the realization of such an event. This “disaster myopia” will lead to a widespread underestimation of the likelihood of extreme events that could question the health of banks.27 Related explanations for lending booms are found in the more recent rational ex­ pectations literature on “herding” in investment and loan decisions. For example, Baner­ jee (1992) or Bikhchandani, Hirshleifer, and Welsh (1992) introduce formal models of in­ formation externalities that can lead to herding. Each agent only observes the actions of other agents and uses Bayesian updating to derive his or her own subjective probabilities of future returns on his investment decisions. Scharfstein and Stein (1990) model man­ agers’ incentives to mimic others in investment or loan decisions, when their own evalua­ tion and reputation depends on their performance relative to the rest of the market.28 The stance of “monetary policy” may also affect bank risk-taking and, in general, asset prices. Page 16 of 43

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Systemic Risk in Banking after the Great Financial Crisis The development of microeconomic (p. 865) banking models with such monetary channels is at an early stage. Allen and Gale (1998, 2000, and 2007) and Diamond and Rajan (2006), among others, have made steps in this direction. In Diamond and Rajan (2006) banks take higher liquidity risk when monetary policy is expansive. In their model, which provides “a liquidity version of the lending channel” of the monetary policy transmission mechanism, banks finance illiquid long-term projects with very liquid demand deposits. This mismatch makes banks reluctant to grant loans in times of liquidity shortages. De­ pending on the aggregate real liquidity conditions, monetary intervention can play a use­ ful role by limiting the depositors’ incentives to withdraw. Banks will respond by continu­ ing, rather than curtailing, risky credit.29 In line with such arguments, Dell’Ariccia and Marquez (2006) develop a model in which banks’ incentives to screen borrowers diminish as interest rates become lower.30 In sum, a too loose monetary policy may contribute to the emergence of credit booms. A further branch of the literature explains excessive or too-risky lending by banks with “moral hazard” (see also section 26.2.4). These writings refer to features of banking mar­ kets that normally do not exist for other industries. For example, Merton (1977, 1978) de­ velops a model showing how fixed rate deposit insurance premiums that are insensitive to banks’ portfolio risks (as observed in many countries) may lead them to increase risk-tak­ ing in order to maximize the put option value on the insurance corporation’s funds. Boot and Thakor (1993) further argue that such deposit insurance can lead to an inefficiently low level of monitoring. Applying modern corporate finance models of firms’ capital struc­ tures to the case of banks, Dewatripont and Tirole (1994) argue that banks’ excessive re­ liance on debt financing (partly related to their provision of retail payment services to a large number of small and relatively uninformed depositors) can also lead to more risktaking in lending. Owing to the existence of explicit or implicit government guarantees for financial institutions, the issue of moral hazard has also been raised in the context of the US savings and loans crisis (Kane, 1989) or regarding the lending boom that partly led to the East Asian crisis (Krugman, 1998). Goodhart and Huang (1999), however, show that a positive level of moral hazard resulting from safety net provisions, such as lending of last resort, might be unavoidable or even optimal to contain the systemic costs or mon­ etary disturbances associated with financial crises. This credit boom literature addresses the issue of systemic risk in an indirect way. Banks’ (or other financial intermediaries’) herding and credit over-expansion leads to the (potentially slow) build-up of imbalances that imply vulnerabilities for a large number of banks (or even other firms and households), which increase the likelihood as well as the severity of systemic events. Once a negative aggregate shock or other event makes the non-sustainability of the boom apparent, many banks may face similar problems simulta­ neously. According to Minsky, Kindleberger, and others, such financial cycles emerge en­ dogenously as an inherent part of a market economy with relatively (p. 866) unregulated financial markets. The modern expression for this phenomenon is the strong “procyclicali­ ty” of financial systems. Many argue that the financial crisis that started in the summer of 2007 is also a reflection of it. Page 17 of 43

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Systemic Risk in Banking after the Great Financial Crisis The second important dimension is the characterization of regime shifts in theoretical macroeconomic models. One important step in the characterization of financial instability in these models was the introduction of the occasionally binding credit constraints of agents that give rise to a non-linearity and amplification of economic fluctuations after a bad shock (e.g., Mendoza, 2002, 2010; Lorenzoni, 2008; Bianchi, 2011; or Korinek, 2011). Brunnermeier and Sannikov (2014) develop a macroeconomic model with a financial sec­ tor, 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. As a conse­ quence there may be multiple equilibria: a crisis equilibrium in which wholesale funding markets freeze—because financiers lose trust in banks’ investment choices—and econom­ ic activity collapses; and another 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, Collard, and Smets (2016) introduce the pos­ sibility of wholesale bank funding market freezes in a dynamic stochastic general equilib­ rium 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 unraveling of widespread financial imbalances, they illustrate that crises can happen entirely endogenously, without any exogenous shocks, and that agents form ex­ pectations about them (anticipating likelihoods for 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 equilib­ ria. 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, they deleverage and the economy collapses. The even more recent generation of agent-based models (e.g., Chan-Lau, 2017; Aymanns et al., 2018) introduce heterogeneity across agents in order to analyze risks in the bank­ ing system in which banks’ business decisions drive the endogenous formation of inter­ bank networks. In these models macro-financial dynamics and systemic risk depend on the number of connections of one institution with others in the network. They are able to explain phenomena that are driven by out-of-equilibrium behavior, such as clustered volatility and fat tails, that characterize systemic risk.

Page 18 of 43

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Systemic Risk in Banking after the Great Financial Crisis

26.4 Empirical Evidence on Systemic Risk in Banking (p. 867)

In this section we survey some of the existing empirical evidence on systemic events and systemic bank crises, as made available in the quantitative economic and finance litera­ ture.31

26.4.1 Evidence on Bank Contagion Testing for bank contagion amounts to testing whether “bad news” about the failure of a specific bank (or group of banks) adversely affects the health of other banks. The first branch of the bank contagion literature is a test for autocorrelation in bank failures. Pro­ vided that all macroeconomic shocks are effectively covered by the control variables, a positive and significant autocorrelation coefficient indicates that bank failures and peri­ ods of tranquility cluster over time, which is consistent with the contagion hypothesis. These tests have to be undertaken for historical periods in countries without strong (pub­ lic) safety nets. Another test of contagion measures the reaction of depositors (wholesale and retail) to “bad news.” If, in response to problems revealed about bank i (or a group of banks), de­ positors also withdraw funds from bank j, then there is evidence of a contagious bank run. Calomiris and Mason (1997) examine the June 1932 Chicago bank panic and conclude that only weaker banks ex ante actually failed during the panic, which is consistent with the hypothesis that “pure” contagious failures, or “strong” systemic events (in the “nar­ row” sense), did not occur. They explain this finding with the existence of private cooper­ ative arrangements among banks. In Calomiris and Mason (2003) they argue that the re­ gional 1930 bank panic was associated with greater deposit withdrawals than could have been predicted from bank-level micro data, and regional and national fundamentals, but they question the notion that uniform withdrawals, unexplained by fundamentals, have happened at the national level before 1933. Iyer and Peydró (2011) test whether inter­ bank-lending exposures can explain contagious deposit withdrawals, as predicted, for ex­ ample, in Allen and Gale (2000), using a detailed micro dataset for a large idiosyncratic Indian bank failure. Banks with higher interbank exposure to the failed bank experience higher deposit withdrawals. This relationship is non-linear and is stronger for banks whose fundamentals are weaker. In addition, more exposed (p. 868) banks suffer further as other banks do not renew their interbank loans. Finally, both households and firms suf­ fer from the relationship in terms of reduced deposits and loans, respectively. Theoretical models of contagion suggest that banking contagion may also happen directly through interbank exposures. Kaufman (1994) reports that, shortly before the failure of Continental Illinois, sixty-five financial institutions had uninsured exposures to the bank in excess of their capital. However, Continental’s actual losses finally reached 5 percent, which was below the 60 percent threshold that would have triggered insolvency of ex­ posed banks. Page 19 of 43

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Systemic Risk in Banking after the Great Financial Crisis The most popular approach to test for contagion effects are event studies of bank stock price reactions in response to “bad news,” such as the announcement of an unexpected increase in loan-loss reserves or the failure of a commercial bank. The presence of conta­ gion is usually tested by measuring “abnormal” bank stock returns (measured by the de­ viation from a standard capital asset pricing model (CAPM) on historical data) following the announcement of “bad news” for other banks. Aharony and Swary (1983), the fore­ runners of this approach, looked at the effects of the three largest bank failures in the US before 1980. Related to, but methodologically distinct from, the above event studies are analyses of bank stock price spillovers to measure bank contagion. In this approach, if a large nega­ tive return of bank i (or a group of banks) is associated with a large negative return of bank j, then this is taken as evidence of bank contagion. Hartmann, Straetmans, and de Vries (2006) apply, for the first time, extreme-value theory (EVT) to the banking sector. They develop a measure of multivariate extreme spillovers between bank stocks, which is based on the conditional probability of any set of banks facing a dramatic decline in their stock price, given a dramatic decline of the stock prices of any set of other banks. The re­ sults for LCBOs (Large and Complex Banking Organizations) between 1992 and 2004 suggest that multivariate extreme bank spillover risk in the US is both economically and statistically higher than in the Eurozone. This measure of banking system risk has gradu­ ally increased during the second half of the 1990s, although only to a very limited extent in Europe, and stayed at the more elevated levels until the end of the sample period. Hartmann, Straetmans, and de Vries (2006) also apply the tail-beta method (i.e., an ex­ treme-value equivalent of the beta in the CAPM, which measures how extreme downturns by the market factor also affect the propensity of bank stocks to crash) to Eurozone and US LCBOs during the 1990s and early 2000s. The results suggest that this extreme sys­ tematic bank risk is of significant and similar magnitude on both sides of the Atlantic and that in both economies it increased over the sample period. Generalizing this approach, several indicators have been proposed to measure the contri­ bution of individual firms to trigger extreme events (“systemic importance”) or their sen­ sitiveness to extreme events (“systemic fragility”). On the one hand, Adrian and Brunner­ meier (2016) rely on the usual risk measure Value at Risk (VaR) through the so-called Conditional Value at Risk (CoVaR). The contribution of an institution is (p. 869) measured as the 5 percent-quantile of loss of the whole financial system, that is the usual VaR, con­ ditional on the fact that the specific institution is already at its 5 percent-VaR. On the oth­ er hand, using tail-beta, Acharya et al. (2017) have extended the concept of expected shortfall to define the marginal expected shortfall (MES). The systemic risk generated by one institution (its marginal contribution) is measured as the average net equity return on the 5 percent lowest daily market returns. Conditioning on these returns restricts the analysis to a situation of general distress. The risk measure aims at capturing the need for capital of an institution in the case of a crisis. Taking a simplified view of banks’ bal­ ance sheets, the MES, combined with the leverage ratio, constitutes an indicator to pre­

Page 20 of 43

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Systemic Risk in Banking after the Great Financial Crisis dict an institution’s systemic expected shortfall (SES), which captures, according to the authors, the propensity to be undercapitalized when the system as a whole is in that case. Controlling for balance-sheet composition, the MES is turned into systemic risk (SRISK) by Brownlees and Engle (2017) who also include a refined dynamic model on returns. The SRISK is the expected capital shortage of a financial institution, conditional on a substan­ tial market decline (e.g., a 40 percent fall over six months) and taking leverage and size into account. However, several important limitations have been raised towards marketbased indicators of system risk: the channels of spillover are not identified; they mainly capture contemporaneous instability and not risks for the future; they may be distorted by asset price bubbles and lack of market discipline (due to, e.g., potential bailouts). The use of measures based on fundamentals such as credit supply growth is therefore crucial (as in, e.g., Jiménez et al., 2012 and 2014). Taking a broader perspective than solely banking markets, Hollo, Kremer, and Lo Duca (2012) construct the ECB’s CISS (Composite Indicator of Systemic Stress) to assess con­ temporaneous stress. Using mostly market data, they first compute a financial stress subindex for five sub-markets: the financial intermediaries sector, money markets, equity markets, bond markets and foreign exchange markets. These sub-indicators are then ag­ gregated using basic portfolio theory. The index takes a higher value in situations when stress prevails in several market segments at the same time, a standard feature of a sys­ temic event. All these measures should be assessed on the basis of out-of-sample prediction. Unfortu­ nately, as shown by Giglio et al. (2013), very few measures survive the tests based on many historical recessions and financial crises. In fact, an aggregate measure that en­ compasses several of these systemic risk measures performs substantially better. It re­ mains, however, that many of these indicators are usual coincident measures of systemic risk and have poor forward-looking properties in the sense that they only identify per­ ceived risk, hence often giving the wrong message until it is too late (Danielsson et al., 2016). Greenwood, Landier, and Thesmar (2015) model the transmission channel of “fire sales” in an accounting model of the value of banks’ portfolio, taken as given exposures and price reactions to asset sell-offs, depending on the liquidity in the secondary market. The model is notably calibrated on banks’ sovereign exposures as published during EBA’s 2011 stress tests for ninety banks in the EU 27 countries to account for the (p. 870) deleveraging that took place in 2010–11. They thus appealingly distinguish between, on the one hand, a bank’s contribution to financial sector fragility and, on the other hand, the impact on a bank’s equity of a shock through deleveraging, hence its vulnerability to systemic risk. In that sense the paper features two of the three dimensions of systemic risk as it shows how the unraveling of imbalances through deleveraging interacts with contagion, through fire-sale effects. There is also a central bank research literature using confidential and often incomplete data on interbank exposures to assess the risk of contagion using counterfactual simula­ tions. Single or multiple banks are assumed to fail and the simulations derive which other Page 21 of 43

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Systemic Risk in Banking after the Great Financial Crisis banks would fail as a consequence of this, everything else equal. Some of these studies suggest that contagion effects are relatively limited in most scenarios. For example, Furfine (2003) finds this for Fed Funds transactions by US commercial banks settled through the Fedwire real-time gross settlement system in 1998. He also shows that the degree of systemic risk depends dramatically on the recovery rate that is assumed for bank failures.32 Elsinger, Lehar, and Summer (2006a, 2006b) combine information about interbank exposures with that on macroeconomic fluctuations for Austria and the UK. It turns out that contagion risk is generally quite low and dominated by risks from correlat­ ed assets. Other papers analyze Belgium (Degryse and Nguyen, 2007), Italy (Mistrulli, 2011), Netherlands (Van Lelyveld and Liedorp, 2006) and Germany (Upper and Worms, 2004).33 More recent papers provide information on banking networks on the basis of actual expo­ sures. This is the case of Cont and Santos (2010) on Brazil and Alves et al. (2013) for the network of the 53 largest EU banks. Work was undertaken in order to derive systemic risk indicators from these measures (Battiston et al., 2012a). Karas and Schoors (2012) introduce the K-coreness, defined by a recursive algorithm borrowed from physics that sequentially weights the nodes of the network with respect to their connectivity. It is pre­ sented as a predictor of an individual bank’s potential to spread contagion. This indicator indeed clearly outperforms others when tested on the Russian interbank market leading to a promising way to identify too-interconnected-to-fail banks. Alves et al. (2013) conclude that solvency shocks are rather innocuous and do not trigger contagion, while liquidity shocks may create more risks, through changes in funding be­ havior (banks stop lending to problem banks). While a full treatment of liquidity risk is not provided, this is a first step in the direction of dynamic and endogenous network for­ mation, and hence to our understanding of systemic risk arising from interbank networks. Indeed, the experience of the Great Financial Crisis seems to be that endogenous re­ sponses by market participants can be very important and amplify risks considerably.

26.4.2 Banking Crises, Aggregate Fluctuations, and Lending Booms (p. 871)

As explained earlier in section 27.3.2, financial intermediaries take excessive ex ante risks, increasing collectively the systemic risk in the financial system. But what are the specific factors and decisions that will cause excessive risks? The main channel is exces­ sive credit and leverage. In fact, these variables show the strongest ex ante correlation with the incidence of financial crises as shown in the empirical literature analyzing large historical and cross-country episodes of systemic financial crises. Credit (debt and lever­ age) acceleration notably increases the likelihood of financial crises and, conditionally on a crisis occurring, it increases its systemic nature and the negative effects on the real economy associated with the crisis. Because there is a great time gap between systemically important financial crises such as the one that started in 2007–8 and the Great Depression (i.e., financial crises are rare Page 22 of 43

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Systemic Risk in Banking after the Great Financial Crisis events at least in developed economies, and thus sample sizes are small), providing an econometric analysis implies expanding datasets across years and countries.34 Reinhart and Rogoff (2008, 2009, 2011) and Schularick and Taylor (2012) analyze long historical time series about private and government debt. The papers exhibit a strong correlation between accelerations in aggregate debt (credit, leverage) and subsequent banking crises. They identify accelerations in debt as the key antecedent to banking crises, with Reinhart and Rogoff focusing on public and private debt and Schularick and Taylor on bank credit.35 Moreover, conditionally on a crisis, the ex ante acceleration of debt makes the ex post systemic costs higher (i.e., worse economic recessions). Jordà, Schularick, and Taylor (2013) study the role of credit in the business cycle, with a focus on private credit overhang. Based on a study of the universe of over 200 recession episodes, they document two key regularities of modern business cycles: financial crisis recessions are more costly than normal recessions in terms of lost output; and for both types of recessions, more ex ante credit-intensive expansions tend to be followed by deep­ er recessions and slower recoveries. They indeed show that “credit bites back.”36 The historical evidence on the relationship between ex ante credit booms and fi­ nancial crises is available for a relatively short panel of countries; however, using a sam­ (p. 872)

ple of fifty-seven emerging market economies and twenty-two advanced economies over the 1973–2010 period, Gourinchas and Obstfeld (2012) find also that the rapid build-up of leverage is important for the likelihood of a financial crisis. In particular, using a discretechoice panel analysis, they find that domestic credit expansion and real currency appreci­ ation have been the most robust and significant predictors of financial crises, regardless of whether a country is emerging or advanced. For emerging economies, moreover, high­ er foreign exchange reserves predict a sharply reduced probability of a subsequent crisis. Credit booms are therefore a crucial ex ante correlate of financial crises. Yet, all of these empirical analyses condition on the occurrence of a crisis and asks what its determinants are. But, do all credit booms end up in a crisis? The IMF (2012) analyzes credit booms for 170 countries over the last forty years of data. It shows that two-thirds of credit booms did not end up in a financial crisis. That is, credit booms due to strong economic funda­ mentals (demand) do not automatically translate into systemic risk, and therefore, policy should be cautious. However, there are ways that can help policymakers better under­ stand the extent to which credit supply side factors generate aggregate fluctuations in credit. This requires that the regulator has access to a timely and comprehensive credit registry with information on every loan given out by the banking sector (see Khwaja and Mian, 2008; Jiménez et al., 2012, 2014; Jiménez, Lopez, and Saurina, 2013). There is emerging literature on the effects of securitization on bank lending and risk-tak­ ing, hence on the generation of boom–bust credit cycles. For example, Keys et al. (2010) empirically examine this issue using a unique dataset on securitized subprime mortgage loan contracts in the United States. They exploit a specific rule of thumb in the lending market to generate exogenous variation in the ease of securitization and compare the composition and performance of lenders’ portfolios around the ad hoc threshold. Condi­ Page 23 of 43

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Systemic Risk in Banking after the Great Financial Crisis tionally on being securitized, the portfolio that is more likely to be securitized defaults by around 10–25 percent more than a similar risk profile group with a lower probability of securitization. Their results are confined to loans where intermediaries’ screening efforts may be relevant and soft information about borrowers determines their creditworthiness. Their findings suggest that existing securitization practices did adversely affect the screening incentives of lenders. Securitization has therefore been associated with lax lending and excessive credit creation in mortgage markets during the 2000s (Mian and Sufi, 2009), and in business loans (Maddaloni and Peydró, 2011; Jiménez, Lopez, and Sau­ rina, 2013). Claessens et al. (2010) analyze the financial crisis of 2007–8 by studying fifty-eight ad­ vanced countries and emerging markets. Their main conclusion is that the crisis may be explained by a number of factors, some common to previous financial crises, but others (somewhat) new. Their analysis shows a differential impact of old and new factors. Fac­ tors common to other crises, like credit booms, asset price bubbles, and current account deficits, help to explain cross-country differences in the severity of economic impacts. New factors, such as increased financial integration and dependence (p. 873) on whole­ sale funding, help to account for the amplification and global spreading of the crisis.37 Within financial crises, there are important negative externalities from the excessive build-up of leverage in the boom, both from balance-sheet, debt-overhang and bank-lend­ ing channels. For example, Jiménez et al. (2012) analyze the credit crunch in the 2007–10 crisis in Spain using a dataset consisting of loan applications. To achieve identification they focus on the set of loan applications made in the same month by the same borrower or for the same loan to different banks of varying balance-sheet strengths (by including in the specifications firm-month or alternatively loan fixed effects). Within this set of loan applications, for which the quality of potential borrowers is constant, they study how eco­ nomic conditions affect the granting of loans depending on bank capital and liquidity. Moreover, they analyze whether firms that get rejected in their initial loan application can undo the resultant reduction in credit availability by successfully applying to other banks. They find that lower GDP growth reduces the probability that a loan application is grant­ ed, particularly during crisis times. The negative effect on loan granting is statistically stronger for banks with low capital. They also find that firms that get rejected in their ini­ tial loan application cannot undo the resultant reduction in credit availability by applying to other banks, especially in periods of tighter economic conditions. González-Hermosillo, Pazarbaşioglu, and Billings (1997) and González-Hermosillo (1999) study the determinants of bank “distress” in various episodes in the US. It turns out that market and liquidity risk factors played a role in explaining “distress,” whereas the role of credit risk and moral hazard is more case specific. However, the introduction of aggre­ gate variables, such as macroeconomic fundamentals and regional variables, significantly improved the predictive power of the models tested, providing evidence in favor of the macro explanation of systemic bank difficulties in the “broad” sense.

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Systemic Risk in Banking after the Great Financial Crisis Demirgüç-Kunt and Detragiache (1998) study the macroeconomic and structural determi­ nants of banking crises in forty-five to sixty developing and industrial countries between 1980 and 1994. Consistently with the business cycle hypothesis for bank crises, in all specifications, GDP growth, real interest rates, and inflation are highly significant. How­ ever, private sector credit growth has only explanatory power in some specifications, pro­ viding mixed evidence in favor of the lending-boom hypothesis. In contrast, the evidence in favor of the moral-hazard hypothesis regarding explicit deposit insurance schemes is stronger. Since data for crises and non-crises times are pooled, this study can claim to isolate the factors causing full-scale banking crises from those only causing a gradual in­ crease in financial fragility or single bank failures. Gourinchas, Valdés, and Landerretche (2001) examine more narrowly the properties of lending booms in a sample of ninety-one industrial and developing countries between 1960 and 1996 and link them to the likelihood of banking and currency crises. In fact, (p. 874) the unconditional probability of banking crises directly after lending boom peri­ ods is higher than during tranquil periods. Somewhat contrary to conventional wisdom, they also find that the build-up and ending phases of booms are fairly symmetric, so that on average abrupt and crash-type ends are not consistent with their data. Dell’Ariccia, Igan, and Laeven (2012) link the subprime mortgage crisis to a decline in lending standards associated with the rapid expansion of this market. They show that lending standards declined more in areas that experienced larger credit booms and house price increases. In addition, lending standards declined more in areas with higher mort­ gage securitization rates. This final finding has also been found by Mian and Sufi (2009). An important issue is also how monetary policy relates to banking system risk. Jiménez et al. (2014) and Ioannidou, Ongena, and Peydró (2013) find empirical evidence that lower levels of short-term interest rates increase the credit risk-appetite of banks (implying banks granting loans with higher default probability). Controlling for the macroeconomic environment, bank, borrower, and loan characteristics, they find that lower short-term in­ terest rates imply that banks give more loans to either borrowers with bad credit histo­ ries, borrowers with no credit histories, or borrowers with subprime ratings. More impor­ tantly, the new loans have a higher hazard rate. They also find that lower interest rates or higher inflation reduce the default risk of outstanding loans, which implies that, in the short-run, expansive monetary policy reduces credit risk. Ioannidou, Ongena, and Peydró (2013), using the credit register of Bolivia, where the banking system is almost complete­ ly “dollarized,” find that not only do banks take on higher credit risk when short-term rates (federal funds rates) are lower, but also loan spreads are reduced, especially for the banks with worse monitoring, thereby suggesting higher bank risk-taking.38 Lastly, boom– bust cycles in real estate markets have been major factors in systemic financial crises (Hartmann, 2015). This originates in a worldwide trend toward the increasing share of re­ al estate assets in banks’ loan portfolio. An increasing number of studies suggest that bor­ rower-based regulatory policies, such as reductions in loan-to-value or debt-to-income limits, can be effective in leaning against real estate booms. A sectoral countercyclical capital buffer focusing on real estate loans could also be envisaged (BCBS, 2018). More Page 25 of 43

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Systemic Risk in Banking after the Great Financial Crisis formal models of such dynamics would be welcome, including the impact of interest rate risk (through fixed/variable rate loans, as well as banks’ funding) when the economy exits from the low interest rate environment.

26.5 Conclusion In this chapter we have discussed the various elements of systemic risk in banking, which are essential for the understanding of financial crises. The overall concept developed can be used as a baseline for financial and monetary policies when attempting to maintain stable banking systems. Our framework starts from the presumption that (p. 875) three types of phenomena can make financial instabilities widespread (“systemic”): Contagion— often a strong form of externality—working from one financial institution or market to an­ other; the endogenous build-up and unraveling of widespread imbalances; and the conse­ quences of wide systematic shocks which adversely affect many banks at the same time. In this sense, and as evidenced by events that took place during and after the Great Fi­ nancial Crisis, systemic risk goes much beyond the vulnerability of single banks to runs in a fractional reserve system. We have reviewed the quantitative literature in the light of our concept of systemic risk. Some important new theoretical contributions have appeared in this literature over the last decade. First of all, a considerable number of theoretical studies have now directly addressed the issue of contagion through interbank markets and the relative stability as­ sociated with different lending patterns in them. Second, many models stress the interac­ tions between banks and asset prices in crisis periods, emphasizing cumulative disrup­ tions induced by forced asset sales. Finally, some progress has been made in better un­ derstanding the role of liquidity for banking system stability. Macroeconomic models now include some dimensions of “vertical” systemic risk. Agent-based models, introducing het­ erogeneity across agents, complement traditional equilibrium models, with stylized be­ havioral assumptions. They allow more realistic institutional constraints, and explain phe­ nomena that are driven by out-of-equilibrium behavior, such as clustered volatility and fat tails, that characterize systemic risk. Available empirical research still continues to focus more on the assessment of bank contagion phenomena than on the macroeconomic caus­ es for banking system instability. Interesting new developments include the use of actual interbank exposures for counterfactual simulations of contagion risk, the application of extreme-value theory to banking system risk, and a starting focus on factors that lead to the build-up of imbalances in financial systems. Further progress could still be made in controlling for aggregate factors in contagion analyses. The difficulty to distinguish be­ tween macroeconomic causes of banking problems and contagion does not allow general answers to the relative merits of different crisis management policies, such as liquidity support to the market as a whole or macroeconomic stabilization policies versus emer­ gency liquidity assistance to individual banks. Studies of systemic risks in payment and settlement systems remain relatively rare. Even though the practical and unambiguous

Page 26 of 43

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Systemic Risk in Banking after the Great Financial Crisis identification of concrete contagion cases continue to be a challenge, the overall under­ standing of bank contagion risks has increased significantly over the last decade. The Great Financial Crisis has highlighted the relevance of systemic banking stability. The available literature illustrates a number of mechanisms that played important roles in it and new mechanisms that may appear relevant in the future, notably those related to real estate dynamics (where more models are warranted, taking into account interest rate risks), climate change (see Battiston et al., 2017) or even Cyber-risk. But, although sub­ stantial work has already been achieved (ECB, 2017), other important factors related in­ ter alia to the use of macroprudential instruments or regarding bank business models should be better understood than is the case and will be of great value to the efforts launched since the Great Financial Crisis to strengthen macroprudential supervision and regulation. AcknowledgementsAny views expressed in this chapter are the authors’ own and do not necessarily reflect those of the European Central Bank, the Banque de France, or the Eurosystem. Additional references to the earlier literature are available in these pa­ pers. We thank Francesc R. Tous for his excellent research assistance. (p. 876)

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Systemic Risk in Banking after the Great Financial Crisis Laeven, L. and Valencia, F. (2013). “Systemic Banking Crises Database,” IMF Economic Review, 61(2), 225–70. Leitner, Y. (2005). “Financial Network: Contagion, Commitment and Private Sector Bailouts,” Journal of Finance, 60, 2925–53. Lorenzoni, G. (2008). “Inefficient Credit Booms,” Review of Economic Studies, 75, 809– 33. Maddaloni, A. and Peydró, J.-L. (2011). “Bank Risk-Taking, Securitization, Supervision, and Low Interest Rates: Evidence from the Euro Area and US Lending Standards,” Re­ view of Financial Studies, 24, 2121–65. Mendoza, E. (2002). “Credit, Prices and Crashes: Business Cycles with a Sudden Stop,” in S. Edwards and J. Frankel (eds.), Preventing Currency Crises in Emerging Markets (Chicago, IL: University of Chicago Press), 335–92. Mendoza, E. (2010). “Sudden Stops, Financial Crises and Leverage,” American Economic Review, 100, 1941–66. (p. 883)

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Systemic Risk in Banking after the Great Financial Crisis Morgenstern, O. (1959). “International Financial Transactions and the Business Cycle,” National Bureau of Economic Research Studies in Business Cycles, Princeton University Press, Princeton, NJ. Rajan, R. (2006). “Has Finance Made the World Riskier?” European Financial Manage­ ment, 12, 499–533. Ranciére, R., Tornell, A., and Westermann, F. (2008). “Systemic Crises and Growth,” Quarterly Journal of Economics, 123, 359–406. Reinhart, C. and Rogoff, K. (2008). “Is the 2007 US Sub-prime Financial Crisis So Differ­ ent? An International Historical Comparison,” American Economic Review, 98, 339–44. Reinhart, C. and Rogoff, K. (2009). This Time Is Different: Eight Centuries of Financial Folly (Princeton, NJ: Princeton University Press). Reinhart, C. and Rogoff, K. (2011). “From Financial Crash to Debt Crisis,” American Eco­ nomic Review, 101, 1676–706. Rochet, J.-C. and Tirole, J. (1996). “Interbank Lending and Systemic Risk,” Journal of Mon­ ey, Credit, and Banking, 28, 733–62. Rochet, J.-C. and Vives, X. (2004). “Coordination Failures and the Lender of Last Resort: Was Bagehot Right After All?” Journal of the European Economic Association, 2, 1116–47. Rose, A. and Spiegel, M. (2009). “Cross-Country Causes and Consequences of the 2008 Crisis: Early Warnings,” Federal Reserve Bank of San Francisco Working Paper No. 2009– 17. Rose, A. and Spiegel, M. (2010). “Cross-Country Causes and Consequences of the 2008 Crisis: International Linkages and American Exposure,” Pacific Economic Review, 15, 340–63. Ruckes, M. (2004). “Bank Competition and Credit Standards,” Review of Financial Stud­ ies, 17, 1073–112. Scharfstein, D.S. and Stein, J.C. (1990). “Herd Behaviour and Investment,” American Eco­ nomic Review, 80, 465–79. Schularick, M. and Taylor, A.M. (2012). “Credit Booms Gone Bust: Monetary Policy, Lever­ age Cycles and Financial Crises, 1870–2008,” American Economic Review, 102, 1029–61. Senior Supervisors Group (2008). “Observations on Risk Management Practices During the Recent Market Turbulence,” March 6. (p. 884)

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Systemic Risk in Banking after the Great Financial Crisis Slovin, M.B., Sushka, M.E., and Polonchek, J.A. (1999). “An Analysis of Contagion and Competitive Effects at Commercial Banks,” Journal of Financial Economics, 54, 197–225. Stiglitz, J.E. (1993). “The Role of the State in Financial Markets,” Paper presented to the Annual World Bank Conference on Development Economics. Tirole, J. (2008a). “Liquidity Shortages: Theoretical Underpinnings, Special Issue on Liq­ uidity,” Banque de France Financial Stability Review, 11, 53–63. Tirole, J. (2008b). “Lecons d’une crise,” Toulouse Sciences Economiques Notes. Upper, C. (2007). “Using Counterfactual Simulations to Assess the Danger of Contagion in Interbank Markets,” Bank for International Settlements Working Paper No. 234. Upper, C. and Worms, A. (2004). “Estimating Bilateral Exposures in the German Inter­ bank Market: Is there a Danger of Contagion?” European Economic Review, 48, 827–49. Van Lelyveld, I. and Liedorp, F. (2006). “Interbank Contagion in the Dutch Banking Sec­ tor,” International Journal of Central Banking, 2(2), 99–133.

Notes: (1) “Stabilizing the Financial Markets and the Economy,” address at the Economic Club of New York, http://www.america.gov/st/texttransenglish/2008/October/ 20081016110841eaifas9.330386e-02.html. (2) Address to the European Parliament, http://www.ecb.int/press/key/date/2008/html/ sp081208_2.en.html. Lehman Brothers’ failure became the largest bankruptcy in US his­ tory, listing liabilities of $613 billion in its filing. (3) Extensive further discussions, reports, and papers on the current crisis are, for exam­ ple, Ferguson et al. (2007); Ashcraft and Schuermann (2008); Federal Reserve Bank of Kansas City (2008); Financial Stability Forum (2008); Greenlaw et al. (2008); Institute of International Finance (2008); Senior Supervisors Group (2008); Evanoff, Hartmann, and Kaufman (2009); and many financial stability reports of central banks. (4) This chapter builds on and updates de Bandt and Hartmann (2000, 2002) and de Bandt, Hartmann, and Peydró (2010). (5) The first subsection below builds on de Bandt and Hartmann (2000 and 2002); de Bandt, Hartmann, and Peydró (2010); and ECB (2009 and 2010). (6) For a specific overview of this line of research, see Hartmann, Hubrich, and Kremer (2013). (7) Obviously, the more depositors are protected through some deposit insurance scheme the less likely it is that confidence crises occur through retail deposits. In fact, during the

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Systemic Risk in Banking after the Great Financial Crisis current global financial crisis, the deposit insurance thresholds were increased world­ wide to contain runs on banks and some wholesale markets were also supported. (8) US Money Market Mutual Funds experienced runs during the September 2008 crisis (Krainer, 2012). The Federal Reserve announced the ABCP Money Market Mutual Fund Liquidity Facility on September 19, 2008. (9) It is beyond the scope of this chapter to cover non-bank financial intermediation “shadow banking” in detail. See, e.g., Chapter 17, this volume) for further discussion and a literature survey. (10) Many banks used off-balance-sheet vehicles to invest during the growth period of se­ curitization in structured finance products. Funding was short term, as banks issued com­ mercial paper backed by their (long-term) assets. Once valuations of structured products were in doubt, investors were no longer inclined to roll over this short-term debt and the vehicles had to be taken back on banks’ balance sheets to avoid their failure. Such off-bal­ ance-sheet vehicles lost importance after the crisis or even disappeared. (11) Northern Rock, for example, relied to 75 percent on wholesale deposits and therefore collapsed in autumn 2007, when the money market became dysfunctional. (12) See Jiménez et al. (2012). (13) See Cassola et al. (2008) or Dang, Gorton, and Holmström (2012). (14) See, e.g., Keys et al. (2010). (15) See Slovin, Sushka, and Polonchek (1993, 1999) for the social costs incurred by the stakeholders of the initially failing bank, and Iyer and Peydró (2011) for the social costs induced by contagion on the stakeholders of the banks that are financially linked to the initial failed bank. (16) For estimations of the macroeconomic costs of crises, see, for example, Bordo et al. (2001); Hoggarth, Reis, and Saporta (2002); Barkbu, Eichengreen, and Mody (2012); Schularick and Taylor (2012). The relationship between the performance of the real and financial sectors can go in both directions. This raises the issue of causality. Dell’Ariccia, Detragiache, and Rajan (2008) argue that if banking crises reduce real activity, then sec­ tors more dependent on external finance should perform relatively worse during such crises. Financial crises can, however, also be the expression of an economy taking greater risks in financing real investment, which could be part of a long-term growth strategy. See Ranciére, Tornell, and Westermann (2008) for evidence that some countries that ex­ perienced financial crises may experience a higher growth path over longer periods of time than countries that take less financial risk. (17) Notice that from a macroprudential perspective the socially optimal probability of in­ dividual bank failures is not zero. For a socially optimal outcome, the probability of “pure”

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Systemic Risk in Banking after the Great Financial Crisis contagion (a self-fulfilling systemic event) and certain cases of “information-based” conta­ gion are zero. (18) Holmström and Tirole (1998) derive an even broader role for the state to provide liq­ uidity to the economy more generally when financial frictions become severe. (19) The takeover of Bear Stearns by JP Morgan Chase at a very low price supported by the US Fed in March 2008 is widely interpreted as an example of the “too complex to fail” case. (20) Some observers wonder whether the decision by the US Fed and Treasury to let Lehman Brothers fail in September 2008 was an application of “constructive ambiguity.” The loss of confidence following this episode could suggest that such an approach also in­ volves risks. Fed chairman Bernanke, however, argued that the two US authorities did not have the authority to absorb the large expected losses, which was necessary to facilitate the acquisition of Lehman by another firm, http://www.america.gov/st/texttransenglish/ 2008/October/20081016110841eaifas9.330386e-02.html. Caballero and Krishnamurthy (2008) challenge “constructive ambiguity” policies in the case of aggregate “Knightian” uncertainty (where even agents have no information about the probability distribution of asset returns). They argue that competent policy authorities should instead announce that they stand ready to provide liquidity in case of a crisis in order to avoid that in­ vestors show “flight to quality” behavior. This would amount to a “constructive clarity” approach. (21) New literature on the so-called risk-taking channel of monetary policy (Jiménez et al., 2014 and Ioannidou, Ongena, and Peydró, 2013) finds empirical evidence that expansion­ ary monetary policy encourages bank credit risk-taking in the medium term. (22) The Volcker rule included in the Dodd–Frank Act in the US forbids proprietary trad­ ing by banks, restricts investments in hedge funds, and private equity. The Vickers rule has the same objective, but requires the ring-fencing of retail activities in order to protect them. (23) See also Allen and Gale (2005). (24) Of course, there can also be the reverse causality. Restrictions in bank lending due to financial fragility may affect the business cycle, thereby creating adverse acceleration or feedback effects. See, in particular, Mishkin (1991); Bernanke, Gertler, and Gilchrist (1999). In the Global Financial Crisis, this direction of causality was the more relevant one. (25) Allen and Carletti (2006) develop a model in which credit risk transfer can lead to contagion. In fact, they argue that credit risk transfer can be detrimental to welfare. (26) Some observers may regard the Madoff scandal, which became known during the Global Financial Crisis, as an example of the greater scope for Ponzi schemes during boom times. Page 41 of 43

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Systemic Risk in Banking after the Great Financial Crisis (27) See also Caballero and Krishnamurthy (2008). (28) They quote Gwynne’s (1986) description of a typical credit analyst’s behavior in lend­ ing decisions to less developed countries: “His job would never be measured by how cor­ rect his country risk analysis was. At the very least, Herrick was simply doing what hun­ dreds of other large international banks had already done, and any ultimate blame for poor forecasting would be shared by tens of thousands of bankers around the globe; this was one of the curious benefits of following the herd.” (29) See also Rajan (2006). (30) See also Ruckes (2004). (31) Laeven and Valencia (2013) build a database of systemic banking crises, which are defined as (1) Significant signs of financial distress in the banking system (as indicated by significant bank runs, losses in the banking system, and/or bank liquidations); and (2) Sig­ nificant banking policy intervention measures in response to significant losses in the banking system. Detken and Peltonen (2017) provide a similar database focusing on EU countries and combining a quantitative approach, as well as expert judgment. (32) In addition, Furfine (2003) studies the federal funds market during the Long-Term Capital Management’s collapse in 1998 and Russian crises, finding that risk premiums on overnight lending were largely unaffected and lending volumes increased. (33) Further studies following the simulation approach are surveyed by Upper (2007). (34) We follow Gorton and Metrick (2012). (35) Reinhart and Rogoff define a banking crisis by the occurrence of one of the following events: “(1) bank runs that lead to the closure, merging, or takeover by the public sector of one or more financial institutions; or (2) if there are no runs, the closure, merging, takeover, or large-scale government assistance of an important financial institution (or group of institutions), that marks the start of a string of similar outcomes for other finan­ cial institutions.” Using this definition, and given their dataset, the historical incidence of banking crises is about the same for advanced economies as for emerging markets, and the incidence varies strongly over time, with a marked reduction between the end of World War II and the late 1970s, which was a period of strong financial regulation after the 1930s systemic crisis. The dataset used in Schularick and Taylor (2012) covers fourteen advanced economies over the years 1870–2008 at annual frequency. The countries included are the United States, Canada, Australia, Denmark, France, Germany, Italy, Japan, the Netherlands, Nor­ way, Spain, Sweden, Switzerland, and the United Kingdom. The share of global GDP ac­ counted for by these countries was around 50 percent in the year 2000. (36) Jordà et al. (2017) extend the sample to seventeen OECD countries over 1870–2013.

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Systemic Risk in Banking after the Great Financial Crisis (37) Other studies have also investigated whether initial conditions can explain the differ­ ential impact of the 2008 crisis across countries. For example, in two related papers, Rose and Spiegel (2009, 2010) find that these initial conditions generally do a poor job in explaining the economic performance of countries during the crisis period, and conclude that global factors played a dominant role. (38) See also Rajan (2006) and Calomiris (2009).

Olivier De Bandt

Olivier De Bandt is Director of International Economics and Cooperation at the Banque de France. He was previously head of the Directorate of Research and Risk Analysis at the ACPR, the French Prudential Supervision and Resolution Authority. He holds a Ph.D from the Department of Economics of the University of Chicago. He contributed many articles in peer-reviewed academic journals on stress-testing meth­ ods, the analysis of systemic risk, the impact of banking regulation, the economics of insurance. He is an Associate Editor of the Journal of Financial Stability. Philipp Hartmann

Philipp Hartmann is Deputy Director General of the research department at the Eu­ ropean Central Bank, which he helped build up from its beginning. He also coordi­ nates the ECB’s work on financial integration and is a Fellow of the Centre for Eco­ nomic Policy Research. Previously, he held positions at the London School of Econom­ ics, the European Monetary Institute and Erasmus University Rotterdam. He pub­ lished research on financial, monetary, and international issues in numerous journal articles and several books. He serves as an associate editor of the Journal of Finan­ cial Stability. His policy work has been published in many official reports and dis­ cussed in fora including the ECOFIN Council, the ECB Governing Council, the Basel Committee on Banking Supervision and the United Nations Economic Commission for Europe. He holds a Doctorat en Sciences Economiques (Paris) earned in the Euro­ pean Doctoral Program in Quantitative Economics.

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Hardy Perennials: Banking Crises Around the World

Hardy Perennials: Banking Crises Around the World   Gerard Caprio, Jr. Jr and Patrick Honohan The Oxford Handbook of Banking (3rd edn) Edited by Allen N. Berger, Philip Molyneux, and John O. S. Wilson Print Publication Date: Oct 2019 Subject: Economics and Finance, Financial Economics Online Publication Date: Nov 2019 DOI: 10.1093/oxfordhb/9780198824633.013.28

Abstract and Keywords In the long history of systemic banking crises—including, but not limited to, the Global Fi­ nancial Crisis—the worst cases have been caused or at least severely exacerbated by what may be called bad banking and bad policies: those that permitted or encouraged ex­ cessive risk-taking and even “looting” of other people’s money. With each crisis there is an inevitable chorus of calls for more official prudential regulation and supervision to pre­ vent a recurrence. Empirical evidence suggests that policy is best directed toward ensur­ ing a dynamic approach to regulation focusing on the information that is being disclosed to market participants, the degree of market discipline on the behavior of bankers, and the incentives in the financial system, including those for regulators. Keywords: banking crisis, bank failure, crisis management, Global Financial Crisis, history of banking, prudential regulation

27.1 Introduction THE great international banking crisis that broke out in August 2007 and the ensuing eu­ ro crisis from 2010 are only the latest episodes in a lengthy history of recurrent banking crises around the world. Failures of banks have often been sudden—with depositors and other creditors scrambling to withdraw their funds or refusing to renew their maturing deposits. They have been costly, both in direct cash costs to bank creditors or to the gov­ ernments who have bailed them out, and in the associated spillover effects on economic activity, including that caused by reduced access to credit. Some financial crises have had their focus elsewhere, as in government debt, exchange rate, and stock market crises, but banks have typically played a central or important supporting role. Although bank solvency is often the victim of adverse shocks arising elsewhere in the economy, and while panic can result in unnecessarily large and damaging depositor with­ drawals, this chapter argues that the most damaging of systemic banking crises—includ­ ing but not limited to the Global Financial Crisis—have ultimately involved, or were sig­ nificantly exacerbated by, what we call bad banking and bad policies—those that permit­ Page 1 of 27

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Hardy Perennials: Banking Crises Around the World ted or encouraged excessive risk-taking and even the “looting” of other people’s money. With each crisis there is an inevitable chorus of calls for more official prudential regula­ tion and supervision to prevent a recurrence. However, cross-country empirical evidence suggests that policy is best directed toward ensuring a dynamic approach to regulation, focusing on the information that is being disclosed to market participants, the degree of market discipline on the behavior of bankers, and the incentives in the financial system, including those for regulators. The second section briefly sketches the historical background, noting the “boom in busts” of the post-Bretton Woods period following a 39-year lull. Not all crises are the same and the third section highlights the distinct role of mismanagement, government (p. 886) inter­ ference, and macroeconomic shocks. The fourth section reviews the aspects of crises that have received attention from economic theoreticians seeking to understand their recur­ rence and severity. The fifth section discusses the costs of crises. The size of these crises explains the importance of prevention and corrective policy and these are discussed in the sixth section. In conclusion, the seventh section suggests that despite an inevitable overhaul of regulation in the coming years, crises will recur periodically, and the goal should be to minimize their frequency and cost without sacrificing the benefit to econom­ ic growth and income equality that a well-functioning financial system can deliver.

27.2 Early History It is no exaggeration to say that banking crises—for now, the widespread insolvency of banks leading to closures, mergers, takeovers, or injections of government resources— are virtually as old as banking itself. When modern banking emerged as a development of money-changing in thirteenth-century Europe, bankers faced information problems more severe than in the least developed countries today. Clients’ trade was subjected to a vari­ ety of shocks—wars, plague, shortage of coins, losses in trade (e.g., ships sinking or being plundered), defalcation by borrowers, etc.—that made lending hazardous. And depositors faced the risk that their bankers would not survive these shocks, or would themselves ab­ scond with the funds. Repeated failures led to some drastic remedies: a Barcelonan banker was executed in front of his failed bank in 1360—a far cry from the limited liabili­ ty that protected bank owners in later times (Kohn, 2009, chapter 8). Sovereigns were less likely to impose such extreme sanctions when they were the source of the problem, and bankers often succumbed to the temptation or were required (literally for their sur­ vival) to lend to the monarch. Such famous early Italian banking houses as the Riccardi of Lucca, the Bardi, the Peruzzi, and even the illustrious Medici of Florence, owed their banking downfall in whole or large part to kings and princes that would not or could not repay. Financing the loser in a war was a sure route to failure, but even winners reneged, leading to a higher interest rate spread on loans to kings and princes than to the more business-minded town governments (Homer and Sylla, 1996, p. 94). That bank failures have come in waves is suggested by the list assembled in Aliber and Kindleberger (2015), covering mostly the more advanced economies since the seven­ Page 2 of 27

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Hardy Perennials: Banking Crises Around the World teenth century, and which displays, for example, the rather regular ten-yearly recurrence of crises through most of the nineteenth century and through to World War II. Emerging economies experienced a higher frequency of crises in the interwar period (Bordo et al., 2001). The post-World War II era saw a period of exceptional quiescence that lasted through the early 1970s. Against the background of a relatively benign macroeconomic environment, regulations that restricted banking competition and product innovation, in­ cluding cross-border activities, probably contributed to this stability. Gradually, however, these regulations became unsustainable as (p. 887) communications technology and finan­ cial innovation (including the emergence of nearbank competitors) led to evasion. Liberalization of banking and of capital flows, together with increasingly volatile macro­ economic conditions (themselves associated with weakened fiscal discipline, the abandon­ ment of the Bretton Woods exchange rate pegs and surges in inflation rates) were fol­ lowed by a return to banking crises at a frequency comparable to what had been experi­ enced before. Already by 1997, over three out of every five member states of the IMF had experienced banking problems severe enough to be regarded as systemic or at least bor­ derline systemic (Lindgren, Garcia, and Saal, 1996; Caprio et al., 2005); the overall inci­ dence of crises remains unchanged as of 2019, as most of the countries affected in recent years previously already had at least borderline crises. But the etiology of crises has var­ ied.

27.3 Diverse Origins: Management, Govern­ ment, and Macroeconomics in Recent Crises Many of the most spectacular systemic banking crises of recent decades have been inex­ tricably linked with macroeconomic crises in a way that makes the direction of causality hard to unravel. However, it is important not to neglect the role of fraud and mismanage­ ment, on the one hand, and government interference, on the other. Indeed, one or the other of these two—bad banking and bad policies1—has been at the root of quite a num­ ber of systemic banking crises, not only in the developing world (Honohan, 1997; Caprio and Honohan, 2005) but also in the latest great international crisis that emerged in the US and Europe.

27.3.1 Management and Fraud Two very large individual bank failures in the Caribbean area can be taken as classic ex­ amples where fraud or mismanagement were at the root of the problem—namely, that in Venezuela (in 1994) and the Dominican Republic (in 2003). Both appear to be cases of the diverted deposits fraud, in which some of the deposits accepted by the bank are not recorded as liabilities and the corresponding resources are looted by insiders even (p. 888) though the bank still appears solvent on paper and even though its recorded as­ sets may be properly performing. In each of these cases, the bank involved was of sys­ temic importance2 and the sums were so large that the loans, which eventually were made by the central bank to enable the bank to make the depositors whole, destabilized Page 3 of 27

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Hardy Perennials: Banking Crises Around the World the macroeconomy. And, in Venezuela, high deposit rates in the “rogue” bank forced up rates, and risk-taking, at other banks. Another very large failure in which the diverted de­ posits fraud appears to have been present was that of the international group BCCI. This group, headquartered in Luxembourg and London, was operating in about seventy coun­ tries and its failure was of systemic importance in some African countries where it had at­ tained a sizable market share (cf. Herring, 2005). The diverted deposits fraud typically in­ volves the acquiescence of audit professionals; the official supervisor can then be hardpressed to detect such frauds because of the complexity of the false accounting struc­ tures that are created. Inadequate management of “rogue” traders has caused several sizable bank failures, most famously that of Barings Bank in 1995, but, although the losses involved in some of these cases have run into ten figures (in dollars), no known cases have been of systemic importance. In January 2008, Société Générale reported the largest single bank loss (over $7 billion) ever attributed to fraud by a lone “rogue” trader. As with the even larger Ponzi scheme uncovered in Bernard Madoff’s investment firm in late 2008, typically fraud is discovered in a period of asset market decline following a long run of over-optimism. Oth­ er forms of mismanagement weakness can be cited, none more apparent than the case of Crédit Lyonnais in the 1990s, where grandiosity and exaggerated ambition in lending pol­ icy broke the then record for the largest single bank loss in the industrial world: without the French government’s bailout, Crédit Lyonnais would have proved insolvent. Lack of management capacity on the part of new controlling insiders also brought insolvency in 1995 to the long-established Meridien BIAO bank in Western and Central Africa—al­ though that bank had already been severely weakened by the effects of government inter­ vention. While the Mexican Tequila crisis (1994–5) crystallized around a currency collapse, which hit the banks because of speculative derivative contracts that gave them a de facto long position on local currency, the underlying weakness of the Mexican banks was subse­ quently traced to insider lending and a long period of evasion of the minimum capitaliza­ tion requirements dating back to their privatization. With little shareholder equity at stake, banks were free to move out on the risk frontier and lend to the few sectors with the highest return, as confirmed by Caprio and Wilson (2000), Haber (2005), and Wilson, Saunders, and Caprio (2000). Significant regime changes in the economy often devalue both the financial and skills portfolio of banks, sharply increasing the risk of a banking crisis. The introduction of (p. 889) new instruments or opportunities for risk-taking often leads some to take on new risks without adequate attention to their downside potential. Likewise, liberalization of economic policies has definitely been associated with a surge of bank failures in countries with weaker information and governance institutions (Demirgüç-Kunt and Detragiache, 1999). Liberalization of entry into banking increased competitive pressures for banks; lib­ eralization of interest rates heightened repayment and market risks; and liberalization of other aspects of economic policy impacted on the creditworthiness of borrowers in ways that were not always easy to perceive, often entailing large changes in relative prices. Page 4 of 27

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Hardy Perennials: Banking Crises Around the World And, to the extent that pre-liberalization portfolios were controlled, the lifting of controls often led banks to expand simultaneously. However, simultaneous portfolio shifts by the banking sector can move asset prices, making the shift look like a safe proposition, as in the case of the Malaysian property boom of the late 1970s and early 1980s, which led to a mid-1980s crisis. In addition to a skewed portfolio, liberalized banks inherit a staff that is short on banking skills, unfortunately precisely when they are greatly needed, just as the government begins with bank supervisors skilled only in checking that banks are comply­ ing with various government commands and not at all trained in modern risk-based bank supervision. Although even the best bankers and supervisors would be challenged during liberalization, those with weak skills and/or incentives are the most likely to fail. In particular, the process of economic transition from socialist or planned economies proved fertile for banking crises, many of which can be attributed to inexperienced or reckless management. Although the first wave of post-transition inflation wiped out much of the real value of their pre-existing deposits, and reduced the debt burden of their bor­ rowers, many transition economy banks—especially in Eastern Europe—misjudged the difficulty of credit appraisal especially in the fluid conditions of the transition. As a result, many made a new round of poor or self-serving loans, which soon fell into non-performing status. Even where transition was managed without a surge of high inflation, as in China and Vietnam, large banking losses were socialized. Indeed, in China, cumulative injections of government funds into the four main government-owned banks alone, from 1998 to 2006, amounted to over $350 billion, or about 30 percent of 2001 GDP, with further injections still considered necessary to restore full capitalization on a realistic evaluation of the re­ coverability of the loan portfolio (see Barth and Caprio, 2007; Honohan, 2008). This mas­ sive bailout was accomplished without loss of depositor confidence, reflecting the ability and undisputed willingness of the state to ensure that depositors at its banks would not suffer. Indeed, expressed as a percentage of GDP, bank deposits in China have been high­ er than almost anywhere else in the developing world, aside from offshore financial cen­ ters. These growing funds were effectively applied up to the mid-1990s as a transitional and partial substitute for the former budgetary allocations made under the planned sys­ tem to key unprofitable state-owned enterprises (Lardy, 1998). Made as loans, these could never have been fully serviced, as was gradually recognized through the various bank re­ structuring measures adopted from 1998 on. The Chinese case, then, provides a conspic­ uous example of how government policy—specifically (p. 890) government-directed lend­ ing policy—has led to loan losses large enough to erode the banks’ capital many times over.

27.3.2 Government Policies Many of the poorest developing-country economies that were not subject to a centrally planned regime also experienced explicit or implicit government policies of directed cred­ it. When these were enforced by statist regimes without regard to the viability of the lending banks, the result was losses, erosion of capital, and a weakening of financial au­ Page 5 of 27

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Hardy Perennials: Banking Crises Around the World tonomy and the motivation of bank managers, often resulting in insolvency. The true fi­ nancial condition of state-owned or heavily controlled banks of this sort was often ac­ knowledged only at a time of regime change or a sizable policy reform. Even in non-so­ cialist economies, government influence has often had similar effects. A good example comes from francophone West Africa where the banks in several countries made what proved to be unrecoverable loans to parastatals and government suppliers, unwisely tak­ ing comfort in the fact that these loans were being rediscounted by the regional central banks. A similar problem arises with provincial governments relying on the national au­ thorities to bail out failing provincial banks, as was seen in Brazil. Banks have always been dependent to a degree on the willingness of the state to allow them to function profitably. Calomiris and Haber (2014) argue that, in autocracies and in populist democracies, this inherent dependence on the government has made them frag­ ile, and that it is only in a handful of liberal democracies that they have remained free of systemic crises. Even where directed credit is not an issue, quasi-fiscal impositions such as unremunerated reserve requirements have weakened bank profitability. Arbitrary ex­ change rate and exchange-control regulations also have a tax-like effect. The most dra­ matic example of this was the forced conversion to local currency of foreign currency de­ posits and loans at Argentine banks in late 2001. Because the conversion was not at mar­ ket rates and furthermore was asymmetric, with a much larger effective write-down of bank loans than of bank deposits, this arbitrary measure created systemic bank insolven­ cy at a stroke. Banks have also needed the state to enforce contracts, a role that can often conflict with government’s interest in maintaining political support. Calomiris and Haber (2014) argue that politics is a key deep determinant of crises. In their framework, there is a “game of bank bargains” among the various political constituencies that determines the availability of credit and the degree of instability, with the latter emerging in part as a result of at­ tempts to use subsidies to cement political support.

27.3.3 Macro Boom and Bust Although the roles of management and government are never irrelevant in a banking cri­ sis, what has dominated many of the larger episodes of systemic crisis is a dynamic (p. 891) instability in widely held expectations about macroeconomic and business prospects generally. A wave of over-optimism about economic growth, often manifested in a real estate price boom, results in expansion of credit by most banks, especially to the sectors specifically favored by the optimism. The resulting increase in leverage often is fuelled in part by capital inflows—as in Mexico and East Asia in the 1990s, but also in the recent mortgage finance booms in the US, Ireland, and elsewhere. Because of the opti­ mism, loan-loss provisioning is lower than will prove necessary and this for a time is justi­ fied by low delinquencies as the overall economic boom financed by credit expansion makes it easy for borrowers to service their debt. This could explain by itself why rapid credit expansion is a predictor of crises. In addition, of course, rapid credit expansion places stresses on credit appraisal capacity and results in errors even conditional on the Page 6 of 27

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Hardy Perennials: Banking Crises Around the World overall optimism. Various forms of contagion or herd effect come into play. Even banks whose managers do not share the optimism feel pressure to relax credit approval stan­ dards for fear of losing market share. The formation of banker expectations can be influ­ enced by peer observation, magnifying and generalizing emerging overconfidence. As a latecomer to the South Sea Bubble (John Martin, of Martin’s Bank) said, “when the rest of the world are mad we must imitate them in some measure” (Dale, 2004, p. 113), words that were echoed in July 2007 (shortly before he lost his job) by the CEO of Citigroup, Chuck Prince, who told the Financial Times that “As long as the music is playing, you’ve got to get up and dance.” Whereas experienced bankers are normally alert to isolated indications of unsound prac­ tices among their peers, in contrast, during the euphoria of the boom phase, they are un­ likely to detect even fatal weaknesses. These waves of over-optimism are sufficiently rare in any one country for learning to be imperfect; regulators and academics also can be swept up in the enthusiasm. Disaster myopia prevails, with decision-makers disregarding the relevance of historical experience at home and abroad (Guttentag and Herring, 1986). Eventually, however, the unsustainability of the fundamentals on which the credit expan­ sion was predicated becomes evident and the process goes into reverse. Sharp falls in property prices reveal the unrecoverability of property-related loans and erode the value of collateral; currency depreciation creates insolvency among unhedged borrowers; asset sales by distressed borrowers seeking liquidity drive down the prices of other securities too; and the resulting economic disruption also undermines the solvency of borrowers in unrelated sectors. Previous examples of the boom-and-bust syndrome are provided by the correlated crises in Scandinavia around 1990, as well as the East Asian crisis of 1997–8, in which extensive failure of banking systems, especially in Thailand, Indonesia, and Korea, were associated with currency collapse and a sharp—albeit transitory—contraction of economic activity following a long period of rapid growth and capital inflows. The sudden withdrawal of what had previously been readily available foreign funds was an aggravating factor in several other crises, notably Chile in 1982. Exchange rate collapse, too, has been a fea­ ture in many episodes; indeed, anticipations of currency movements during crises can re­ sult in sizable depositor withdrawals exacerbating bank liquidity problems. To be sure, in all of these cases, connected lending and excessive risk-taking (p. 892) were a good part of the story, as they often are in large crises (Harvey and Roper, 1999; World Bank, 2001). Although some features of the international crisis that began in 2007, such as the role of derivative securities, seemed new, this crisis in fact displayed many familiar features (sec­ tion 27.4 and cf. Reinhart and Rogoff, 2008). In particular, it exhibited a wave of over-opti­ mism leading to extreme leverage, and unsound management and regulatory responses to financial innovation. Even after the existence of a bank solvency crisis has been publicly acknowledged, the scale of the crisis is rarely evident at first. Bank insiders have many reasons to conceal

Page 7 of 27

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Hardy Perennials: Banking Crises Around the World weaknesses as long as possible. Almost all recent systemic crises have involved several waves of intervention, generally spread over a period of months or even years.

27.4 Panic and Contagion: Explaining Sudden and Fast-Moving Banking Crises A sudden and irresistible depositor run, the classic form in which systemic crises have been seen as crystalizing, which was certainly present in September and October of 2008, and which dominates the theoretical literature, has actually only featured in a minority of the cases in recent decades. Even in Argentina, 1995—the response of depositors to fears of a spillover from Mexico’s 1994 Tequila event—aggregate depositor withdrawals from the system were little more than 20 percent, spread over several months. In this case, when depositor concerns shifted from the health of specific banks to the prospects for the currency peg, they exited the system altogether. This pattern was repeated in Argentina in 2001, though on that occasion the fleeing depositors were vindicated in that the gov­ ernment did subsequently abandon the currency peg. But, even if depositor runs are not as common as a reading of textbooks would suggest, the sudden onset of correlated bank failures that have characterized some systemic bank­ ing crises, with widespread consequences for economic activity, raises the question of what is special about banks that might make banking systems prone to such dramatic col­ lapses. Five distinctive and interrelated features of banking stand out as contributing factors to this vulnerability. First, the highly leveraged nature of modern banks; second, the degree of maturity transformation (or liquidity creation) with which they are associated; third, the demandable or very short-term nature of the bulk of their liabilities; fourth, the opaque nature of bank assets; and fifth, the fact that the bulk of their assets and liabili­ ties are denominated in fiat currency. Of course, each of these features represents a key contribution of banking to the economy, which is probably part of the explanation as to why authorities have not adopted proposals for “narrow” banking—few are disposed to give up these benefits. Efforts to prohibit banks from taking risk can (p. 893) backfire—as those holding cash in times of inflation, or of government obligations when those default, have learned well throughout history. Moreover, to the extent that narrow banking forces risk-taking and funds into a less-regulated non-bank financial sector, the likelihood of a subsequent clamor for the government to extend the scope of bailouts beyond narrow banking cannot be ignored. That high leverage has a role in crises seems obvious: it is why much policy effort now fo­ cuses on limiting leverage through capital adequacy regulation (even though the risk-re­ ducing goal of such regulation can often be nullified by bankers’ offsetting assumption of higher risks in unregulated dimensions). Opacity also matters: just as banks are at an in­ formational disadvantage vis-à-vis borrowers, so too are depositors and other creditors (as well as supervisors) in relation to banks. Much recent theory has developed around Page 8 of 27

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Hardy Perennials: Banking Crises Around the World the second and third of these features (Allen and Gale, 2009). It is not just the liquidity problems that can arise if depositors wish to withdraw more than expected from a bank that has committed its resources to loans that can be liquidated early only at a loss. There is the consideration that even depositors who have no immediate need to withdraw might do so if they foresee a bank failure. The possibility of self-fulfilling depositor panics, not based on any fundamental change in the bank’s asset portfolio or any special liquidity shock to its depositors, has been known to theoreticians for decades, though the realworld relevance of self-fulfilling panics unwarranted by weak fundamentals has been much debated. From this theoretical perspective, there is no difference between the visi­ ble retail depositor run and the “silent run” of the bank’s wholesale creditors, including other banks through the interbank market. Indeed, in practice it is often the better-in­ formed wholesale market that undermines a failing bank’s liquidity and, as in the case of Northern Rock in 2007, leads to a run in the retail market. Better-informed wholesale market participants might well be the first to realize that the bank’s problem is solvency and not just illiquidity. In theory, liquidity runs can lead to insolvency by forcing a “fire sale” of assets at unfavorable prices, but in practice it is difficult to distinguish this case from insolvency due to excessive risk-taking. One structural feature of banking implicated in panics is the demandable nature of de­ posit liabilities, which has the effect of encouraging early withdrawals (Calomiris and Kahn, 1991). It is “first come, first served” for bank depositors (known as “sequential ser­ vice” in the theoretical literature). Until an insolvent bank closes its doors, early with­ drawing depositors will receive their full deposit, paid out of the bank’s liquid assets; while those that arrive too late will bear between them the full capital deficiency. Even a small overall initial deficiency could result in the remaining depositors suffering severe losses if enough others have withdrawn before the bank is closed. Awareness of this risk makes astute depositors alert to signs of trouble and indeed serves to ensure that there will be an incentive for large depositors to monitor the performance of the bank man­ agers. As is confirmed by well-documented cases such as that of Continental Illinois bank (Stern and Feldman, 2004), as well as from less precise information from the changing size distribution of deposits in crises in developing countries (Halac and Schmukler, 2005), it is wholesale depositors and interbank lenders who have been the first to with­ draw. Some system-wide bank failures may be simply due to numerous banks being hit by a common shock external to the banking system. But the speed with which several very large systemic crises have emerged without apparent warning and the depth of the ensuing financial and economic crisis has suggested a contagious transmission and ampli­ fication of the problems of one bank to others. Furthermore, even if the failure of a num­ ber of banks is attributable to an exogenous macroeconomic shock, the consequences of that failure on aggregate credit availability and on the value of asset prices may in turn amplify the macroeconomic downturn, feeding back again into the banking system. (p. 894)

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Hardy Perennials: Banking Crises Around the World Models of contagion focus on different aspects. Contagion can occur through depositor panic, as the failure of one bank causes a reassessment by depositors of the default risks associated with other banks, and the loss of liquidity from one bank failure may cause de­ positors to withdraw from other banks in the system. At the broader national level, both such factors seem to have been at work in the international crises of 1997–8 and in the liquidity and “credit crunch” of 2007–12. Information and fears can be transmitted through several distinct channels including the prices of bank equity, credit default swaps, and the secondary market in bank debt, as well as ratings announcements. Regu­ lations introduced during 2008 to suspend short-selling of bank equities reflect official suspicion of market manipulation in some of these markets at times of panic. On the asset side, too, bank distress can be transmitted through the system. If it foreclos­ es on some of its borrowers or is unable to extend credit, a bank’s distress will be spread to the customers of those borrowers, in turn worsening the loan-loss experience of other banks. The weakening of asset portfolios will become general if there is a scramble for liquidity in asset markets, which drives down prices including of assets used as collateral. Pure informational cascades, where pessimistic opinions on the part of some bankers or investors become generalized, have also been studied as channels of contagion. The use by banks of identical or similar formulaic risk assessment technologies could have the un­ fortunate effect of coordinating banks’ responses to shocks, thereby amplifying their ef­ fect (International Monetary Fund, 2007). Indeed, the depth of the “credit crunch” in 2007–9 reflects the correlated realization by leading bankers that the risk management paradigm that they all shared had failed. Models of such feedback can exhibit multiple equilibria: a good equilibrium in which in­ vestors’ confidence is validated by high asset prices boosting the creditworthiness of bor­ rowers with productive and profitable investments, and a bad equilibrium where in­ vestors’ skepticism is justified by low asset prices, a lack of creditworthiness, weak ag­ gregate demand, and business and bank insolvency. The equilibrium value of the nominal or real exchange rate is at the heart of several of these models, reflecting the central role of currency collapses in some of the largest crises. If there are multiple equilibria, the oc­ currence of a crisis can be considered a coordination failure (Diamond and Dybvig, 1983; Allen and Gale, 2009).

(p. 895)

27.5 Costs of Crises

Even if it is hard to get a precise estimate, it is clear that the aggregate costs of banking crises around the world have been very substantial indeed. Two main concepts have been employed to calculate the cost of banking crises, namely fiscal and economic. The first approach to measuring costs focuses on the fiscal and quasi-fiscal costs incurred by efforts to indemnify depositors of failing institutions and to recapitalize failing banks. Total fiscal costs of crises in developing countries alone since the 1970s exceeds $1 tril­ lion—a sum far in excess of all development aid provided by the advanced economies. These costs tended to be higher where government policy contributed to moral hazard Page 10 of 27

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Hardy Perennials: Banking Crises Around the World (Honohan and Klingebiel, 2003). The fiscal costs of the wave of interrelated crises that began in 2007 were relatively high, with the experience of Iceland and Ireland in particu­ lar entering the rankings close to the top end of the historic range. Gross fiscal costs re­ ported for two dozen advanced economies affected by banking crises 2008–12 come to about US $2 trillion (based on Bova et al., 2016; cf. Laeven and Valencia, 2012). Although relatively straightforward to calculate, the gross fiscal costs do not represent an ideal measure. For one thing, changing prices, exchange rates, and asset values in the months and years following the crisis greatly complicate the calculation. For example, fa­ vorable property price movements in Norway and Sweden post-crisis allowed the authori­ ties to recover most if not all of the gross outlays they had initially made in respect of fail­ ing banks. The same was true in several other countries (including the United States) af­ ter the 2008 crisis. (Note, however, that this cash accounting neglects the risk that was assumed by the fiscal authorities in bailing-out: the risk-adjusted returns were likely neg­ ative.) The most striking example of the post-crisis claw-back of fiscal funds committed to bail­ ing out banks is in Iceland, where the Government’s gross injection of funds coming to 44 percent of GDP (needed to bail out depositors of branches within Iceland) have subse­ quently been wholly offset by better than expected recoveries on defaulted loans and by substantial exit taxes and contributions paid by foreign holders of Icelandic assets subject to exchange control (Benediktsdottir, Eggertsson, and Þórarinsson, 2017). In Ireland, however, less than half of the gross fiscal outlay of some 40 percent of GDP will be recov­ ered. Direct fiscal outlays do not correspond to the economic costs of bank failures. To the ex­ tent that the sums expended by the authorities are to fill resource gaps resulting from loss-making economic activity by borrowers, the fiscal costs can be considered as an esti­ mate of true economic costs. But, since some of the fiscal outlays simply go to compen­ sate depositors for resources that were diverted to others, and as such represent a trans­ fer, this would overstate true economic costs. On the other hand, the distortions created by poor (p. 896) banking practice will have affected decision-making more widely, result­ ing in losses and missed opportunities that are not captured in the direct fiscal costs. Estimates of indirect fiscal costs of banking crises tend to be much larger than direct costs, reflecting both the revenue and expenditure implications of the associated econom­ ic downturn. Reinhart and Rogoff (2009, 2013) have emphasized this aspect of banking crises, and it is clear that the growth in government debt that is often associated with banking crisis can impede the authorities’ ability to offset the aggregate expenditure downturn both in the immediate crisis and in future years (Jordà, Schularick, and Taylor, 2016).3 Attempts to measure the aggregate economic costs of banking crises typically focus on the shortfall in GDP following a crisis.

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Hardy Perennials: Banking Crises Around the World After the Global Financial Crisis, the sharp initial downturn in several of the most affect­ ed countries and the prolonged—indeed indefinite—period during which economic activi­ ty has remained far below pre-crisis projections adds up to an aggregate output shortfall greater than one-year’s GDP. Much of these losses can indeed be attributed to the un­ winding of the banking excesses. Indeed, economic downturns in advanced economies that follow the ending of a credit-fueled boom tend to be deeper and more long-lasting than other recessions (cf. Jordà, Schularick, and Taylor, 2013; Brunnermeier and Schn­ abel, 2016). And when banks are left under-capitalized following a crash that has not been fully cleaned-up, the ensuing recession tends to be more prolonged (Homar and Van Wijnbergen, 2015). More generally, though, to regard the dip in growth rates around the time of any macro-financial crisis as a measure of the economic costs attributable to the banking crash neglects the extent to which the economic downturn (which exposed the bank insolvencies) may have been triggered by unrelated factors, as well as the extent to which the previous upturn might have been unsustainable, reflecting the euphoria noted earlier. The economic costs of crises have been felt across the income spectrum with sharp in­ creases in the fraction of the population below the poverty line (World Bank, 2001; Hono­ han, 2005). Notwithstanding the heavy costs incurred in banking crises, some countries—Chile and Korea, for example—have seen their financial system recover nicely from even large crises. Unfortunately other countries, notably Argentina, have had numerous crises in the last 150 years, pointing to a sizable, even critical, benefit from the application of good policies of prevention, containment, and resolution.

(p. 897)

27.6 Crisis Response and Prevention

27.6.1 An Ounce of Prevention The design of regulatory policy and practice that could most effectively reduce the risk of banking crises is controversial. The Basel Committee on Bank Supervision, established in 1974, has emerged as a standard setter for bank regulation and supervision. In Basel II and Basel III (the latest variant, adopted in stages during 2010–17 and to be implemented by 2019 and beyond in many countries), the Committee’s approach to prudential regula­ tion involves three pillars: capital, supervision, and disclosure. The first pillar defines a minimum amount of capital to be held by banks in relation to the risks that they have as­ sumed; the second pillar is a supervisory regime to ensure compliance with this capital minimum and generally discourage excessive risk-taking; the third pillar mandates disclo­ sure of relevant accounting information. Unfortunately, while a bank with more capital can undoubtedly absorb larger shocks (as emphasized by Admati and Hellwig, 2014), Basel’s approach to setting required capital is highly controversial (Keating et al., 2001), not only because of the difficulty of measuring Page 12 of 27

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Hardy Perennials: Banking Crises Around the World the underlying risks, but because reliance on the mandated approaches could exacerbate herding to the extent that banks adopt similar approaches to modeling risk. Indeed, such herding seemed to play an important role in the crisis of 2007–08 the epicenter of which was in the countries that had been supposed to be the models for bank regulation and su­ pervision. Furthermore, cross-country empirical evidence casts considerable doubt on the merits of relying on discretionary action by official supervisors to limit banking failure. Specifically, Barth, Caprio, and Levine (2004, 2006) show that this approach does not seem to help prevent banking crises. Using their database on bank regulation and super­ vision around the world, this study compiled indexes that represented the extent of capi­ tal regulation, supervisory powers, market monitoring (effectively, the three pillars of Basel II) and other regulatory variables, and related them to the development, efficiency, vulnerability, integrity (lack of corruption), and governance of the banking system, after controlling for other determinants of the latter variables and also dealing with concerns about endogeneity. On vulnerability, they found that none of the three pillars explained the probability of a banking crisis (though private monitoring helped explain the other en­ dogenous variables of interest). Instead, this research indicates that authorities con­ cerned with reducing the likelihood of a crisis should either not adopt or greatly circum­ scribe deposit insurance, and should encourage banks to diversify both their activities and their geographic and sectoral exposure. Lack of such diversification helps explain the large number of failures in the US (roughly 15,000 bank failures in the period 1920–33), compared with Canada (just one in the period). This research also suggests that an ap­ proach to regulation that in effect tries to work with market forces, rather than supplant them, would work better. Although devising appropriate rules is difficult enough, finding a way to encour­ age regulators to implement them in a timely fashion is more difficult still. Barth, Caprio, (p. 898)

and Levine (2012) argue that regulators had many tools to address the build-up of risk prior to 2007, and yet, despite many clear warning signs, failed to take obvious actions (e.g., to reign in overly rapid credit expansion at banks in Iceland and Ireland, or to re­ spond to evidence in 2004 of widespread fraud in US mortgage markets). Previous crises, such as that of the Savings and Loans institutions in the US, were characterized by simi­ lar failures of implementation, yet regulatory changes enacted in the wake of that crisis to require “prompt, corrective actions” were not effective. Prevention would be easier if the onset of crises could be predicted, but models are bet­ ter at showing fragility than predicting timing (Demirgüç-Kunt and Detragiache, 2005). Rapid credit expansion is one important risk factor (and this has been recognized with the introduction in Basel III of a countercyclical capital buffer which can be calibrated by reference to recent credit trends). Analysis of historical data from advanced economies over the past century and a half suggests that it is when credit growth is accompanied by rapid property price inflation and rising loan-to-deposit ratios that the risk of crisis is par­ ticularly elevated (Richter, Schularick, and Wachtel, 2017). Recent models exploit data on bank equity prices to measure the potential contribution of each bank to systemic risk; despite promising theoretical properties, the forecasting ability of this new approach has disappointed to date (cf. Brownlees et al., 2017). With no fully effective forecasting sys­ Page 13 of 27

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Hardy Perennials: Banking Crises Around the World tem, good containment and resolution policies are also needed to deal with the next crisis when it comes. Understandably, efforts focused on detecting underlying misalignments are more promising; as noted, in many crises the warning signs of excessive leverage are usually evident.

27.6.2 A Pound of Cure The two key policy functions that are typically activated when a crisis hits are the provi­ sion of lender of last resort (LOLR) facilities and the restructuring of troubled entities. The threat of contagion among banks has led many policymakers to intervene to stop a run before healthy banks and borrowers are impaired. Central banks have accepted the role as LOLR since the early nineteenth century, though not uniformly or without con­ tention (Wood, 2003). The advice from Bagehot, that the LOLR should lend freely but at a penalty rate and only to solvent institutions with good collateral, has become convention­ al wisdom, if not always followed, and his additional lessons—lend quickly before a run takes off, and only use the LOLR rarely to avoid moral hazard—also are regularly quoted by central bankers. This seemingly straightforward advice is notoriously difficult to apply in practice, as it involves judgments on collateral, solvency, and speed.4 As noted below, in the wake of the most recent crisis, the role of the LOLR has (p. 899) become more con­ troversial. Many countries have moved to ensure that banks are resolvable in a way that protects essential economic functions without imposing heavy direct fiscal costs (Hono­ han, 2017). Longer-term restructuring and rehabilitation of banks raise issues that go beyond the scope of this chapter (World Bank, 2001; Honohan and Laeven, 2005). In the spirit of Bagehot, it is worth noting that once authorities decide to intervene, it is important that their intervention be comprehensive, dealing with all potential problem banks especially where depositors fear that they will suffer from bank closures. The failure of the initial 1997 bank restructuring package in Indonesia (according to the announcement of which only sixteen banks would be closed—both a much smaller number than had been expect­ ed by public opinion and than subsequently proved necessary) has been attributed to its less than comprehensive nature. Soon, all of the private banks were run, with depositors putting their funds in what they assumed were safe public banks. The central bank then extended liquidity support to the private banks, who appear to have used the funds to buy foreign exchange, exacerbating the decline of the currency (for a chronology of the events, see Enoch et al., 2001). In several crises in Argentina, the public would run to public sector and foreign banks, from the domestic private banks. In almost all crises, a sizable fraction of the banking system has survived, remaining sol­ vent and liquid (Caprio and Honohan, 2005). An exception: all but one of the seven banks in Guinea, accounting for 98 percent of the banking assets in the country were deemed insolvent and closed following massive frauds. Interestingly, the one bank left open failed several years later. Another exception is Iceland, where all three of the main banks failed in 2008; in this case there was no adequately resourced LOLR because the banks had ex­ panded into international business, denominated in foreign exchange, and had gross lia­ Page 14 of 27

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Hardy Perennials: Banking Crises Around the World bilities of the order of ten times Iceland’s GDP. In Ireland too, all the major banks lost all or most of their equity capital when losses resulting from the collapsing property bubble began to crystallize 2008–10, but most were recapitalized by their foreign shareholders or by the Irish Government. Although luck can play a part in survival, that in each case some banks typically survive points to the potential for well-managed banks to cope with severe shocks, and to the im­ portance of maintaining an incentive structure that encourages safe-and-sound banking. But, the survivors may not be easily able or willing to expand to fill the gap that would be created if the failed banks are removed from the system and often become more conserv­ ative in their lending decisions. Indeed, post-crisis “credit crunches” are (p. 900) signifi­ cant contributors to the macroeconomic dips noted earlier, which was one of the reasons for the exhortations of Bagehot.

27.7 The Crisis of 2007 and the Euro Crisis: Some Things Old and New Was the crisis of 2007 or, for that matter, the Euro crisis, very different from previous ex­ perience? At the center of the former were the growing market in US-originated mort­ gage-backed securities and the boom in housing prices in many industrial countries. Pro­ vided by Basel I with a clear incentive to reduce required capital by shifting loans off their balance sheet, and notwithstanding the well-understood adverse selection problem that historically had limited loan sales, banks in the US (to a much less extent in other countries) had increasingly turned to an “originate and distribute” model, in which stan­ dardized loans, mostly mortgages, could be bundled and sold as securities without re­ course to the originating bank, thereby leaving that institution free to reuse its capital elsewhere.5 Non-depository financial intermediaries jumped into the same business, giv­ en the ability to earn fees and yet not retain credit risk. By careful structuring of these se­ curities and in particular their priority in receiving cash flow from the servicing of the original portfolios, favorable credit ratings were obtained for most of the securities sold, seemingly overcoming the adverse selection problem that had hitherto prevented such loan sales (buyers’ assumption that sellers would only part with their worst loans). How­ ever, knowing that the loans they originated would be sold to others reduced the incen­ tive to make careful credit assessment. Indeed, US banks and finance companies originat­ ed a large number of high-risk mortgages (e.g., “no money down,” interest only or less as the initial payment, with no documentation on borrowers’ capacity to pay and initial “teaser” interest rates that would adjust upwards even if market rates remained con­ stant). Ratings agencies seemed to become the partners of those doing the securitization, rather than serving as unbiased arbiters of credit quality. The initial ratings they had attached to the securities proved over-optimistic and most had to be downgraded sharply. As the US housing market cooled and rates adjusted (from teaser levels, and then with the tighten­ ing of monetary policy), defaults spread, leading to sizable loan losses for many of the Page 15 of 27

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Hardy Perennials: Banking Crises Around the World world’s biggest international banks, and inducing them to raise additional capital to strengthen their balance sheets. Thanks to securitization, US banks had retained only part of the mortgage risk, passing much of it to European and other banks and invest­ ment funds. Indeed, the first bank failures from the US subprime mortgages were two German banks that had taken unwarranted risks in this market. (p. 901) Surprisingly, as of the spring of 2018, some of the same incentive problems that affect the US ratings indus­ try remain uncorrected; as Rivlin and Soroushian (2017) summarize, the SEC has neither proposed a new business model nor instituted a random assignment process for what it terms “nationally recognized statistical rating organizations (NRSROs)”; the US Depart­ ment of Labor has not removed credit ratings from its regulations; and the SEC has not changed the legal liability for CRAs. Banks were not really able to assess the risk of the increasingly complex securities that were being created. This very complexity destroyed information and made resolution and workout of distressed debt enormously more difficult and uncertain. Yet, possibly sedated by being paid so well, almost all involved—including the purchasers of these securities in many countries—played along despite the warning signs; at each stage of the securitiza­ tion process, large bonuses were taken from the fees, even by the ratings agencies. The bonus boom, in turn, was most pronounced in the US and Europe, where a bank merger boom was encouraging growth at any cost. Thus, in banks such as Lehman Brothers and UBS, audits found that bonuses were rewarding return, with insufficient attention to risk, and indeed with conscious manipulation or evasion by some agents of risk management mechanisms (Barth, Caprio, and Levine, 2012, chapter 3; see also Valukas, 2011). The dramatic decline in the market value of these securities from 2007 both illustrated and precipitated a growing revulsion for complex and risky lending, and a retreat to liq­ uidity leading to a global “credit crunch.” But the crisis of 2007 was much more than a US story. As reports in Iceland, Ireland, and the United Kingdom show, their crises were homegrown, meaning that they would have occurred regardless of the American crisis (Barth, Caprio, and Levine, 2012, chapter 5). Lending in these three countries was growing at astonishing rates (all three cases), with clear violations of lending criteria (Anglo-Irish Bank), currency mismatches (Iceland), and excessive reliance on short-term funding (Northern Rock), yet without regulatory inter­ vention. The timing of these crises, but not their inevitability, was influenced by that of the US. While portions of the US side of the crisis seem new, with the reliance on securi­ tized finance, in Europe securitization played a distinctly minor role. And although the plethora of new instruments appeared to disguise the American crisis, some facts were plainly visible to all: the boom in leverage, the availability of loans with no requirements for information, soaring compensation in the sector, and the financial alchemy of manu­ facturing safe securities from doubtful loans. As with the South Sea Bubble and many similar events, many were gulled into playing along and, at least with more modern crises, regulators did not do their jobs.

Page 16 of 27

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Hardy Perennials: Banking Crises Around the World Two elements of the crisis seem new. First, it spread with even greater speed than previ­ ous international crises, with markets drying up or disappearing, thus preventing the val­ uation of erstwhile assets. This speed was linked with the growth of a number of interna­ tionally active banks. Perhaps more significantly, securitization not only led to over half of US mortgage debt being held abroad but also far greater complexity. With the ability to offload their own loans and buy securities with hundreds or thousands of loans and other obligations, often held off a bank’s balance sheet, it became more (p. 902) difficult to know which institutions were safe and which were not. Consequently, as news spread about in­ creasing defaults in US mortgage markets, the response was to a generalized run and a drying up of financing. Second, and perhaps even more notable, was the appearance of “too big to save,” the problem that banking systems in some countries had grown so large relative to GDP that a rescue of the banks either was not possible (Iceland, Cyprus) or came at a crippling budgetary cost (other countries led by Ireland). The potential mismatch between the scale of some banking systems in Europe relative to the fiscal capacity of the host govern­ ments, combined with a lack of national control over monetary policy and the exchange rate, had been recognized conceptually in advance. To be sure, offshore financial systems have operated with banks that were much larger together than the local economy, but as most of their business was offshore, few thought local governments were standing behind them, nor would many have placed much value on such support. More cases of “too big to save” became apparent in recent years in light of exceptionally rapid financial deepening. Also, increased government indebtedness puts a premium on a parsimonious use of guar­ antees, so, without any available central resources from a European fund, it was in­ evitable that the banking crisis that crystallized in Cyprus in 2013 (associated with large prospective losses of the two main banks on their Cyprus and Greek loan portfolio, as well as losses incurred by them in the Greek debt exchanges of 2011–12) resulted in large losses for uninsured depositors and other creditors. “Too big to save” and “too indebted to save anyone” likely will lead to a decreased willingness to protect the uninsured and perhaps even to more expensive or less generous deposit insurance. The vicious circle linking bank failure, government solvency stress and macroeconomic instability, already evident not least from historic episodes in Argentina, Brazil, and Chile, was highlighted most vividly in the euro crisis that got under way in 2010. The Euro crisis was the result of interrelated banking and fiscal and competitiveness weaknesses in many Euro Area countries. Cross-border banking claims threatened to transmit weakness from the most stressed countries such as Greece, Portugal, and Ire­ land, to banks elsewhere in the monetary union. High indebtedness of countries such as Italy no longer seemed as easily supportable as had previously appeared. And even stronger countries experienced sizable banking losses. At certain moments, the combina­ tion of problems seemed to market participants to threaten the very sustainability of the institutional arrangements supporting the common currency. Accelerated balance-sheet repair associated with aggregate macroeconomic demand weakness aggravated the situa­ tion (Lane, 2012; Shambaugh, 2012). As unique as the Euro Area crisis may seem, that part pertaining to banking—excessive loans to governments—is as old as modern bank­ Page 17 of 27

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Hardy Perennials: Banking Crises Around the World ing. The Euro crisis also revealed clearly the problems occurring absent a common ap­ proach to bank regulation and to resolution (so that banks headquartered in one location do not become the fiscal obligation of that locale; cf. Veron and Wolff, 2013)—the “too big to save” issue just mentioned. In the US prior to the 1930s, even modest unit banks be­ came too expensive for states to save, and the failure of most state-run deposit insurance schemes led those states’ representatives to propose about (p. 903) 150 bills for federal deposit insurance before the Great Depression eroded the opposition to this policy (Calomiris and White, 1994). Crisis management during 2007–9 evolved slowly. Despite numerous indications that should have triggered alarm, a degree of complacency with regard to the likely scale and likely incidence of losses embedded in what was a very opaque set of banking portfolios, and with regard to the market’s likely resilience, meant that government intervention in insolvent banks and loss allocation were slow to start, reactive on a case-by-case basis, and piecemeal. At first, the main efforts were devoted to addressing the illiquidity that suddenly emerged in the interbank and other short-term money markets from August 2007. Progressively over the following eighteen months central banks bought, or accept­ ed as collateral, an increasingly large and varied range of assets. A few banks were res­ cued by public authorities during the early months, but they were treated as poorly man­ aged outliers, which had become excessively exposed to the mispriced securities backed by badly underwritten mortgages, rather than as symptomatic of a wider solvency prob­ lem. Even with the failure in March 2008 of the important US investment bank Bear Stearns, policy remained on a case-by-case basis. But after three major ad hoc actions in September—(i) the guarantees provided to the large US Government-sponsored whole­ sale mortgage banks Fannie Mae and Freddie Mac; (ii) the decision to allow another US investment bank Lehman Brothers go into bankruptcy; and (iii) the rescue of the large in­ surance company AIG which had underwritten credit default swap contracts on a sys­ temic scale—market expectations were destabilized. Confidence was not helped by the initial Congressional reaction to the US Treasury’s sketchy proposal to use vast bud­ getary resources to buy from the banks the most opaque securities. The following weeks were marked by sharp declines in stock market values, an extraordinary widening of credit spreads and sharp curtailment of credit, including international trade credit, and the failure or near-failure of several large banks in Europe and the US. The prospect of a generalized freezing of the global banking system triggered coordinated international de­ cisions in mid-October 2008 to make public funds available systematically and on a large scale to recapitalize the main banks. This action, which led, for example, to the UK gov­ ernment assuming a majority and large minority stake in two of its four largest banks, Royal Bank of Scotland and Lloyds, reassured markets of governments’ intention to res­ cue any other large banks getting into difficulties—as indeed was confirmed by a package announced by the US authorities in late November 2008 for Citigroup. The delay in recognizing the scale of the solvency issues and the piecemeal official re­ sponse probably exacerbated the growth in risk aversion in and around banks during 2008. By the end of that year credit remained extremely tight (with interbank rates well above the equivalent swap rates). The “credit crunch” had begun to depress economic ac­ Page 18 of 27

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Hardy Perennials: Banking Crises Around the World tivity worldwide, even in countries whose banks had not been implicated in the excesses and errors of US and European markets. This deepening global turndown began in turn to have a feedback effect on bank loan losses. The fallout from these two crises continued for years, with the experience of Cyprus (2013) and of Greece (whose banking system was frozen in 2015 when political uncertain­ ty (p. 904) triggered a bank run) showing that, even after eight years of crisis, no fixed template had emerged for dealing with each new situation, and instead a sequence of novel policy responses was taken. Partly as a result of the associated persistence of mar­ ket uncertainty, macroeconomic recovery in high-income economies was much weaker than in previous recessions, with greater fiscal tightening (notwithstanding greater eas­ ing early in the US) and more reliance on monetary easing. Impairment of the market for securitized finance, which had become a central element in the way in which advanced country banking systems delivered credit to the economy, seemed likely to persist. The main reason for weak recovery, though, was probably the fallout from the amplitude of the boom, which implied the need for sizable deleveraging, and the fact that it had been associated mainly with a housing price and construction boom. As was shown by Claessens, Kose, and Terrones (2011), credit crises coupled with housing price collapses tend to be more severe and longer than credit downturns on their own. Indeed, Japan has been dealing for almost a quarter century with the consequences of a credit, real estate, and housing price collapse; after two decades of weak growth and with the highest gov­ ernment debt/GDP ratio in the OECD area, Japan embarked in 2013 on a newly vigorous policy of monetary expansion to end the persistence of negative inflation, aiming for a 2 percent inflation target as the basis for monetary policy. Extrapolating from Japan’s expe­ rience, it may be that the adverse growth impact of the banking crisis in the advanced economies could be very long-lasting. The hallmarks of these recent crises have been their large fiscal cost and, for many, their occurrence at all, as they occurred in countries where the state of regulation and supervi­ sion was thought to be most advanced. In addition to changes both in regulation and how regulators are held to account (see section 27.8), governments, particularly those with es­ pecially heavy fiscal pressures coming due from demographic changes, should consider how to reduce the generosity of guarantees to the banking sector and to make sure that their fiscal position is sufficiently strong enough to sustain the guarantees that they are offering.

27.8 Toward Dynamic Regulation In the years leading up to the current crisis, the regulatory approach in industrial coun­ tries, as embodied by the work of the Basel Committee on Bank Supervision, was taken as a model for others. Quantitative risk management was on the rise, and the Basel Commit­ tee reflected this by moving away from crude, arbitrary risk weights decided by regula­ tors (Basel I) to an approach that placed reliance either on weights derived from the judg­ ments of credit rating agencies (CRAs) or the risk models of the banks themselves. Yet, Page 19 of 27

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Hardy Perennials: Banking Crises Around the World the locus of failures in the current crisis prominently featured some wildly over-optimistic ratings by the CRAs and the utter failure of risk management modeling to protect the banking system—indeed, overconfidence in the effectiveness of (p. 905) these systems contributed to management complacency and common sense being overridden. (As a re­ sult, Basel III was amended in 2017 to prevent internal risk models from generating capi­ tal requirements too far below what standardized risk weights would produce.) Similarly, prompt corrective action, the key regulatory change in the wake of the US S&L crisis, was too often dormant—neither prompt, nor corrective. Modern financial instruments, which were supposed to parcel out risk to those who could best bear it, were pushed be­ yond their capacity by users who ignored the danger that variances and correlations might not be stationary over time, and indeed that they might be endogenous to the com­ mon behavior of bankers. As a result, these tools instead contributed to a reduction in in­ formation and in the incentive to monitor risk. It is striking how many of the features stressed by Minsky (1986) as being typical of pre­ vious banking crises have been present in recent events. Low interest rates made many debtors look good, and their subsequent rise regularly revealed “surprises.” Financial safety nets, not limited to the boom in deposit insurance since the 1980s, increased risktaking. And large current account imbalances contain their own risks, as they are sooner or later eroded by a slowdown in the dynamism of the surplus party (whether that be a UK or a China) or a revision of opinion as to the creditworthiness of the borrower (an Ar­ gentina or the US). Since finance itself is dynamic, easily adjusting to changes in the real economy and regu­ lation, financial regulation and supervision necessarily must be dynamic as well; any no­ tion that it is possible to come up with a static set of rules to govern the sector and then leave the system to operate on automatic pilot should be dismissed. Such an approach can too easily be blindsided by some distinctively new and unexpected features, such as the hidden weaknesses of risk management for highly engineered financial instruments. Finance cannot return to the highly controlled and segmented world of the 1930s. Regu­ latory arbitrage needs to be acknowledged as a fact of life, one made infinitely easier thanks to inexpensive communications and computing. In making regulation more dynamic, it should be geared to revealing information, not se­ questering it in the files of the supervisor; and to be revealing, especially in boom times, of the risks that are being taken and the compensation of the risk-takers. By publication or by regulatory consequences, financial firms need to be dissuaded from paying out huge rewards out of current profits. Those managing other people’s money need to face the consequences of their decisions rather than be protected by their fulfillment of require­ ments that they hold highly rated paper. And, those with deeper pockets who lend to in­ termediaries need to experience losses when they have made poor decisions. In other words, crises focus attention on incentives, and the less regulation is incentive-based, the larger will be the losses to society. If regulators are to have the discretion to respond, some ways (such as that proposed by Barth, Caprio, and Levine, 2012) must be found to hold them more accountable. Hitherto, responses to the latest crises have focused on Page 20 of 27

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Hardy Perennials: Banking Crises Around the World changing the rules, not on what it takes to get them enforced, and to have regulators re­ spond to new risks. At some point, this focus might change.

(p. 906)

Acknowledgments

We would like to thank Thorsten Beck, Roger Bolton, Stijn Claessens, Asli Demirgüç-Kunt, James Hanson, Luc Laeven, Philip Lane, Millard Long, Peter Montiel, Steven Nafziger, Sergio Schmukler, and Andrew Sheng for comments. Nonetheless, the responsibility for any errors and omissions lies with the authors. And we owe the subtitle to Charles Kindle­ berger, from the title of chapter 1 of his classic, Manias, Panics, and Crashes: A History of Financial Crises, originally published in 1978 (Wiley and Sons) and now in its 7th edition (with Robert Aliber, Palgrave).

References Admati, A. and Hellwig, M. (2014). The Bankers’ New Clothes: What’s Wrong with Bank­ ing and What to Do About It, updated edn (Princeton, NJ: Princeton University Press). Aliber, R. and Kindleberger, C. (2015). Manias, Panics, and Crashes: A History of Finan­ cial Crises, 7th edn (New York: Palgrave Macmillan). Allen, F. and Gale, D. (2009). Understanding Financial Crises (New York: Oxford Universi­ ty Press). Barth, J. and Caprio, Jr., G. (2007). “China’s Changing Financial System: Can it Catch Up With, or Even Drive Growth?” Milken Review, 9/3. Barth, J., Caprio, Jr., G., and Levine, R. (2004). “Bank Regulation and Supervision: What Works Best,” Journal of Financial Intermediation, 12, 205–48. Barth, J., Caprio, Jr., G., and Levine, R. (2006). Rethinking Bank Regulation: Till Angels Govern (New York: Cambridge University Press). Barth, J., Caprio, Jr., G., and Levine, R. (2012). Guardians of Finance: Making Regulators Work for Us (Cambridge, MA: MIT Press). Benediktsdóttir, S., Eggertsson, G.B., and Þórarinsson, E. (2017). “The Rise, Fall, and Res­ urrection of Iceland: A Post-Mortem Analysis of the 2008 Financial Crisis,” Brookings Pa­ pers on Economic Activity, Fall, 191–308. Bordo, M., Eichengreen, B., Klingebiel, D., and Martínez Pería, M.S. (2001). “Is the Crisis Problem Growing More Severe?” Economic Policy, 32, 51–82. Bova, E., Ruiz-Arranz, M., Toscani, F., and Ture, H.E. (2016). “The Fiscal Costs of Contin­ gent Liabilities: A New Dataset,” International Monetary Fund Working Paper No. WP/ 16/14, January.

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Hardy Perennials: Banking Crises Around the World Brownlees, C., Chabot, B., Ghysels, E., and Kurz, C. (2017). “Back to the Future: Backtest­ ing Systemic Risk Measures During Historical Bank Runs and the Great Depression,” CEPR Discussion Paper 12178. Brunnermeier, M.K. and Schnabel, I. (2016). “Bubbles and Central Banks: Historical Per­ spectives,” in M.D. Bordo, O. Eitrheim, M. Flandreau, and J.F. Qvigstad (eds.), Central Banks at a Crossroads—What Can We Learn from History? (Cambridge: Cambridge Uni­ versity Press), 493–562. Calomiris, C.W. and Haber, S. (2014). Fragile by Design: Banking Panics, Scarce Credit and Political Bargains (Princeton, NJ: Princeton University Press). Calomiris, C.W. and Kahn, C. (1991). “The Role of Demandable Debt in Structuring Opti­ mal Banking Arrangements,” American Economic Review, 81, 497–513. Calomiris, C.W. and White, E. (1994). “The Origins of Federal Deposit Insurance,” in C. Goldin and G. Libecap (eds.), The Regulated Economy: A Historical Approach to Political Economy (Cambridge: National Bureau of Economic Research). (p. 907)

Caprio, Jr., G. and Honohan, P. (2005). “Starting Over Safely: Rebuilding Banking

Systems,” in G. Caprio, Jr., J.A. Hanson, and R.E. Litan (eds.), Financial Crises: Lessons from the Past, Preparation for the Future (Washington, DC: Brookings Institution Press). Caprio, Jr., G. and Wilson, B. (2000). “Financial Fragility and Mexico’s 1994 Peso Crisis: An Event-Window Analysis of Market Valuation Effects,” Journal of Money, Credit, and Banking, 32, 450–68. Caprio, Jr., G., Klingebiel, D., Laeven, L., and Noguera, G. (2005). “Banking Crisis Data­ base,” in P. Honohan and L. Laeven (eds.), Systemic Financial Crises (Cambridge: Cam­ bridge University Press). Claessens, S., Kose, M.A., and Terrones, M.E. (2011). “Financial Cycles: What? How? When?” IMF Working Paper No. WP/11/76, The International Monetary Fund, April. Dale, R. (2004). The First Crash: Lessons from the South Sea Bubble (Princeton, NJ: Princeton University Press). de Juan, A. (2002). “From Good Bankers to Bad Bankers,” in G. Caprio, Jr., P. Honohan, and D. Vittas (eds.), Financial Sector Policy for Developing Countries: A Reader (Washington, DC: The World Bank). Demirgüç-Kunt, A. and Detragiache, E. (1999). “Financial Liberalization and Financial Fragility,” in B. Pleskovic and J.E. Stiglitz (eds.), Proceedings of the 1998 World Bank Con­ ference on Development Economics (Washington, DC: World Bank). Demirgüç-Kunt, A. and Detragiache, E. (2005). “Cross-Country Empirical Studies of Sys­ temic Bank Distress: A Survey,” National Institute Economic Review, 192.

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Hardy Perennials: Banking Crises Around the World Diamond, D. and Dybvig, P. (1983). “Bank Runs, Deposit Insurance, and Liquidity,” Journal of Political Economy, 91, 401–19. Enoch, C., Baldwin, B., Frecaut, O., and Kovanen, A. (2001). “Indonesia: Anatomy of a Banking Crisis: Two Years of Living Dangerously 1997–99,” IMF Working Paper No. 01/52. Guttentag, J.M. and Herring, R.J. (1986). “Disaster Myopia in International Banking,” Princeton Essays in International Finance, 164, September. Haber, S. (2005). “Mexico’s Experiments with Bank Privatization and Liberalization, 1991–2003,” Journal of Banking & Finance, 29, 2325–53. Halac, M. and Schmukler, S.L. (2005). “Distributional Effects of Crises: The Financial Channel,” Economia, 5, 1–67. Harvey, C. and Roper, A. (1999). “The Asian Bet,” in A. Harwood, R.E. Litan, and M. Pomerleano (eds.), The Crisis in Emerging Financial Markets (Washington, DC: Brookings Institution Press). Herring, R.J. (2005). “BCCI and Barings: Bank Resolutions Complicated by Fraud and Global Corporate Structure,” in D. Evanoff and G. Kaufman (eds.), Bank Resolutions and Financial Stability (Cambridge, MA: MIT Press). Homar, T. and van Wijnbergen, S. (2015). “On Zombie Banks and Recessions after Sys­ temic Banking Crises: Government Intervention Matters,” CEPR Discussion Paper DP10963. Homer, S. and Sylla, R. (1996). A History of Interest Rates (New Brunswick, NJ: Rutgers University Press). Honohan, P. (1997). “Banking System Failures in Developing and Transition Countries: Di­ agnosis and Prediction,” Bank for International Settlements Working Paper No. 39, Janu­ ary, available at: http://www.bis.org/publ/work39.htm. Honohan, P. (2005). “Banking Sector Crises and Inequality,” World Bank Policy Research Working Paper WPS No. 3659. Honohan, P. (2008). “Protecting Depositors in China: Experience and Evolving Policy,” in A. Demirgüç-Kunt, E. Kane, and L. Laeven (eds.), Deposit Insurance (Cambridge, MA: MIT Press). Honohan, P. (2017). “Management and Resolution of Banking Crises: Lessons from Recent European Experience,” PIIE Policy Brief 17–1, Peterson Institute for Interna­ tional Economics, Washington, DC. (p. 908)

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Hardy Perennials: Banking Crises Around the World Honohan, P. and Laeven, L. (2005). Systemic Financial Distress: Containment and Resolu­ tion (New York: Cambridge University Press). International Monetary Fund (2007). The Global Financial Stability Review (Washington, DC: International Monetary Fund). Jordà, Ò., Schularick, M., and Taylor, A.M. (2013). “When Credit Bites Back,” Journal of Money, Credit and Banking, 45(s2), 3–28. Jordà, Ò., Schularick, M., and Taylor, A.M. (2016). “Sovereigns versus Banks,” Journal of the European Economic Association, 14(1), 45–71. Keating, C., Shin, H.S., Goodhart, C., and Danielsson, J. (2001). “An Academic Response to Basel II,” Financial Markets Group Special Paper 130, London School of Economics. Kohn, M. (2009). “The Origins of Western Economic Success: Commerce, Finance, and Government in Pre-Industrial Europe,” available at: https://sites.dartmouth.edu/ mkohn/origins/. Laeven, L. and Valencia, F. (2012). “Systemic Banking Crises Database: An Update,” IMF Working Paper No. WP/12/163. Lane, P. (2012). “The European Sovereign Debt Crisis,” Journal of Economic Perspectives, 26(3), 49–68. Lardy, N.R. (1998). China’s Unfinished Economic Revolution (Washington, DC: Brookings Institution Press). Lindgren, C.J., Garcia, G., and Saal, M. (1996). Bank Soundness and Macroeconomic Poli­ cy (Washington, DC: International Monetary Fund). Minsky, H.P. (1986). Stabilizing an Unstable Economy (New Haven, CT: Yale University Press). Reinhart, C.M. and Rogoff, K.S. (2008). “Is the 2007 U.S. Subprime Financial Crisis So Different? An International Historical Comparison,” American Economic Review, 98, 339– 44. Reinhart, C.M. and Rogoff, K.S. (2009). This Time Is Different: Eight Centuries of Finan­ cial Folly (Princeton, NJ: Princeton University Press). Reinhart, C.M. and Rogoff, K.S. (2013). “Banking Crises: An Equal Opportunity Menace,” Journal of Banking and Finance, 37, 4557–73. Richter, B., Schularick, M., and Wachtel, P. (2017). “When To Lean Against the Wind,” CEPR Discussion Paper 12188.

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Hardy Perennials: Banking Crises Around the World Rivlin, A. and Soroushian, J. (2017). “Credit Rating Agency Reform is Incomplete,” The Brookings Institution, available at: https://www.brookings.edu/research/credit-ratingagency-reform-is-incomplete/, March 6. Shambaugh, J. (2012). “The Euro’s Three Crises,” Brookings Papers on Economic Activity, 43(1), 157–231. Stern, G.H. and Feldman, R.J. (2004). Too Big to Fail: The Hazards of Bank Bailouts (Washington, DC: Brookings Institution Press). Valukas, A.R. (2011). Lehman Brothers Holdings Inc. Chapter 11 Proceedings Examiner Report, New York: United States Bankruptcy Court Southern District of New York, avail­ able at: http://jenner.com/lehman/. Veron, N. and Wolff, G. (2013). “From Supervision to Resolution: Next Steps on the Road to European Banking Union,” Bruegel Policy Contribution, Issue 2013/04, Feb­ ruary. (p. 909)

Wilson, B., Saunders, A., and Caprio, Jr., G. (2000). “Mexico’s Financial Sector Crisis: Propagative Links to Devaluation,” Economic Journal, 110, 292–308. Wood, J.H. (2003). “Bagehot’s Lender of Last Resort: A Hollow Hallowed Tradition,” The Independent Review, 7, 343–51. World Bank (2001). Finance for Growth: Policy Choices in a Volatile World (Washington, DC and New York: The World Bank and Oxford University Press).

Notes: (1) We use “bad banking” to embrace a range of management practice, from fraud to mis­ calculations of risk to deliberate exploitation of the put option inherent in deposit insur­ ance, which heightens the likelihood of bank failure. Of course, all banking involves risk, not least because of the ever-present information problems of adverse selection and moral hazard, but these are managed and adequately priced in normal banking operation. Pressure of circumstances can turn good bankers into bad bankers, as is graphically char­ acterized by de Juan (2002). (2) The payments system can create a strong short-term interdependency of banks, so that the failure of one major bank could disrupt the entire system of payments and shortterm credit on which much of day-to-day economic activity depends. For this reason, some banks of systemic importance are perceived as being TBTF, requiring official sup­ port for their continued operation even if they are insolvent. (3) Reinhart and Rogoff (2009) also stress the damaging indirect effects on long-term eco­ nomic growth that may result from the accumulation by fiscal authorities of sharp in­ creases in debt as a result of banking costs through the socialization of unpayable bank­ ing debts and through the automatic stabilizers associated with the accompanying macro­ Page 25 of 27

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Hardy Perennials: Banking Crises Around the World economic downturn. Although their estimates of the scale of such an effect can be chal­ lenged, it would be unwise to neglect this possible channel of causation. (4) LOLR actions need an effective communications strategy if they are to be successful in restoring depositors’ confidence. When the UK mid-sized mortgage lender Northern Rock in 2007 had difficulty in refinancing its mortgage portfolio in the wholesale markets and was given exceptional liquidity support by the Bank of England (eventually amounting to the equivalent of about US $50 billion, larger than any previous such loan in history), the tone of the accompanying statements seems to have triggered a retail depositor run so unnerving that the authorities issued a temporary open-ended depositor guarantee. It re­ mains debatable whether Northern Rock’s solvency at the time of its first request re­ mains debatable. If it were, the authorities’ initial hesitation to assist may have been in­ consistent with Bagehot’s rule; if not, it demonstrates the difficulty for the LOLR when in­ solvent banks are not promptly closed before a run begins. This recent case also illus­ trates the importance of encouraging banks to manage carefully their risks, including liq­ uidity positions, which frequent LOLR support will undermine. (5) According to the Basel system, various loans and other assets were assigned different risk weights, thereby leading to the incentive to shed assets with a higher risk charge.

Gerard Caprio, Jr. Jr

Gerard Caprio, Jr. is William Brough Professor of Economics at Williams College and Chair of the Center for Development Economics. Previously he was the Director for Policy in the World Bank’s Financial Sector Vice Presidency and head of the financial sector research group. His research included establishing the first databases on banking crises around the world and on bank regulation and supervision, and he worked on financial system reform and development issues around the world. He has consulted for the IMF, the World Bank, and various governments. He has authored numerous articles, and co-authored The Guardians of Finance: Making Regulators Work for Us, with Jim Barth and Ross Levine (MIT Press, 2012), with whom he also wrote Rethinking Bank Regulation: Till Angels Govern (Cambridge University Press, 2006). Earlier positions include: Vice President and Head of Global Economics at JP­ Morgan, and economist positions at the Federal Reserve Board and the IMF. He has taught at Trinity College Dublin, where he was a Fulbright Scholar, and at George Washington University. Patrick Honohan

Patrick Honohan is Honorary Professor of Economics at Trinity College Dublin, a Non-resident Senior Fellow at the Peterson Institute for International Economics and a Research Fellow of CEPR. From 2009–15 he was Governor of the Central Bank of Ireland. Previously, he was a Senior Advisor at the World Bank and his career has al­ so included periods on the staffs of the IMF, the Economic and Social Research Insti­ tute, Dublin, and as Economic Advisor to the Taoiseach.

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Hardy Perennials: Banking Crises Around the World

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Bank Failures, The Great Depression, and Other “Contagious” Events

Bank Failures, The Great Depression, and Other “Con­ tagious” Events   Charles W. Calomiris The Oxford Handbook of Banking (3rd edn) Edited by Allen N. Berger, Philip Molyneux, and John O. S. Wilson Print Publication Date: Oct 2019 Subject: Economics and Finance, Financial Economics Online Publication Date: Nov 2019 DOI: 10.1093/oxfordhb/9780198824633.013.39

Abstract and Keywords Deposit withdrawal pressures on banks, which sometimes take the form of sudden runs, have figured prominently in the discussion of public policy toward banks and the con­ struction of safety nets such as deposit insurance and the lender of last resort. This chap­ ter examines historical evidence from the Great Depression, and other episodes, on the factors that prompted withdrawals, the discussion of contagious runs, and the public poli­ cy implications. The historical evidence is presented in detail and is connected to the de­ bate over the proper roles of deposit market discipline via the threat of withdrawals, the insurance of deposits, and lender-of-last-resort support for banks facing withdrawal pres­ sures. Keywords: banking crises, contagion, fundamental shocks, Great Depression, lender-of-last-resort, panics

28.1 Introduction CONCERNS about the susceptibility of banks to unwarranted withdrawals of deposits during panics, the possibility of bank failures, and contractions of bank credit resulting from unwarranted withdrawals of deposits (which is sometimes described as the result of “contagious” weakness among banks) and the attendant adverse macroeconomic conse­ quences of bank disappearance or bank balance-sheet contraction, have motivated much of the public policies toward banks. The global financial crisis of 2007–9 was the most re­ cent illustration of this phenomenon (Calomiris, 2008; Litan, 2012). In reaction to initial bank losses (e.g., on subprime mortgage-related exposures), a scramble for liquidity en­ sued in which banks reduced their lending and scrambled to shore up their liquidity and reduce their leverage. Interest rate spreads on risky assets skyrocketed, and money mar­ ket instruments (commercial paper, interbank deposits, and repurchase agreements) con­ tracted sharply, adding to the “liquidity crunch.”

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Bank Failures, The Great Depression, and Other “Contagious” Events Several policies have come into existence to deal with such shocks, including assistance mechanisms intended to protect banks from unwarranted withdrawals of deposits (cen­ tral bank lending during crises, deposit insurance, and government-sponsored bank bailouts), and a host of prudential regulatory policies (intended to promote banking sys­ tem stability, and especially to prevent banks from taking advantage of government pro­ tection by increasing their riskiness—the so-called “moral-hazard” problem of protection). This chapter reviews the theory and historical evidence related to the prevalence of bank­ ing contagion and the effects of the policies designed to mitigate it.

28.2 “Contagion” versus Fundamentals as Causes of Bank Failures (p. 911)

Theoretical models have been devised in which banking crises result from systemic “con­ tagion,” when banks that are intrinsically solvent are subjected to large unwarranted withdrawals, and may fail as a consequence of this withdrawal pressure. Advocates of the view that banking systems are inherently vulnerable to such contagion often emphasize that the structure of banks—the financing of illiquid assets with demandable debts, and the “sequential service constraint” (which mandates that depositors who are first in line receive all of their deposits)—tends to aggravate the tendency for unwarranted with­ drawals (see Diamond and Dybvig, 1983; Allen and Gale, 2004; Diamond and Rajan, 2004). Unwarranted withdrawals (that is, those unrelated to the solvency of the bank) can occur, in theory, for a number of reasons. Diamond and Dybvig (1983) develop a banking model with multiple equilibria, where one of the equilibria is a systemic bank run, which occurs simply because depositors believe that others will run. More generally, observers of his­ torical panics sometimes document depositors imitating each other’s withdrawal behav­ ior; depositors may line up to withdraw their funds simply because others are doing so, particularly in light of the incentives implied by the sequential service constraint. It is im­ portant to recognize, however, that evidence about mimetic withdrawals does not gener­ ally confirm the all-or-nothing runs by all depositors imagined by some theoretical mod­ els; rather, mimesis may be partial and gradual (see Ó Gráda and White, 2003; Bruner and Carr, 2007). A second possibility, which is particularly relevant for understanding pre-World War I banking panics in the US (e.g., the nationwide US Panics of 1857, 1873, 1884, 1890, 1893, 1907, and some events during the Great Depression, including the Chicago banking panic of June 1932) is that a signal is received by depositors, which contains noisy infor­ mation about the health of the various banks. Depositors have reason to believe that a loss has occurred that might cause a bank to suffer a significant loss or even become in­ solvent, but they cannot observe which bank has suffered the loss. In that circumstance, depositors may withdraw large amounts of funds from all banks, including those that are

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Bank Failures, The Great Depression, and Other “Contagious” Events (unobservably) financially strong, simply because they would rather not risk leaving their money in a bank that turns out to be weak or insolvent. For fundamental shocks to precipitate withdrawals they need not lead depositors or other holders of similar short-term “money market” debts (such as commercial paper or repur­ chase agreements) to believe that insolvency risk has risen substantially. Indeed, one of the key insights of recent models of banking is that depositors may have reason to be risk-intolerant, not just risk-averse—meaning that even a small increase in the risk of de­ fault may lead to significant withdrawals (for recent evidence, see Calomiris, Himmel­ berg, and Wachtel, 1995; Gorton and Metrick, 2011). In theory, this can be a consequence of concerns about changes in behavior by weakened banks due to an increased likelihood of conflict in interest between principals (depositors) and their agents (bankers), as in Calomiris and Kahn (1991) and Calomiris, Heider, and Hoerova, (2017). Alternatively, it may reflect reduced liquidity of bank deposits when they become risky (Gorton and Pen­ nacchi, 1990; Dang, Gorton, and Holmstrom, 2012). Third, exogenous shocks to depositors’ liquidity preferences, or to the supply of reserves in the banking system, unrelated to banks’ asset condition, may cause an excess demand for cash on the part of depositors relative to existing reserves, which can lead banks to a scramble for reserves, which in turn can produce systemic runs (a banking version of the game “musical chairs”). Liquidity demand and supply shocks may be related to govern­ ment policies affecting the reserve market, or to foreign exchange risks that lead deposi­ tors to want to convert to cash. This mechanism may have had a role in some banking sys­ tem crises (notably, the nationwide US Panics of 1837 and 1933). Withdrawal pressures can be associated with warranted concerns traceable to fundamentals or unwarranted withdrawals that result from “panic.” Withdrawal pressures can accumulate over time or can take the extreme form of a sud­ den “bank run” (when depositors decide en masse to remove deposits). During the Great Depression, deposit withdrawals, bank closures, and even the threat of withdrawal, in­ duced substantial contraction of bank credit as banks disappeared or sought to shore up their liquidity and reduce their fundamental risk to increase their chances of surviving. Such contractions in credit supply can have important macroeconomic consequences, which can amplify business cycle downturns and spread financial distress from banks to the whole economy (Bernanke, 1983; Calomiris and Mason, 2003b; Calomiris and Wilson, 2004; Carlson and Rose, 2011). Part of the reason that bank distress during the Depres­ sion caused such a significant decline in bank credit was that many banks were forced to exit the market, not only because their losses were large, but because few banks were healthy enough to acquire those that were failing (Carlson, 2010; Carlson and Rose, 2011). Other episodes of banking panics outside the Great Depression have also been identified as times of severe withdrawal pressure on banks, especially in the US during the nineteenth and early twentieth centuries, although the adverse consequences for bank credit seem to have been less severe.

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Bank Failures, The Great Depression, and Other “Contagious” Events Differences in opinion about the sources of shocks that cause bank failures can have im­ portant implications for policy. While it is true that both concerns about spontaneous pan­ ic and concerns about fundamental loss can motivate public policies to prevent runs, bank closures and credit crunches, the emphasis on panics provides special motives for public policies to protect banks from withdrawal risk. The fundamentalist view, in con­ trast, sees banks as generally inherently stable—that is, neither victims of unwarranted withdrawals, nor a major source of macroeconomic shocks. According to the fundamen­ talist view, market discipline of banks is not random, and indeed, helps preserve efficien­ cy in the banking system. It may be desirable to limit or even avoid government protec­ tion of banks to preserve market discipline in banking (making banks more vulnerable to the risk of depositor withdrawal). Preserving market discipline (p. 913) encourages good risk management by banks (Calomiris, Heider, and Hoerova, 2017), even though bank de­ posit and credit contractions attendant to adverse economic shocks to bank borrowers may aggravate business cycles. Indeed, some empirical studies have argued that policies that insulate banks from market discipline tend to produce worse magnifications of down­ turns, due to excessive bank risk-taking in response to protection (e.g., Barth, Caprio, and Levine, 2006). These two views of the sources of bank distress (the panic view that banks are fragile and highly subject to panic, or, alternatively, the fundamentalist view that banks are stable and generally not subject to unwarranted large-scale withdrawals) do not define the uni­ verse of possibilities. One or the other extreme view may do a better job of explaining dif­ ferent historical crises, and both fundamentals and unwarranted withdrawals may play a role during some banking crises. The recent empirical literature on banking crises has tried to come to grips with the causes and effects of systemic bank failures in different places and times, to ascertain the dominant causal influences connecting banking dis­ tress to macroeconomic decline, and to try to draw inferences about the appropriate pub­ lic policy posture toward banks. The remainder of this chapter selectively reviews the em­ pirical literature on the causes of bank failures during systemic banking crises. This re­ view begins with a lengthy discussion of the Great Depression in the US, which is fol­ lowed by a discussion of US bank distress prior to the Depression, historical bank distress outside the US, and contemporary banking system distress (which is discussed more fully by Caprio and Honohan in Chapter 27, this volume).

28.3 US Bank Distress During the Great De­ pression The list of fundamental shocks that may have weakened banks during the Great Depres­ sion is a long and varied one. It includes declines in the value of bank loan portfolios pro­ duced by waves of rising default risk in the wake of regional, sectoral, or national macro­ economic shocks to bank borrowers, as well as monetary-policy-induced declines in the prices of the bonds held by banks. There is no doubt that adverse fundamental shocks rel­ evant to bank solvency were contributors to bank distress; the controversy is over the Page 4 of 20

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Bank Failures, The Great Depression, and Other “Contagious” Events size of these fundamental shocks—that is, whether banks experiencing distress were tru­ ly insolvent or simply illiquid. Friedman and Schwartz (1963) are the most prominent advocates of the view that many bank failures resulted from unwarranted “panic” and that failing banks were in large measure illiquid rather than insolvent. Friedman and Schwartz’s emphasis on contagion imagined that bank failures mainly reflected a problem of illiquidity rather than insolven­ cy. Illiquid but solvent financial institutions, in their view, failed purely as the result of withdrawal demands by depositors, particularly during sudden moments of (p. 914) panic. In contrast, an insolvent institution fails to repay depositors as a result of fundamental losses in asset value, rather than the suddenness of depositor withdrawals. Friedman and Schwartz attach great importance to the banking crisis of late 1930, which they attribute to a “contagion of fear” that resulted from the failure of a large New York bank, the Bank of US, which they regard as itself a victim of panic. They also identify two other banking crises in 1931—from March to August 1931, and from Britain’s departure from the gold standard (21 September 1931) to the end of the year. The fourth and final banking crisis they identify occurred at the end of 1932 and the beginning of 1933, culmi­ nating in the nationwide suspension of banks in March 1933. The 1933 crisis and suspen­ sion was the beginning of the end of the Depression, but the 1930 and 1931 crises (be­ cause they did not result in suspension) were, in Friedman and Schwartz’s judgment, im­ portant sources of shock to the real economy that turned a recession in 1929 into the Great Depression of 1929–33. The Friedman and Schwartz argument is based upon the suddenness of banking distress during the panics that they identify, and the absence of collapses in relevant macroeco­ nomic time series prior to those banking crises (see charts 27–30 in Friedman and Schwartz, 1963, p. 309). But there are reasons to question Friedman and Schwartz’s view of the exogenous origins of the banking crises of the Depression. As Temin (1976) and many others have noted, the bank failures during the Depression marked a continuation of the severe banking sector distress that had gripped agricultural regions throughout the 1920s. Of the nearly 15,000 bank disappearances that occurred between 1920 and 1933, roughly half pre-date 1930. And massive numbers of bank failures occurred during the Depression era outside the crisis windows identified by Friedman and Schwartz (no­ tably, in 1932). Wicker (1996, p. 1) estimates that “[b]etween 1930 and 1932, of the more than 5,000 banks that closed only 38 percent suspended during the first three banking crisis episodes.” Recent studies of the condition of the Bank of US indicate that it too may have been insolvent, not just illiquid, in December 1930 (Lucia, 1985; Wicker, 1996). So there is some prima facie evidence that the banking distress of the Depression era was more than a problem of panic-inspired depositor flight. How can one attribute bank failures during the Depression mainly to fundamentals when Friedman and Schwartz’s time series evidence indicates no prior changes in macroeco­ nomic fundamentals? First, Friedman and Schwartz omitted important aggregate mea­ sures of the state of the economy relevant for bank solvency—for example, measures of Page 5 of 20

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Bank Failures, The Great Depression, and Other “Contagious” Events commercial distress and construction activity may be useful indicators of fundamental shocks. Second, aggregation of fundamentals masks important sectoral, local, and region­ al shocks during the Depression that buffeted banks with particular credit or market risks. The empirical relevance of these factors has been demonstrated in the work of Wicker (1980, 1996) and Calomiris and Mason (1997, 2003a). Using a narrative approach similar to that of Friedman and Schwartz, but relying on data disaggregated to the level of the Federal Reserve districts and on local newspaper ac­ counts of banking distress, Wicker argues that it is incorrect to identify the banking crisis of 1930 and the first banking crisis of 1931 as national panics comparable to those of the pre-Fed era. According to Wicker, the proper way to understand (p. 915) the process of banking failure during the Depression is to disaggregate, both by region and by bank, be­ cause heterogeneity was very important in determining the incidence of bank failures. Once one disaggregates, Wicker argues, it becomes apparent that at least the first two of the three banking crises of 1930–1 identified by Friedman and Schwartz were largely re­ gional affairs. Wicker (1980, 1996) argues that the failures of November 1930 reflected regional shocks and the specific risk exposures of a small subset of banks, linked to Nashville-based Caldwell and Co., the largest investment bank in the South at the time of its failure. Temin (1989, p. 50) reaches a similar conclusion. He argues that the “panic” of 1930 was not really a panic, and that the failure of Caldwell and Co. and the Bank of US reflected fundamental weakness in those institutions. Wicker’s analysis of the third banking crisis (beginning in September 1931) also shows that bank suspensions were concentrated in a very few locales, although he regards the nationwide increase in the tendency to convert deposits into cash as evidence of a possi­ ble nationwide banking crisis in September and October 1931. Wicker agrees with Fried­ man and Schwartz that the final banking crisis (of 1933), which resulted in universal sus­ pension of bank operations, was nationwide in scope. The banking crisis that culminated in the bank holidays of February–March 1933 resulted in the suspension of at least some bank operations (bank “holidays”) for nearly all banks in the country by 6 March. From the regionally disaggregated perspective of Wicker’s findings, the inability to ex­ plain the timing of bank failures using aggregate time series data (which underlay the Friedman-Schwartz view that banking failures were an unwarranted and autonomous source of shock) would not be surprising even if bank failures were entirely due to funda­ mental insolvency. Failures of banks were local phenomena in 1930 and 1931, and so may have had little to do with national shocks to income, the price level, interest rates, and as­ set prices. The unique industrial organization of the American banking industry historically plays a central role in both the Wicker view of the process of bank failure during the Depression, and in the ability to detect that process empirically. Banks in the US (unlike banks in oth­ er countries) did not operate throughout the country. They were smaller, regionally isolat­ ed institutions. In the US, therefore, large region-specific shocks might produce a sudden wave of bank failures in specific regions even though no evidence of a shock was visible Page 6 of 20

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Bank Failures, The Great Depression, and Other “Contagious” Events in aggregate macroeconomic time series (see the cross-country evidence in Bernanke and James, 1991; and Grossman, 1994). The regional isolation of banks in the US, due to pro­ hibitions on nationwide branching or even statewide branching in most states, also makes it possible to identify regional shocks empirically through their observed effects on banks located exclusively in particular regions. Microeconomic studies of banking distress have provided some useful evidence on the re­ actions of individual banks to economic distress. White (1984) shows that the failures of banks in 1930 are best explained as a continuation of the agricultural distress of the 1920s, and are traceable to fundamental disturbances in agricultural markets. Calomiris and Mason (1997) study the Chicago banking panic of June 1932 (a locally iso­ lated phenomenon). They find that the panic resulted in a temporary contraction of (p. 916) deposits that affected both solvent and insolvent banks, and, in that sense, unwar­ ranted deposit contraction did occur. Fundamentals, however, determined which banks survived. Apparently, no solvent banks failed during that panic. Banks that failed during the panic were observably weaker ex ante, judging from their balance sheets and income statements, and from the default risk premiums they paid on their debts. Furthermore, the rate of deposit contraction was not identical across banks; deposits declined more in failing weak banks than in surviving banks. Calomiris and Wilson (2004) study the behavior of New York City banks during the inter­ war period, and, in particular, analyze the contraction of their lending during the 1930s. They find that banking distress was an informed market response to observable weak­ nesses in particular banks, traceable to ex ante bank characteristics. It resulted in bank balance-sheet contraction, but this varied greatly across banks; banks with higher default risk were disciplined more by the market (that is, experienced greater deposit with­ drawals), which encouraged them to target a low-risk of default. Calomiris and Mason (2003a) construct a survival duration model of Fed member banks throughout the country from 1929 to 1933. This model combines aggregate data at the national, state, and county level with bank-specific data on balance sheets and income statements to identify the key contributors to bank failure risk and to gauge the relative importance of fundamentals and panics as explanations of bank failure. Calomiris and Mason find that a fundamentals-based model can explain most of the failure experience of banks in the US prior to 1933. They identify a significant, but small, national panic effect around September of 1931, and some isolated regional effects that may have been panics, but, prior to 1933, banking panics were not very important contributors to bank failures compared to fundamentals. The fact that a consistent model based on fundamentals can explain the vast majority of US bank failures prior to 1933 has interesting implications. First, it indicates that the in­ fluence of banking panics as an independent source of shock to the economy was not im­ portant early in the Depression. Only in 1933, at the trough of the Depression, did failure risk become importantly delinked from local, regional, and national economic conditions and from fundamentals relating to individual bank structure and performance. Second, Page 7 of 20

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Bank Failures, The Great Depression, and Other “Contagious” Events the timing of this observed rise in risk unrelated to indicators of credit risk is itself inter­ esting. In late 1932 and early 1933, currency risk became increasingly important; deposi­ tors had reason to fear that President Roosevelt would leave the gold standard, which gave them a special reason to want to convert their deposits into (high-valued) dollars be­ fore the devaluation of the dollar (Wigmore, 1987). Currency risk, of course, is also a fun­ damental. It is also interesting to connect this account of bank distress during the Depression— which emphasizes fundamental shocks, rather than simply illiquidity, as the source of bank distress—with the history of lender of last resort (LOLR) assistance to banks during the Depression. Many commentators have faulted the Federal Reserve for failing to pre­ vent bank failures with more aggressive discount window lending. While it is certainly true that expansionary monetary policy, particularly in 1929–31, could have made an (p. 917) enormous difference in preventing bank distress (through its effects on macroeco­ nomic fundamentals), that is not the same as saying that more generous terms at the dis­ count window (holding constant the overall monetary policy stance) would have made much of a difference. Discount window lending only helps preserve banks that are suffer­ ing from illiquidity, which was not the problem for most banks in the 1930s that were ex­ periencing large depositor withdrawals. At the same time, recent work on the Depression has shown that under some circum­ stances, timely liquidity assistance can be useful in preventing crises from becoming more severe. For example, Carlson, Mitchener, and Richardson (2011) show that aggres­ sive action by the Federal Reserve Bank of Atlanta to provide liquidity to banks in Florida in 1929 arrested a panic and prevented many banks from failing. Similarly, Richardson and Troost (2009) show that the Atlanta Fed’s relatively aggressive approach to liquidity assistance reduced bank failure rates in the early 1930s. Mitchener and Richardson (forthcoming) show that the pyramiding of reserves in the banking system, combined with the low percentage of country banks that were members of the Federal Reserve System, aggravated liquidity risk during the Depression, and contributed to the contraction in credit supply and bank suspensions. The impact of liquidity assistance to address these problems was limited during the De­ pression. Non-Fed members did not have access to Fed lending, and relied instead on in­ direct access to liquidity through the pass-throughs of Fed lending to member banks, which is inherently limited in providing sufficient access to Fed lending (Anderson et al., 2018). In 1932, President Hoover created the Reconstruction Finance Corporation (RFC), to enlarge the potential availability of liquidity, but this additional source of liquidity as­ sistance seems to have made no difference in helping borrowing banks avoid failure (Ma­ son, 2001; Calomiris et al., 2013). Commentators at the time noted that, because the col­ lateralized RFC and Fed loans were senior to deposits, and because depositor with­ drawals from weak banks reflected real concerns about bank insolvency, loans from the Fed and the RFC to banks experiencing withdrawals did nothing to help, and actually of­ ten did harm to banks, since those senior loans from the Fed and the RFC reduced the

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Bank Failures, The Great Depression, and Other “Contagious” Events amount of high quality assets available to back deposits, which actually increased the riskiness of deposits and created new incentives for deposit withdrawals. In 1933, however, once the RFC was permitted to purchase the preferred stock of finan­ cial institutions (which was junior to depositors), RFC assistance to troubled banks was effective in reducing the risk of failure and increasing the supply of lending (Mason, 2001; Calomiris, Mason, Weidenmier, and Bobroff, 2013). Finland enjoyed similar success with its use of preferred stock in the early 1990s. Preferred stock injections were not so successful in resolving Japanese bank distress in 1999 and 2000, which reflected the magnitude of the Japanese banks’ problems, problems in the implementation of the pro­ gram, and the limitations of preferred stock injections for helping resolve problems of deep bank insolvency (Calomiris and Mason, 2004; Calomiris, 2009). Preferred stock in­ jections had limited beneficial effects on large global banks during the 2007–9 crisis, per­ haps for similar reasons.

28.4 Microeconomic Studies of Local Con­ tagion (p. 918)

As part of their bank-level analysis of survival duration during the Depression, Calomiris and Mason (2003a) also consider whether, outside the windows of “panics” identified by Friedman and Schwartz, the occurrence of bank failures in close proximity to a bank af­ fects the probability of survival of the bank, after taking into account the various funda­ mental determinants of failure. This measure of “contagious failure” is an upper bound, since in part it measures unobserved cross-sectional heterogeneity common to banks lo­ cated in the same area, in addition to true contagion. Calomiris and Mason (2003a) find small, but statistically significant, effects associated with this measure. The omission of this variable from the analysis raises forecasted survival duration by an average of 0.2 percent. They also consider other regional dummy variables associated with Wicker’s (1996) instances of identified regional panics, and again find effects on bank failure risk that are small in national importance. Ó Gráda and White (2003) provide a detailed account of depositor behavior based on indi­ vidual account data during the 1850s for a single bank, the Emigrant Savings Bank of New York, which offers a unique perspective on depositor contagion during banking pan­ ics. In 1854, Emigrant experienced an unwarranted run that can be traced to mimetic be­ havior among inexperienced, uninformed depositors. This run, however, was easily han­ dled by the bank, which was able to pay off depositors and restore confidence. In con­ trast, the run in 1857 was an imitative response to the behavior of informed, sophisticat­ ed depositors who were running for a reason, and that run resulted in suspension of con­ vertibility. Furthermore, in both of these episodes, mimesis was not sudden: “In neither 1854 nor 1857 did depositors respond to a single signal that led them to crowd into banks all at once. Instead, panics lasted a few weeks, building and sometimes ebbing in intensi­ ty, and only a fraction of all accounts were closed” (Ó Gráda and White, 2003, p. 215). Ó Gráda and White show that contagion can be a real contributor to bank distress, but they Page 9 of 20

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Bank Failures, The Great Depression, and Other “Contagious” Events also show that runs based on random beliefs tend to dissipate with little effect, while runs based on legitimate signals tend to grow in importance over time. The fact that runs are not sudden, and that many depositors do not participate in them at all, is important, since it implies the ability of events to unfold over time; that is, for a form of collective learning among depositors to take place during panics. A similar account of mimetic withdrawals based on a random rumor can be found in an article by Nicholas in Moody’s Magazine in 1907. A bank in Tarpen Springs, Florida, ex­ perienced an unwarranted outflow of deposits based on a false rumor that was spread through the local Greek-American community, which included many of the bank’s deposi­ tors. The bank quickly wired to have cash sent from its correspondent bank, which ar­ rived in time to prevent any suspension of convertibility, and brought the run to an end. Nicholas noted that, if the bank had really been in trouble, not only would the correspon­ dent not have provided the funds, but it and other banks would have probably (p. 919) withdrawn any funds it had on deposit at the bank long before the public was aware of the problem (a so-called “silent run”; see the related discussions in Stern and Feldman, 2003; Halac and Schmukler, 2004).

28.5 US Bank Distress in the Pre-Depression Era As scholars have recognized for many years, for structural reasons, US banks were un­ usually vulnerable to systemic banking crises that saw large numbers of bank failures be­ fore the Depression, compared to banks in other countries (for reviews, see Bordo, 1985; Calomiris, 2000; Calomiris and Haber, 2014). Calomiris and Gorton (1991) identify six episodes of particularly severe banking panics in the US between the Civil War and World War I, and prior to the Civil War, there were other nationwide banking crises in 1819, 1837, and 1857. In the 1920s, the US experienced waves of bank failures in agricultural states, which have always been identified with fundamental shocks to banks, rather than national or regional panics. Other countries, including the US’s northern neighbor, Cana­ da, however, did not suffer banking crises during these episodes of systemic US banking system distress. The key difference between the US and other countries historically was the structure of the US banking system. The US system was mainly based on unit banking —geographically isolated single-office banks; no other country in the world imitated that approach to banking, and no other country experienced the US pattern of periodic bank­ ing panics prior to World War I, or the waves of agricultural bank failures that gripped the US in the 1920s. The pyramiding of bank reserves added to systemic risk by aggravating interbank liquidi­ ty risk. For example, banks in medium-sized cities acted both as depositors in New York and Chicago banks, and as repositories for deposits of country banks. When New York City banks suspended convertibility of deposits in 1893, banks in medium-sized cities suf­ fered two-sided liquidity risk (the inability to access their deposits in New York, and con­ tinuing withdrawal pressure from their own country-bank depositors). The results were Page 10 of 20

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Bank Failures, The Great Depression, and Other “Contagious” Events contractions of lending and bank failures that otherwise would not have occurred (Calomiris and Carlson, 2017). Canada’s early decision to permit branch banking throughout the country ensured that banks were geographically diversified and thus resilient to large sectoral shocks (like those to agriculture in the 1920s and 1930s); able to compete through the establishment of branches in rural areas (because of low overhead costs of establishing additional branches); and able to coordinate the banking system’s response in moments of confusion to avoid depositor runs (the number of banks was small, and assets were highly concen­ trated in several nationwide institutions). Coordination among banks facilitated systemic stability by allowing banks to manage incipient panic episodes to prevent widespread bank runs. In Canada, the Bank of Montreal occasionally would coordinate (p. 920) actions by the large Canadian banks to stop crises before the public was even aware of a possible threat. The US was unable to mimic this behavior on a national or regional scale (Calomiris and Schweikart, 1991; Calomiris, 2000; Calomiris and Haber, 2014). US law prohibited nation­ wide branching, and most states prohibited or limited within-state branching. US banks, in contrast to banks elsewhere, were numerous (e.g., numbering more than 29,000 in 1920), undiversified, insulated from competition, and geographically isolated from one another, and thus were unable to diversify adequately or to coordinate their response to panics. US banks did establish clearing houses in cities, which facilitated local responses to panics beginning in the 1850s, as emphasized by Gorton (1985), but despite the spread of clearing houses throughout the country in the late nineteenth century, the lack of inter­ regional coordination made it impossible for clearing houses to prevent systemic crises. Indeed, it may have been that the presence of clearing houses encouraged excessive con­ fidence about the management of liquidity risk, which itself may have contributed to sys­ temic risk (Jaremski, forthcoming). The structure of US banking explains why the US uniquely suffered banking panics de­ spite the fact that the vast majority of banks were healthy, and were able to avoid ulti­ mate failure. Empirical studies show that the major US banking panics of 1857, 1873, 1884, 1890, 1893, 1896, and 1907 were moments of heightened asymmetric information about bank risk. Banking necessarily entails the delegation of decision-making to bankers, who specialize in screening and monitoring borrowers and making non-transpar­ ent investments. Bankers consequently have private information about the attendant risks. During normal times, the risk premium banks pay in capital markets and money markets contains a small “opacity” premium—part of the risk depositors and bank stock­ holders face and charge for comes from not being able to observe the value of bank as­ sets moment to moment—that is, not being able to mark bank portfolios to market. Dur­ ing the US panics, the normally small opacity premium became very large, as people be­ came aware that risks had increased and were also aware of what they didn’t know— namely, the incidence among banks of the probable losses that accompanied the observ­ able increased risk.

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Bank Failures, The Great Depression, and Other “Contagious” Events Calomiris and Gorton (1991) show that banking panics were uniquely predictable events that happened at business cycle peaks. In the pre-World War I period (1875–1913), every quarter in which the liabilities of failed businesses rose by more than 50 percent (season­ ally adjusted) and the stock market fell by more than 8 percent, a panic happened in the following quarter. This happened five times, and the Panic of 1907 was the last of those times. Significant national panics (i.e., events that gave rise to a collective response by the New York Clearing House) never happened otherwise during this period. Bank failure rates, even during these panic episodes, were small, and the losses to depos­ itors associated with them were also small. In 1893—the panic with the highest failure rate and highest depositor loss rate—depositor losses were less than 0.1 percent of GDP. Expected depositor losses during the panics also appear to have been small. Oliver Sprague (1910, pp. 57–8, 423–4) reports that the discount applied to bankers’ cashier checks of New York City banks at the height of the Panic of 1873 did not exceed (p. 921) 3.5 percent and, with the exception of an initial ten-day period, remained below 1 per­ cent, and a similar pattern was visible in the Panic of 1893. A 1 percent premium would be consistent with depositors in a New York City bank estimating a 10 percent chance of a bank’s failing with a 10 percent depositor loss if it failed. Clearly, banking panics during this era were traceable to real shocks, but those shocks had small consequences for bank failures in the aggregate, and even at the height of the crisis those consequences were expected to be small. Historical US panics teach us that even a small expected loss can lead depositors to demand their funds, so that they can sit on the sidelines until the inci­ dence of loss within the banking system has been revealed (usually a process that took a matter of weeks). Bank failure rates in the 1830s and 1920s were much higher than those of the other preDepression systemic US banking crisis episodes. The 1830s saw a major macroeconomic contraction that caused many banks to fail, which historians trace to large fundamental problems that had their sources in government-induced shocks to the money supply (Rousseau, 2002), unprofitable bank-financed infrastructure investments that went sour (Schweikart, 1987), and international balance of payments shocks (Temin, 1969). The 1920s agricultural bank failures were also closely linked to fundamental problems—in this case, the collapses of agricultural prices at the end of World War I, which were mani­ fested in local bank failures in the absence of regional or national bank portfolio diversifi­ cation (Calomiris, 1992; Alston, Grove, and Wheelock, 1994). In the 1920s, deposit insur­ ance protection, passed in several states as part of the regulation of state-chartered banks, substantially contributed to the collapses of agricultural banks (Calomiris, 1992; Calomiris and Jaremski, forthcoming). Banks in counties that were experiencing signifi­ cant run-ups in agricultural prices during World War I were more affected by deposit in­ surance protection than banks elsewhere. As the price bubble inflated, insured banks were able to attract deposits which they used to fund risky agricultural loans that only would have been profitable if the temporary increase in relative prices had been perma­ nent.

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Bank Failures, The Great Depression, and Other “Contagious” Events

28.6 Other Historical Experiences with Bank Failures Although the US was unique in its propensity for panics, it was not the only economy to experience occasional waves of bank failures historically. Losses (i.e., the negative net worth of failed banks), however, were generally modest and bank failure rates were much lower outside the US. The most severe cases of banking distress during this era, Argenti­ na in 1890 and Australia in 1893, were the exceptional cases; they suffered banking sys­ tem losses of roughly 10 percent of GDP in the wake of real estate market collapses in those countries. Only three other countries experienced severe insolvency crises during the pre-World War I period: Brazil in 1892, Italy in 1893, and Norway in 1900. Loss rates tended to be low because banks structured themselves to limit their risk of loss by maintaining adequate equity-to-assets ratios, sufficiently low asset risk, and adequate liquidity. Market discipline (the potential for depositors fearful of bank de­ fault to withdraw their funds) provided incentives for banks to behave prudently (Calomiris and Kahn, 1991; Calomiris, Heider, and Hoerova, 2017). The picture of small depositors lining up around the block to withdraw funds has received much attention by journalists and banking theorists, but perhaps the more important source of market disci­ pline was the threat of an informed (“silent”) run by large depositors (often other banks). Banks maintained relationships with each other through interbank deposits and the clear­ ing of deposits, notes, and bankers’ bills. Banks often belonged to clearing houses that set regulations and monitored members’ behavior. A bank that lost the trust of its fellow bankers could not long survive. (p. 922)

28.7 Bank Failures in the Late Twentieth Cen­ tury Recent research on systemic bank failures has emphasized the destabilizing effects of bank safety nets. Early examples were the experiences of the US Savings and Loan indus­ try debacle of the 1980s, the banking collapses in Japan and Scandinavia during the 1990s, the collapse of Chilean banks in the early 1980s, and similar banking system deba­ cles occurring in most countries in the last two decades of the twentieth century, with me­ dian banking system losses of roughly 16 percent of GDP (data are from Caprio and Klingebiel, 1996, updated by Laeven and Valencia, 2012). Empirical studies of these unprecedented losses conclude that deposit insurance and oth­ er policies that protect banks from market discipline, intended as a cure for instability, have instead become the single greatest source of banking instability. The theory behind the problem of destabilizing protection has been well known for over a century, and was the basis for Franklin Roosevelt’s opposition to deposit insurance in 1933 (an opposition shared by many). Ironically, federal deposit insurance is one of the major legacies of the Roosevelt presidency, despite the fact that President Roosevelt, the Federal Reserve, the Page 13 of 20

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Bank Failures, The Great Depression, and Other “Contagious” Events Treasury, and Senator Carter Glass—the primary authorities on banking policy of the time —all were opposed to it on principle. Deposit insurance was seen by them and others as undesirable special-interest legislation designed to benefit small banks. They acquiesced in its passage for practical reasons—to get other legislation passed—not because they wanted deposit insurance to pass per se. Numerous attempts, dating from the 1880s, to introduce federal deposit insurance legislation failed to attract support in the Congress (Calomiris and White, 1994). Opponents understood the theoretical arguments against deposit insurance espoused today—that deposit insurance removes depositors’ incentives to monitor and discipline banks, and frees bankers to take imprudent risks (especially when they have little or no remaining equity at stake, (p. 923) and see an advantage in “resurrection risk-taking”); and that the absence of discipline also promotes banker in­ competence, which leads to unwitting risk-taking. Research on the banking collapses of the last two decades of the twentieth century have produced new empirical findings indicating that the greater the protection offered by a country’s bank safety net, the greater the risk of a banking collapse (see, e.g., Caprio and Klingebiel, 1996; Demirgüç-Kunt and Detragiache, 2002; Barth, Caprio, and Levine, 2006; Demirgüç-Kunt, Kane, and Laeven, 2008; Calomiris and Jaremski, 2016; Calomiris and Chen, 2018). Empirical research on prudential bank regulation similarly emphasizes the importance of subjecting some bank liabilities to the risk of loss to promote discipline and limit risk-taking (Shadow Financial Regulatory Committee, 2000; Mishkin, 2001; Barth, Caprio, and Levine, 2006). Studies of historical deposit insurance reinforce these conclusions (Calomiris, 1990; Calomiris and Jaremski, forthcoming). Opposition to deposit insurance in the 1930s re­ flected the disastrous experience with insurance in several US states in the early twenti­ eth century, which resulted in banking collapses in all the states that adopted insurance. Government protection of banks played a similarly destabilizing role in Argentina in the 1880s (leading to the 1890 collapse) and in Italy (leading to its 1893 crisis). In retrospect, the successful period of US deposit insurance, from 1933 through the 1960s, was an aberration, reflecting limited insurance during those years (insurance limits were subse­ quently increased), and the unusual macroeconomic stability of the era.

28.8 Conclusion Banking failures, in theory, can be a consequence either of fundamental, exogenous shocks to banks, or, alternatively, unwarranted withdrawals by depositors associated with contagions of fear, or panics. Interestingly, although many economists associate conta­ gions of fear with the banking distress of the Great Depression, empirical research indi­ cates that panics played a small role in Depression-era distress, which was mainly con­ fined to regional episodes (e.g., June 1932 in Chicago) or to the banking collapse of 1933. More importantly, empirical research on banking distress clearly shows that panics are neither random events nor inherent to the function of banks or the structure of bank bal­ ance sheets. Panics in the US were generally not associated with massive bank failures, Page 14 of 20

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Bank Failures, The Great Depression, and Other “Contagious” Events but rather were times of temporary confusion about the incidence of shocks within the banking system. This asymmetric-information problem was particularly severe in the US. For the late nineteenth and early twentieth centuries, system-wide banking panics like those that the US experienced in that period did not occur elsewhere. The uniquely panicridden experience of the US, particularly during the pre-World War I era, reflected the unit banking structure of the US system. Panics were generally avoided by other coun­ tries in the pre-World War I era because their banking systems were composed of a much smaller number of banks operated on a national basis, who consequently enjoyed greater portfolio diversification ex ante, and a greater ability to coordinate their actions (p. 924) to stem panics ex post. The US also experienced waves of bank failures unrelated to panics (most notably in the 1920s), which reflected the vulnerability to sector-specific shocks (e.g., agricultural price declines) in an undiversified banking system, which was further aggravated by deposit insurance schemes that encouraged risk-taking during the agricul­ tural price bubble of World War I. More recent banking system experience worldwide indicates unprecedented costs of banking system distress—an unprecedented high frequency of banking crises, many bank failures, and large losses by failing banks, sometimes with disastrous costs to taxpayers who end up footing the bill of bank loss. This new phenomenon has been traced empiri­ cally to the expanded role of the government safety net. Government protection removes the effect of market discipline. It thereby encourages excessive risk-taking by banks, and also creates greater tolerance for incompetent risk management (as distinct from pur­ poseful increases in risk). Ironically, the government safety net, which was designed to forestall the (overestimated) risks of contagion, seems to have become the primary source of systemic instability in banking.

References Allen, F. and Gale, D. (2004). “Financial Fragility, Liquidity, and Asset Prices,” Journal of the European Economic Association, 2, 1015–48. Alston, L.J., Grove, W.A., and Wheelock, D.C. (1994). “Why Do Banks Fail? Evidence from the 1920s,” Explorations in Economic History, 30, 409–31. Anderson, H., Calomiris, C.W., Jaremski, M., and Richardson, G. (2018). “Liquidity Risk, Bank Networks, and the Value of Joining the Federal Reserve System,” Journal of Money, Credit and Banking, 50, 173–201. Barth, J.R., Caprio, Jr., G., and Levine, R. (2006). Rethinking Bank Regulation: Till Angels Govern (Cambridge: Cambridge University Press). Bernanke, B.S. (1983). “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression,” American Economic Review, 73, 257–76.

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Bank Failures, The Great Depression, and Other “Contagious” Events Bernanke, B.S. and James, H. (1991). “The Gold Standard, Deflation, and Financial Crisis in the Great Depression: An International Comparison,” in R.G. Hubbard (ed.), Financial Markets and Financial Crises (Chicago, IL: University of Chicago Press), 33–68. Bordo, M. (1985). “The Impact and International Transmission of Financial Crises: Some Historical Evidence, 1870–1933,” Revista di Storia Economica (2nd series), 2, 41–78. Bruner, R.F. and Carr, S.D. (2007). The Panic of 1907: Lessons Learned from the Market’s Perfect Storm (Chichester: Wiley). Calomiris, C.W. (1990). “Is Deposit Insurance Necessary? A Historical Perspective,” Jour­ nal of Economic History, 50, 283–95. Calomiris, C.W. (1992). “Do Vulnerable Economies Need Deposit Insurance? Lessons from U.S. Agriculture in the 1920s,” in P.L. Brock (ed.), If Texas Were Chile: A Primer on Bank Regulation (San Francisco, CA: The Sequoia Institute), 237–349, 450–8. Calomiris, C.W. (2000). U.S. Bank Deregulation in Historical Perspective (Cambridge: Cambridge University Press). Calomiris, C.W. (2008). “The Subprime Turmoil: What’s Old, What’s New, and What’s Next,” in Federal Reserve Bank of Kansas City’s Jackson Hole Symposium, Maintaining Stability in a Changing Financial System, August 21–22. Calomiris, C.W. (2009). “Helping Wall Street—and Main Street,” Forbes.com, Jan­ uary 21. (p. 925)

Calomiris, C.W. and Carlson, M. (2017). “Interbank Networks in the National Banking Era: Their Purpose and Their Role in the Panic of 1893,” Journal of Financial Economics, 125, 434–53. Calomiris, C.W. and Chen, S. (2018). “The Spread of Deposit Insurance and the Global Rise in Asset Risk Since the 1970s,” mimeo, Columbia University. Calomiris, C.W. and Gorton, G. (1991). “The Origins of Banking Panics: Models, Facts, and Bank Regulation,” in R.G. Hubbard (ed.), Financial Markets and Financial Crises (Chicago, IL: University of Chicago Press), 107–73. Calomiris, C.W. and Haber, S. (2014). Fragile By Design: The Political Origins of Banking Crises and Scarce Credit (Princeton, NJ: Princeton University Press). Calomiris, C.W. and Jaremski, M. (2016). “Deposit Insurance: Theories and Facts,” Annual Review of Financial Economics, 9, 97–120. Calomiris, C.W. and Jaremski, M. (forthcoming). “Stealing Deposits: Deposit Insurance, Risk-Taking and the Removal of Market Discipline in Early 20th Century Banks,” Journal of Finance.

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Bank Failures, The Great Depression, and Other “Contagious” Events Calomiris, C.W. and Kahn, C.M. (1991). “The Role of Demandable Debt in Structuring Op­ timal Banking Arrangements,” American Economic Review, 81, 497–513. Calomiris, C.W. and Mason, J.R. (1997). “Contagion and Bank Failures During the Great Depression: The June 1932 Chicago Banking Panic,” American Economic Review, 87, 863– 83. Calomiris, C.W. and Mason, J.R. (2003a). “Fundamentals, Panics and Bank Distress During the Depression,” American Economic Review, 93, 1615–47. Calomiris, C.W. and Mason, J.R. (2003b). “Consequences of Bank Distress During the Great Depression,” American Economic Review, 93, 937–47. Calomiris, C.W. and Mason, J.R. (2004). “How to Restructure Failed Banking Systems: Lessons from the U.S. in the 1930s and Japan in the 1990s,” in T. Ito and A. Krueger (eds.), Governance, Regulation, and Privatization in the Asia-Pacific Region (Chicago, IL: University of Chicago Press), 375–420. Calomiris, C.W. and Schweikart, L. (1991). “The Panic of 1857: Origins, Transmission, and Containment,” Journal of Economic History, 51, 807–34. Calomiris, C.W. and White, E.N. (1994). “The Origins of Federal Deposit Insurance,” in C. Goldin and G. Libecap (eds.), The Regulated Economy: A Historical Approach to Political Economy (Chicago, IL: University of Chicago), 145–88. Calomiris, C.W. and Wilson, B. (2004). “Bank Capital and Portfolio Management: The 1930s ‘Capital Crunch’ and Scramble to Shed Risk,” Journal of Business, 77, 421–55. Calomiris, C.W., Heider, F., and Hoerova, M. (2017). “A Theory of Bank Liquidity Require­ ments,” mimeo, Columbia University. Calomiris, C.W., Himmelberg, C., and Wachtel, P. (1995). “Commercial Paper, Corporate Finance, and the Business Cycle: A Microeconomic Approach,” Carnegie-Rochester Series on Public Policy, 42, 203–50. Calomiris, C.W., Mason, J.R., Weidenmier, M., and Bobroff, K. (2013). “The Effects of Re­ construction Finance Corporation Assistance on Michigan Banks’ Survival in the 1930s,” Explorations in Economic History, 50, 526–47. Caprio, Jr., G. and Klingebiel, D. (1996). “Bank Insolvencies: Cross Country Experience,” Working Paper No. 1620, The World Bank. Carlson, M. (2010). “Alternatives for Distressed Banks During the Depression,” Journal of Money, Credit and Banking, 42, 421–41. Carlson, M. and Rose, J. (2011). “Credit Availability and the Collapse of the Bank­ ing Sector in the 1930s,” mimeo, Federal Reserve Board of Governors. (p. 926)

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Bank Failures, The Great Depression, and Other “Contagious” Events Carlson, M., Mitchener, C., and Richardson, G. (2011). “Arresting Banking Panics: Federal Reserve Liquidity Provision and the Forgotten Panic of 1929,” Journal of Political Econo­ my, 119, 889–924. Dang, T.V., Gorton, G., and Holmstrom, B. (2012). “Ignorance, Debt and Financial Crises,” mimeo, February. Demirgüç-Kunt, A. and Detragiache, E. (2002). “Does Deposit Insurance Increase Bank­ ing System Stability? An Empirical Investigation,” Journal of Monetary Economics, 49, 1373–406. Demirgüç-Kunt, A., Kane, E., and Laeven, L. (eds.) (2008). Deposit Insurance Around the World (Cambridge, MA: MIT Press). Diamond, D. and Dybvig, P. (1983). “Bank Runs, Deposit Insurance, and Liquidity,” Journal of Political Economy, 91, 401–19. Diamond, D. and Rajan, R. (2004). “Liquidity Shortages and Banking Crises,” Journal of Finance, 60, 615–47. Friedman, M. and Schwartz, A.J. (1963). A Monetary History of the United States, 1867– 1960 (Princeton, NJ: Princeton University Press). Gorton, G. (1985). “Clearing Houses and the Origin of Central Banking in the United States,” Journal of Economic History, 45, 277–83. Gorton, G. and Metrick, A. (2011). “Securitized Banking and the Run on Repo,” Journal of Financial Economics, 104, 425–51. Gorton, G. and Pennacchi, G. (1990). “Financial Intermediaries and Liquidity Creation,” Journal of Finance, 45, 49–71. Grossman, R.S. (1994). “The Shoe That Didn’t Drop: Explaining Banking Stability During the Great Depression,” Journal of Economic History, 54, 654–82. Halac, M. and Schmukler, S. (2004). “Distributional Effects of Crises: The Financial Chan­ nel,” Economia, 5, 1–67. Jaremski, M. (forthcoming). “The (Dis)Advantages of Clearing Houses Before the Fed,” Journal of Financial Economics. Laeven, L. and Valencia, F. (2012). “Systemic Banking Crises Database: An Update,” In­ ternational Monetary Fund Working Paper No. 12/163. Litan, R.E. (ed.) (2012). The World in Crisis: Insights from Six Shadow Financial Regulato­ ry Committees (Philadelphia, PA: Wharton Financial Institutions Center). Lucia, J.L. (1985). “The Failure of the Bank of United States: A Reappraisal,” Explorations in Economic History, 22, 402–16. Page 18 of 20

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Bank Failures, The Great Depression, and Other “Contagious” Events Mason, J.R. (2001). “Do Lender of Last Resort Policies Matter? The Effects of Reconstruc­ tion Finance Corporation Assistance to Banks During the Great Depression,” Journal of Financial Services Research, 20, 77–95. Mishkin, F.S. (ed.) (2001). Prudential Supervision: What Works and What Doesn’t (Chicago, IL: University of Chicago Press). Mitchener, K. and Richardson, G. (forthcoming). “Network Contagion and Interbank Am­ plification During the Great Depression,” Journal of Political Economy. Nicholas, H.C. (1907). “Runs on Banks,” Moody’s Magazine, December. Ó Gráda, C. and White, E.N. (2003). “The Panics of 1854 and 1857: A View from the Emi­ grant Industrial Savings Bank,” Journal of Economic History, 63, 213–40. Richardson, G. and Troost, W. (2009). “Monetary Intervention Mitigated Banking Panics During the Great Depression: Quasi-Experimental Evidence from a Federal Reserve Dis­ trict Border, 1929–1933,” Journal of Political Economy, 117, 1031–73. Rousseau, P. (2002). “Jacksonian Monetary Policy, Specie Flows, and the Panic of 1837,” Journal of Economic History, 62, 457–88. (p. 927)

Schweikart, L. (1987). Banking in the American South from the Age of Jackson to Recon­ struction (Baton Rouge, LA: Louisiana State University Press). Shadow Financial Regulatory Committee (2000). Reforming Bank Capital Regulation (Washington, DC: American Enterprise Institute). Sprague, O.M.W. (1910). “History of Crises under the National Banking System,” National Monetary Commission, 61st Congress, 2nd Session, Document No. 538. Stern, G.H. and Feldman, R.J. (2003). Too Big to Fail: The Hazards of Bank Bailouts (Washington, DC: Brookings Institution Press). Temin, P. (1969). The Jacksonian Economy (New York: W.W. Norton). Temin, P. (1976). Did Monetary Forces Cause the Great Depression? (New York: W.W. Nor­ ton). Temin, P. (1989). Lessons from the Great Depression (Cambridge, MA: MIT Press). White, E.N. (1984). “A Reinterpretation of the Banking Crisis of 1930,” Journal of Econom­ ic History, 44, 119–38. Wicker, E. (1980). “A Reconsideration of the Causes of the Banking Panic of 1930,” Jour­ nal of Economic History, 40, 571–83. Wicker, E. (1996). The Banking Panics of the Great Depression (Cambridge: Cambridge University Press). Page 19 of 20

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Bank Failures, The Great Depression, and Other “Contagious” Events Wigmore, B.A. (1987). “Was the Bank Holiday of 1933 a Run on the Dollar Rather than the Banks?” Journal of Economic History, 47, 739–56.

Charles W. Calomiris

Charles W. Calomiris is the Henry Kaufman Professor of Financial Institutions at Co­ lumbia Business School, a Professor at Columbia’s School of International and Public Affairs, and a Research Associate of the National Bureau of Economic Research. He is a member of the Shadow Open Market Committee and the Financial Economists Roundtable. He is a Distinguished Visiting Scholar at the Hoover Institution, where he co-directs the Initiative on Regulation and the Rule of Law, and a Fellow at the Manhattan Institute. He received a B.A. in Economics from Yale University in 1979 and a Ph.D in Economics from Stanford University in 1985.

Page 20 of 20

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Banking Globalization: Cross-border Entry, Complexity,and Systemic Risk

Banking Globalization: Cross-border Entry, Complexity,and Systemic Risk   Claudia M. Buch and Gayle L. Delong The Oxford Handbook of Banking (3rd edn) Edited by Allen N. Berger, Philip Molyneux, and John O. S. Wilson Print Publication Date: Oct 2019 Subject: Economics and Finance, Financial Economics Online Publication Date: Nov 2019 DOI: 10.1093/oxfordhb/9780198824633.013.29

Abstract and Keywords The financial crisis has renewed interest in the globalization of the banking industry, the patterns of entry into foreign markets, and the effects of complex banking organizations. There is a rich body of literature on international banks, which has recently been expand­ ed by the improved theoretical modeling of the international banking firm and by focus­ ing on implications for (systemic) risk. In this chapter, we focus on three main questions. First, what are the determinants of cross-border entry through acquisitions of commer­ cial banks? Second, what are the effects of cross-border entry on complexity and the effi­ ciency of banks? Third, what are the risk effects of international bank acquisitions, in par­ ticular with regard to systemic risk? We begin with a brief summary of the stylized facts, and we conclude with implications for researchers and policymakers. Keywords: complexity, cross-border entry, international banking, mergers and acquisitions, systemic risk

29.1 Introduction THE global financial crisis has been a watershed for globally active banks.1 Banks have reorganized their business models and in particular their international strategies. They have withdrawn from some markets, not least in an attempt to reduce the complexity of their organizations. They have adjusted the mix of their activities in terms of being present in a foreign market or serving the market through cross-border lending and bor­ rowing. These adjustments have been precipitated by post-crisis changes in the regula­ tion of banks, changes in the macroeconomic environment, changes in the patterns of globalization, and changes in technologies affecting the provision of banking services. Global banking has moved from being rather limited, and being shaped by the globaliza­ tion of trade until a couple of decades ago, toward being at the center of global financial markets. Cross-border bank acquisitions, in particular, have been a key driver of the glob­ alization of finance. This trend reversed during the course of the global financial crisis. In 2007, nearly 40 percent of acquisitions involving at least one commercial bank included Page 1 of 31

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Banking Globalization: Cross-border Entry, Complexity,and Systemic Risk firms headquartered in two different countries.2 Post-crisis, the share of cross-border bank acquisition ranged from 20 percent in 2012 to 25 percent in 2017. (p. 929) In this pe­ riod, most merger activity took place within countries, and the number of cross-border bank acquisitions fell.3 This decline in (cross-border) merger activity is one facet of the increasing fragmentation of financial markets that could be observed during the crisis. This raises the question of how the integration (and disintegration) of banking markets affects the provision of finan­ cial services and the stability of financial systems. Are integrated banking markets more stable because shocks can dissipate across different financial systems and because banks can buffer shocks via internal capital markets? Or does a high degree of integration of markets contribute to the propagation of shocks and increase the fragility of the system instead? The answer to these questions is not clear-cut: there is a non-linear link between the degree of financial integration and systemic risk (Allen and Gale, 2000). And there are many reasons for market fragmentation to prevail, which can largely be grouped into cul­ tural, economic, or regulatory barriers. These barriers, in turn, could affect the risk and efficiency of international banking activities. In this chapter, we provide an overview of research on the causes and effects of interna­ tional banking activities with a special focus on entry through bank acquisitions. Consid­ ering the large number of issues at stake, we have to be selective. See Berger, Demsetz, and Strahan (1999) or Berger et al. (2000) for a review of earlier literature on the consoli­ dation and globalization of financial institutions. We focus on three main questions: First, what are the patterns and determinants of cross-border entry through bank acquisitions? Second, what are the effects of cross-border bank acquisitions on the competition and ef­ ficiency of financial institutions? Third, what are the implications of bank acquisitions for risks in banking?

29.2 Stylized Facts on Cross-Border Entry and Complexity 29.2.1 Cross-Border Entry Through Mergers and Acquisitions Global financial markets have gone through different phases of integration and regula­ tion.4 In the post-war period, banking markets were largely protected by capital controls and restrictions on the activities of domestic financial institutions. Deregulation of bank­ ing markets started in the 1980s, with the lifting of branching restrictions, including cross-border restrictions. The third phase, following the financial crisis, has been charac­ terized by reforms of the financial system, dealing with legacy issues, changing patterns of globalization, and increasing competitive pressure through non-bank financial interme­ diaries.

Page 2 of 31

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Banking Globalization: Cross-border Entry, Complexity,and Systemic Risk Starting in the mid-1990s, cross-border bank acquisitions became more and more common. Yet a more careful examination of the numbers suggests that international ac­ quisitions of financial institutions are relatively recent phenomena and tend to show spe­ cific regional patterns. (p. 930)

Figures 29.1 and 29.2 show how domestic and international bank acquisitions have evolved over time. We examine cross-border acquisitions that were announced and com­ pleted between 1985 and 2017 where at least one of the partners was a commercial bank and the other partner was any type of firm. Usually, the other partner was in financial ser­ vices, i.e. commercial banking, securities, or insurance. We define a cross-border acquisi­ tion as any acquisition where the headquarters of the target is not located in the same country as the ultimate parent of the acquirer. We obtain the names of acquirers and tar­ gets from Thomson Financial Securities Data. Up to 1992, the database includes all deals with values of at least $1 million. After 1992, deals of any value are covered. Also includ­ ed are transactions with undisclosed values as well as public and private transactions. Thomson Financial Securities Data identifies 7,538 acquisitions that meet our criteria.

Figure 29.1 Bank Acquisitions (by Year) 1985–2017. Source: Own calculations based on data provided by Thomson Financial Securities Data.

Figure 29.2 Percentage of Bank Acquisitions that Are Cross-Border (by Year) 1985–2017. Source: Own calculations based on data provided by Thomson Financial Securities Data.

Figure 29.1 shows that the number of international bank acquisitions mirrors worldwide macroeconomic conditions. When the world economy is prospering, the number of crossborder acquisitions goes up; when the world experiences economic turmoil, the number falls. The number of cross-border acquisitions increased steadily between 1985 and 2000, Page 3 of 31

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Banking Globalization: Cross-border Entry, Complexity,and Systemic Risk but dipped between 2001 and 2003, when the Internet bubble burst. The number peaked at 446 in 2007, but fell steadily since 2008 to a low of 163 in 2017. Figure 29.2 shows that the percentage of bank acquisitions that are cross-border grew rather steadily from es­ sentially zero in 1985 to peak at 38 percent in 2007. The percentage fell precipitously in 2008 to roughly 20 percent and remained at that level for seven years. The share picked up slightly starting in 2015 and stood at 25 percent in 2017. Table 29.1 looks further into the regional structure of cross-border mergers and acquisi­ tions (M&A) in banking and reveals three phases of development. All regions experienced a growth in the number of cross-border acquisitions in the years 1996 to 2007 (p. 931) compared with the years 1985 to 1995. Almost all regions doubled and sometimes more than tripled the number of cross-border acquisitions. Growth in domestic acquisition ac­ tivity also accompanied these increases, but, despite the domestic growth, Europe, the Americas, and other regions—especially Africa, and the Middle East—experienced a sig­ nificant growth in the share of cross-border bank acquisitions between the time periods. Asia was the only region to experience a significant fall in the percentage of bank acquisi­ tions represented by cross-border transactions between those time periods, albeit from a small base. The trend ended abruptly in 2008, and both the number and percentage of cross-border acquisitions have fallen significantly in all regions. Table 29.1 also shows a pattern regarding acquisitions between continents. Comparing the earliest phase (1985–95) to the middle phase (1996–2007), cross-border acquisitions increasingly occurred between continents. Comparing the middle phase to the most re­ cent phase (2008–17), banks have retreated to acquisitions closer to home. Data through 2007 suggest that, as banks polish the skills needed for cross-border acquisitions, they venture farther from their homes. Since 2008, however, the percentage of acquisitions be­ tween continents decreased, suggesting that economic uncertainty and changes in regu­ lations that increase sensitivity to risk may negatively influence the desire to venture to far-off lands.

Page 4 of 31

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Banking Globalization: Cross-border Entry, Complexity,and Systemic Risk Table 29.1 Cross-Border Bank Acquisitions by Geographic Region, 1985–2017 Europe

Americas

Asia

Other

Worldwide

Panel A: 1985 to 2017 Number of bank acquisitions

14221

15441

3450

2276

33121

Cross-border as a % of total

37.2%

14.0%

41.0%

45.7%

22.8%

Intra-continen­ tal as a % of to­ tal

86.9%

90.3%

74.3%

58.4%

89.4%

Panel B: 1985 to 1995 Number of bank acquisitions

3071

5124

427

411

8407

Cross-border as a % of total

32.6%

8.7%

49.4%

39.4%

16.2%

Intra-continen­ tal as a % of to­ tal

87.4%

93.1%

66.0%

43.8%

94.2%

Page 5 of 31

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Banking Globalization: Cross-border Entry, Complexity,and Systemic Risk Panel C: 1996 to 2007 Number of bank acquisitions

5865

6327

1668

927

13799

Cross-border as a % of total

45.4%

17.9%

44.4%

48.8%

27.5%

Intra-continen­ tal as a % of to­ tal

84.8%

88.6%

72.2%

59.0%

89.4%

Panel D: 2008 to 2017 Number of bank acquisitions

5285

3990

1355

938

10915

Cross-border as a % of total

30.8%

14.6%

34.1%

45.3%

21.9%

Intra-continen­ tal as a % of to­ tal

89.0%

89.5%

79.4%

64.2%

85.7%

Differences between panels B and C

Page 6 of 31

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Banking Globalization: Cross-border Entry, Complexity,and Systemic Risk Cross-border as a % of total

12.8%

9.2%

−5.0%

9.3%

11.3%

(z-statistic)

(12.0)

(14.8)

−(1.8)

(3.2)

(20.4)

Intra-continen­ tal as a % of to­ tal

−2.7%

−4.5%

6.1%

15.2%

−4.8%

(z-statistic)

(3.5)

(8.4)

(2.4)

(5.2)

(13.2)

Differences between panels C and D Cross-border as a % of total

−14.6%

−3.3%

−10.3%

−3.5%

−5.6%

(z-statistic)

−(18.8)

−(4.9)

−(6.3)

−(1.5)

−(11.0)

Intra-continen­ tal as a % of to­ tal

4.3%

0.9%

7.2%

5.2%

−3.6%

(z-statistic)

(6.7)

(1.4)

(4.7)

(2.3)

(8.5)

(*) Totals are less than the sum of the regions due to acquisitions between banks headquartered in two nations that are located in the same region. Source: Own calculations based on data provided by Thomson Financial Securities Data. Page 7 of 31

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Banking Globalization: Cross-border Entry, Complexity,and Systemic Risk Figure 29.3 depicts the number of bank acquisitions by region. Asia and other regions fol­ low the general pattern in that the number of international acquisitions rise and fall with the number of overall acquisitions. Only in the Americas do international acquisitions rep­ resent a rather small and steady number. Regardless of domestic activity, banks in the Americas participate in a relatively small number of cross-border acquisitions.

Figure 29.3 Bank Acquisitions (by Region and Year) 1985–2017. Source: Own calculations based on data provided by Thomson Financial Securities Data.

This observation is more poignant in Figure 29.4, which shows by region the percentage of all acquisitions that cross-border acquisitions represent. Note the different scales used in each panel. In most areas of the world, international acquisitions represent at least 25 percent of all acquisitions. The percentage in the Americas, however, reaches 25 percent only in one year (2007) and is typically below 20 percent. (p. 932)

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Banking Globalization: Cross-border Entry, Complexity,and Systemic Risk

Figure 29.4 Percentage of Cross-Border Bank Acqui­ sitions (by Region and Year) 1985–2017. Source: Own calculations based on data provided by Thomson Financial Securities Data.

Overall, the crisis that struck international financial markets beginning in 2007 had a ma­ jor impact on the incentives for banks to merge and to form alliances, both across bor­ ders and domestically. Banks have been forced to sell parts of their assets and to raise new capital. See Hellwig (2008) for a detailed account of the causes and potential conse­ quences of the crisis. Generally, the crisis has called into question the viability of certain business models, for instance business models based on a large share of wholesale fund­ ing, thus leading to a shift of activities from weaker to stronger banks. But, (p. 933) partly, the crisis has also revealed overcapacities in banking systems, which caused low margins and incentives for risk taking. These forces put pressure on incumbent financial institu­ tions to exit the market, thus requiring effective regimes for the recovery and resolution of banks. Existing regimes often turned out not to be fit for dealing with larger banks in distress, and reforming these regimes has in fact been a key objective of post-crisis re­ forms (Financial Stability Board, 2017). One channel for the exit of financial institutions is through acquisitions of banks. Exit can be triggered through market forces, moral suasion of the supervisors, or outright inter­ ventions of policymakers. While the share of cross-border acquisitions decreased world­ wide, the percentage of intra-continental acquisition increased. This suggests banks made fewer forays into foreign lands, and when they did, the foreign land was not far from home. In many countries, rescue packages that governments have put into place to recapitalize the banking systems foresee provisions to restructure and to merge financial institutions. As a result, the number of domestic acquisitions has increased while international acqui­ sitions have become almost as rare as they were in the mid-1980s. In the following, we will focus on an explanation of the relatively modest increase in cross-border acquisition activity in the past, the regional concentration, and the domi­ (p. 934)

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Banking Globalization: Cross-border Entry, Complexity,and Systemic Risk nance of a few large countries. We will also address the implications of cross-border bank acquisitions for efficiency and risks in banking.

29.2.2 Changing Patterns in Bank Complexity The complexity of international banking operations has implications for the provision of financial services across countries, and it can also affect financial stability (Gai, Haldane, and Kapadia, 2011). Regulators, for example, use a number of criteria to designate global systemically important financial institutions (G-SIFIs). These criteria include size, com­ plexity, connectedness, and bank-specific involvement in intricate instruments like overthe-counter derivatives. Generally, complexity can be measured along different dimensions, including the spread­ ing of activities across jurisdictions, markets, or types of activities. Hence, changes in complexity are closely related to the adjustment of globally active banks along the exten­ sive margin. In a study that looks across global banks, Cetorelli and Goldberg (2014) highlight three measures of complexity: business complexity (the concentration of the number of affiliates across types of business activities); geographical complexity (the con­ centration of business activity across regions); and organizational complexity, which mea­ sures the breadth of activities (the number of non-bank and foreign subsidiaries). Similar measures are used by Carmassi and Herring (2016). Claessens, Ganum, and Minoiu (unpublished) suggest different measures of assetside or “activity” diversity: product diversification proxied by loan underwriting, securi­ ties underwriting, and M&A advisory services; industry diversification; and geographical diversification. They find that banks from member countries of the Organisation for Eco­ nomic Co-operation and Development (OECD) tend to be more diversified while nonOECD banks are catching up. (p. 935)

Laeven and Levine (2007) use Bankscope data to study lending versus non-lending activi­ ties based on measures for asset diversity and income diversity. Elsas, Hackethal, and Holzhäuser (2010) use an adjusted Herfindahl–Hirschman index based on Bankscope da­ ta to study revenue diversification. Hughes and Mester (2013) propose a measure of out­ put diversification looking at liquid assets, securities, lending activity, trading activity, and off-balance-sheet items, each relative to total assets. Berger, Hasan, and Zhou (2010) use a profit function for loan portfolios to construct a loan focus index. Liu, Norden, and Spargoli (2018) use balance-sheet data of US bank holding companies to calculate their “uniqueness” in the sense of the degree to which the activities of banks differ from each other. The effects of heterogeneity in bank structures for financial stability is discussed in Wagner (2011).

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Banking Globalization: Cross-border Entry, Complexity,and Systemic Risk

29.3 Determinants of Cross-Border Bank Entry Through Acquisitions Why would a bank acquire an institution in a different country?5 The traditional literature on multinational banks distinguishes between location- and ownership-specific factors (Sagari, 1992; Williams, 1997). Theoretical work has also focused on specific aspects of international banking such as the effects of regulation (Repullo, 2001; Dalen and Olsen, 2003; Harr and Ronde, 2005) or the role of foreign banks in Eastern Europe (De Haas and Naaborg, 2006; De Haas and van Lelyveld, 2006; Claeys and Hainz, 2007). Yet, formal theoretical work on the “multinational bank” has largely been lacking until recently. See textbooks covering banking theory such as Allen and Gale (2000) or Freixas and Rochet (1998). Several authors thus suggest borrowing from the literature on the cross-border foreign investment of non-financial firms to explain cross-border banking activity (Gray and Gray, 1981; Berger et al., 2004; Goldberg, 2004). A few recent studies have closed this gap, applying tools that have proven useful to model non-financial multinationals to the modeling of multinational banks. Studies use gravitytype models to assess the determinants of banking market integration (Niepmann, 2011; Brüggemann, Kleinert, and Prieto, 2012). The gravity model essentially relates bilateral economic activities between two countries to the size of markets and geographic dis­ tance. Empirical studies using bank-level data can additionally take into account the en­ try decision by estimating limited dependent variable models of banks’ foreign expan­ sions. Using data for German banks, Buch, Koch, and Koetter (2011) show that only a few large banks have a commercial presence abroad, consistent with the size pecking order documented for manufacturing firms. The relationship between internationalization and productivity also yields two inconsistencies with trade models: Virtually all banks hold at least some foreign assets, irrespective of size or productivity. Also, some fairly unproduc­ tive banks maintain commercial presences abroad. (p. 936)

Theoretically, entry decisions of banks are modeled by Faia and Ottaviano (2017). In their model, multinational banks compete for retail deposits and loans in several jurisdictions. Multinational banking can reduce risk-taking by promoting local competition. Key to their results is a trade-off between, on the one hand, the increase in banks’ profits through larger scale and, on the other hand, the compression of the spread between the loan and the deposit rate. In equilibrium, multinational and domestic banks co-exist. Globalization is modeled as the decline, or even complete removal, of costs of banks’ activities in for­ eign markets, which leads to an increase in banks’ foreign market shares. Banks fund their foreign operations by raising local deposits. Another strand of theoretical literature focuses on the impact of bank heterogeneity for cross-border banking. De Blas and Russ (forthcoming) show that entry of foreign-owned banks can have the combined effect of increasing efficiency and increasing markups.

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Banking Globalization: Cross-border Entry, Complexity,and Systemic Risk In the remainder of this section, we review the empirical literature on the determinants of cross-border bank acquisitions. We structure the discussion around the main determi­ nants—information costs, regulations, bank-specific variables, and macroeconomic fac­ tors. Given that the crisis has shown the fragilities of a highly interconnected and open banking system, it is important to understand the drivers of integration and how they af­ fect stability.

29.3.1 Information Costs Operating a financial institution in a foreign country raises performance challenges for fi­ nancial institution managers due to differences in culture, regulation, and distance costs (Berger et al., 2004). These cross-border managerial challenges add to the difficulties of operating an acquired institution during the post-acquisition transition period. Hence, Berger, DeYoung, and Udell (2001) argue that “efficiency” barriers related to these fac­ tors could inhibit cross-border bank acquisitions. Information costs can be proxied by ge­ ographical distance, a common language, or a common legal system. Distance thus not only captures the physical costs of trading but influences international capital flows (Ahearne, Griever, and Warnock, 2002; Buch, 2003, 2005; Portes and Rey, 2005; Buch and Lipponer, 2006, 2007). Buch and DeLong (2004) use bilateral data on the number of bank acquisitions between countries and find that information costs and regulations in fact impede (p. 937) cross-bor­ der acquisitions. At the same time, large, efficient banks located in countries with devel­ oped banking markets can overcome these barriers and often expand abroad. Alibux (2007) uses more recent data (1995–2005) and confirms the importance of information costs and regulations as impediments to cross-border acquisitions. Focarelli and Pozzolo (2005) find that potential profit opportunities and favorable regulatory environments are important for banks to expand their cross-border shareholdings. Berger et al. (2003) find that foreign affiliates of multinational corporations operating in European countries usu­ ally choose domestically-owned banks for cash management services.

29.3.2 Regulations The empirical literature on the determinants of bank acquisitions generally supports the hypothesis that deregulation can have an impact on acquisition decisions.6 Deregulation of entry matters in a domestic context (Jayaratne and Strahan, 1998; Saunders, 1999), and can explain the formation of international financial centers (Choi, Tschoegl, and Yu, 1986; Ter Wengel, 1995). Also, foreign banks have often made inroads into domestic banking systems that have undergone major privatization programs in Latin America (Guillén and Tschoegl, 2000) or Central and Eastern Europe (Bonin and Abel, 2000; Bar­ ros et al., 2005; Haselmann, 2006). Comparative advantages for foreign banks, coupled with low government entry barriers, can generally explain high ratios of foreign bank ownership in some emerging markets (Berger, 2007).

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Banking Globalization: Cross-border Entry, Complexity,and Systemic Risk Even if governments have largely abolished official restrictions to the cross-border entry of banks, implicit barriers related to differences in supervisory practices can still be effec­ tive (European Commission, 2005). Political factors, differences in institutions and cul­ tures, the use of different payment and settlement systems, and differences in capital markets, taxes, and regulations across countries may all serve to deter cross-border con­ solidation (Giddy, Saunders, and Walter, 1996; Lannoo and Gros, 1998; Boot, 1999; Bland­ on, 2000; Goddard, Molyneux, and Wilson, 2001; Köhler, 2009). This reduces the savings of fixed costs resulting from cross-border acquisitions, and in particular smaller financial institutions find it difficult to sell the same product in different markets. But regulation is not all that matters. Fecht and Grüner (2008) provide an alternative ex­ planation for a relative limited degree of pan-European bank acquisitions. In a theoretical model, they argue that the allocation of liquidity shocks may constitute a natural limit to the merger of banks. In their model, benefits from diversification and the costs of conta­ gion may be traded off optimally when banks from some but not all regions merge. Carlet­ ti, Hartmann, and Spagnolo (2007) propose a theoretical model discussing the liquidity effects of bank mergers focusing on the trade-off between internalization and diversifica­ tion. The search for capital to meet regulatory standards could spur cross-border bank acquisitions as well. Valkanov and Kleimeier (2007) find evidence supporting that acquir­ (p. 938)

ing banks strategically raise their capital levels by taking over banks that hold capital be­ yond the amount mandated by regulators. The stock market recognizes and rewards this strategy. Several elements of the post-crisis reform agenda aim at influencing the complexity of fi­ nancial institutions. In the context of frameworks for the recovery and resolution of finan­ cial institutions, for example, “living wills” have to be developed, and the structure of such living wills depends crucially on the complexity of the organization involved. Also, new guidelines and principles for misconduct regulation, including “know your customer (KYC)” and “know your customer’s customer (KYCC),” affect the incentives of banks to set up complex international organizations and to maintain correspondent banking relation­ ships. These aspects add to more traditional incentives to set up international organiza­ tional structures driven by the attempt to exploit comparative advantage or to engage in regulatory arbitrage. First empirical work shows that the withdrawal of banks from corre­ spondent banking activities can have negative implications for trade (Kirschenmann and Steinrücke, 2017).

29.3.3 Bank-Specific Factors Regulations and macroeconomic factors affect all banks alike. Obviously, bank-specific characteristics matter as well. Factors that increase the likelihood of entering into an ac­ quisition include efficiency, experience in a competitive environment, economies of scale and scope, and domestic clients that have international operations. Using various mea­ sures of efficiency and profitability, studies find that stronger banks take over weaker Page 13 of 31

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Banking Globalization: Cross-border Entry, Complexity,and Systemic Risk ones in that acquirers tend to be more cost efficient (Berger and Humphrey, 1992), more profitable (Peristiani, 1993), or better capitalized (Wheelock and Wilson, 2000) than their targets. For European banks, Vander Vennet (1998) confirms that acquiring banks tend to be larger and more efficient than their targets. Correa (2009) finds that foreign banks tend to take over poorly performing banks in small countries with concentrated banking systems. Acquirers in cross-border consolidations are generally large institutions from countries with developed financial markets (Focarelli and Pozzolo, 2001, 2005).

29.3.4 Macroeconomic Factors Macroeconomic factors such as a high growth potential of host countries (pull-factors) or lagging growth in the home country (push-factors) affect cross-border entry. Also, the de­ mand for differentiated financial services tends to increase with the level of economic de­ velopment. This heightened demand increases the incentives for banks to form cross-bor­ der alliances and to jointly provide financial services. A high gross domestic product (GDP) per capita and large market size could also generate economies of scale and, hence, create motives for international acquisitions (Berger, Hunter, and Timme, 1993; (p. 939) Benston, Hunter, and Wall, 1995; Berger et al., 2000). Consistent with these hy­ potheses, empirical literature finds a positive effect of market size and GDP per capita on cross-border bank acquisitions (Buch and DeLong, 2004; Focarelli and Pozzolo, 2005). One implication of theories of multinational firms is that, as two countries become more similar in size, relative factor endowments, and technical efficiency, foreign direct invest­ ment (FDI) will increase relative to trade between the two countries (Markusen and Ven­ ables, 1995). Trade theory would thus predict cross-border financial institution M&A pri­ marily between country pairs with similar national characteristics. Empirically, trade the­ ory and the traditional theory of comparative advantage find support in the data and ex­ plain the geographic patterns of international M&A of financial institutions between 1985 and 2000 (Berger et al., 2004). Claessens and van Horen (2007) use data on FDI of banks and confirm the importance of comparative advantages and institutional familiarity. Extensive literature on FDI in banking has also dealt with the question of whether trade and finance are linked. According to this literature, banking organizations engage in a “follow-your-customer” strategy of setting up offices in countries where their home coun­ try customers have foreign affiliates (Goldberg and Saunders, 1981; Brealey and Kapla­ nis, 1996; Focarelli and Pozzolo, 2005). However, other researchers point out that foreignowned banks lend mostly to borrowers other than customers from the home country (Stanley, Roger, and McManis, 1993; Seth, Nolle, and Mohanty, 1998). An empirical study by Adams and Gramlich (2014) for the United States allows us to dis­ tinguish between macroeconomic factors and regulations as drivers of cross-border entry. These authors model the choice of banks to enter a foreign market as a binary decision to enter country i in year t. In the United States, the number of new banks entering the mar­ ket declined from more than one hundred annually between 1990 and 2008 to fewer than two in the period 2009 through 2013. Adams and Gramlich (2014) show that this decline Page 14 of 31

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Banking Globalization: Cross-border Entry, Complexity,and Systemic Risk in the number of new business formations would have occurred even absent regulatory changes because weak macroeconomic conditions and low interest rates explain about 75–80 percent of this decline. Finally, prior to the recent globalization wave, much of the discussion on the international expansion of banks centered around the globalization of non-financial firms.7 There are good reasons to believe that developments in the globalization of non-financial firms im­ pact upon the international expansion of banks. Baldwin (2016), for instance, documents changing trends in globalization of the corporate sector, including changes in the pat­ terns of value-added chains that are likely to shape bank globalization as well.

29.3.5 Summary There is a fairly large body of literature dealing with the question of why banks enter into foreign markets and in particular why they do so through bank acquisitions. At the bank level, the probability of becoming an acquirer in an international deal is positively (p. 940) linked to size and profitability. At the country level, acquisitions are more frequent be­ tween large and developed market economies and countries with similar cultural back­ grounds. Literature also shows that there are many implicit or explicit barriers to entry, some of which are related to regulations.

29.4 Effects of Cross-Border Entry on Efficien­ cy and Competition Cross-border bank acquisitions can affect the efficiency of banks through a number of channels. The merged entity could be able to exploit economies of scale and scope, or management and corporate governance practices could be improved. At the same time, managing an increasingly large and complex organization operating in several countries may lead to managerial inefficiencies and lower performance. Which of the two effects dominates has been the subject of a large body of empirical literature. A first set of studies uses event studies to address the impact of acquisitions on banking performance. A second set of studies compares the efficiency of domestic versus foreignowned banks. Because foreign ownership is often the result of acquisitions, these studies also address the trade-off between higher efficiency in the banks involved in cross-border acquisitions and effects on the competitive structure of the banking system. Boot and Marinc (2009) present a theoretical study of the trade-off between competition, efficien­ cy, and the effectiveness of bank regulation.

29.4.1 Event Studies Research on cross-border acquisitions of financial institutions in developed countries sug­ gests, at best, mediocre post-acquisition financial performance. Studies of cross-border acquisitions in Europe tend to find no or even negative effects on performance (Cybo-Ot­ Page 15 of 31

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Banking Globalization: Cross-border Entry, Complexity,and Systemic Risk tone and Murgia, 2000; Beitel and Schiereck, 2001). Similarly, a study of US domestic deals found that acquisitions that combine two firms from different geographic areas cre­ ate less shareholder value, consistent with fewer benefits from cross-border acquisitions (DeLong, 2001). DeLong (2003) compares market reactions to US bank acquisitions and to cross-border acquisitions. She finds that acquirers of domestic banks outside the Unit­ ed States earn more on average than acquirers of domestic banks in the United States. Moreover, non-US targets tend to earn less than their US counterparts. For the subset of acquisitions in countries with relatively well-developed stock markets, partners both in­ side and outside the United States earn similar returns. Macroeconomic factors are also important in market returns to cross-border merger part­ ners, yielding an inverse relationship between US bidder returns and target country eco­ nomic conditions (Kiymaz, 2004). Conversely, returns to US targets are higher when (p. 941) US economic conditions are better than conditions in the bidder’s country. Ayadi and Pujals (2005) study bank M&A in Europe. They find that domestic acquisitions help cut costs but fail to achieve revenue synergies. Cross-border acquisitions, in contrast, generate revenue synergies. See Carbo and Rodríguez (2007) for a study of bank margins in Europe. Carletti, Hartmann, and Ongena (2007) analyze the impact of regulations on the effects of acquisitions and identify events that strengthen the powers of competition authorities for nineteen countries and for the years 1987–2004. They find two positive effects of a more competition-oriented regime for acquisition control: the stock price increases for banks but not for non-financial firms, and targets of bank acquisitions become larger and more profitable. Generally, regulators are subjecting banks to more scrutiny, requiring more justification for acquisitions, especially cross-border acquisitions. Beltratti and Paladino (2013) show that the stock market noticed the increased scrutiny and was indifferent to the announce­ ments of bank acquisitions between 2007 and 2012. After acquirers passed regulatory hurdles and completed a takeover, the market rewarded them. This increased scrutiny, however, could increase the riskiness of a bank.

29.4.2 Comparisons of Bank Efficiency Whereas event studies of cross-border consolidations analyze the stock market reaction to bidders and targets upon the announcement of a foreign acquisition, several studies compare the efficiency of domestic and foreign-owned banks (Berger, 2007). In developed countries, foreign-owned banks tend to be less efficient than domestic banks (DeYoung and Nolle, 1996; Chang, Hasan, and Hunter, 1998; Berger et al., 2000). However, a few studies find that foreign institutions have about the same efficiency on average as domes­ tic institutions (Vander Vennet, 1996). Peek, Rosengren, and Kasirye (1999) argue that the poor performance of foreign bank subsidiaries is mainly due to pre-existing condi­ tions.

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Banking Globalization: Cross-border Entry, Complexity,and Systemic Risk Many of the alleged benefits of cross-border bank acquisitions are more prevalent for emerging markets than for advanced market economies. Through foreign entry, emerging host countries can benefit from technology transfer, competition, and demonstration ef­ fects (Bank for International Settlements, 2004). Foreign-owned banks in emerging mar­ kets tend to have a relatively high profitability compared to their local peers (DemirgüçKunt and Huizinga, 1999; Claessens and van Horen, 2007, 2013, 2014). This is consistent with disadvantages in financial institution management for local banks in these countries. To assess the overall welfare implications of bank acquisitions, the impact of acquisitions on market power must be assessed as well. Huizinga, Nelissen, and Vander Vennet (2001) show that the trade-off between efficiency and competition need not be steep. Effects of complexity on bank performance have been studied less intensively. Cetorelli and Goldberg (2016) study the effects of changes in complexity on the balance-sheet man­ agement of (global) banks. They look at the sensitivity of lending by their (p. 942) US branches to wholesale funding shocks and find that branches of more complex conglom­ erates are less sensitive to those shocks. This can be taken as evidence for the operation of an internal capital market within banks. The empirical model they estimate is at the bank level, relating changes in lending growth to measures of complexity and control variables.

29.4.3 Summary Although added competition through foreign entry can be expected to increase efficiency and lower costs, empirical studies often find foreign-owned banks to be less efficient than domestic banks in developed countries. This suggests that the impact of entry on compe­ tition is rather muted and that foreign banks occupy market niches that differ from those of domestic banks. The findings for emerging markets often differ: here, banks from ad­ vanced economies tend to be more efficient than their domestic counterparts.

29.5 Effects of Cross-Border Entry on Risk Cross-border banking activities can affect the risk of individual banks or even financial stability.8 A large set of studies looks at the determinants of risks in banking, but only a handful of these addresses the impact of the internationalization of banks (De Nicolò, 2001; González, 2005; Nier and Baumann, 2006). A common argument is that cross-bor­ der (geographic) acquisitions have the potential to reduce a bank’s risk of insolvency (Se­ gal, 1974; Vander Vennet, 1996; Berger, 2000): it is better for a bank not to “put all its eggs in one basket” and, thus, geographic diversification is a naturally risk-reducing ac­ tivity. (See Acharya, Hasan, and Saunders (2006), Deng and Elyasiani (2008), Faia, Otta­ viano, and Sanchez Arjona (2017), or Stiroh and Rumble (2006) for the effects of diversifi­ cation empirically.)

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Banking Globalization: Cross-border Entry, Complexity,and Systemic Risk However, offsetting these perceived benefits are at least two potential costs that may well increase the probability that a bank becomes insolvent and, ultimately, the risk of sys­ temic crises. The first risk-increasing effect comes from the incentives banks have to shift risk when the regulatory “safety net” and its associated implicit and explicit guarantees are underpriced. As discussed by John, John, and Senbet (1991) and John, Saunders, and Senbet (2000), banks have incentives to increase their risk exposure beyond the level that would be privately optimal in a world in which there are no safety net guarantees or in which the safety net is “fairly” priced. Here, the safety net is broadly defined, including deposit insurance and, implicitly, resolution regimes addressing bank closure. (p. 943) One way for a bank to exploit the underpricing of risk and thus the safety net might be to ac­ quire other (risky) banks by cross-border expansion. If the risky investment pays off, then the acquiring bank has the potential to keep any upside returns. If the acquisition of the foreign target fails and the domestic bank’s (acquirer’s) solvency is threatened, then the acquiring bank may be bailed out either by its own home or domestic regulator or per­ haps by the host regulator (the regulator of the target bank). As a result, cross-border ac­ quisitions may increase the insolvency risk exposure of either one or both the domestic (acquirer) and host (target) bank regulators. A second reason why cross-border acquisitions may increase an acquirer’s risk concerns “who is watching the eggs in the basket” (Winton, 1999). Specifically, by extending its op­ erations into new overseas markets, the (domestic) bank is confronted with potentially new and risk-increasing monitoring problems related to the loan customer base, the oper­ ating cost structure, etc., of the target bank. If monitoring costs are high, these problems may also increase the insolvency risk of the domestic acquiring bank and implicitly the risk of domestic (and foreign) regulators. The question is whether and to whom cross-border acquisitions are beneficial. For exam­ ple, if cross-border acquisitions do not raise the risk of acquiring banks relative to other domestic (home country) banks, or even reduce their risk, then domestic regulators may encourage domestic banks to expand abroad. By contrast, if cross-border acquisitions in­ crease the relative domestic riskiness of the acquiring bank, then domestic regulators may wish to scrutinize such acquisitions more carefully and may even seek to restrict them in an effort to reduce safety net subsidies and to reduce risk-shifting behavior. Amihud, DeLong, and Saunders (2002) thus examine risk effects of cross-border bank ac­ quisitions. They analyze the change in the total risk of an acquiring bank as a result of a cross-border banking deal, the changes in the systemic (market) risk of acquiring banks relative to home, foreign, and world market bank indexes, and the reaction of stock prices to news about the acquisition and examine the relationship between this stock price reac­ tion and changes in risk brought about by cross-border bank acquisitions. They find that, on average, cross-border bank acquisitions do not change the risk of acquiring banks in any significant way. This would imply that the effect of an overseas acquisition is highly bank-dependent or idiosyncratic. On average, the risk-decreasing effects of cross-border bank acquisitions are offset by risk-increasing effects, and the nature of the merging part­ ners’ operation changes in a way so as to leave the acquirer’s risk unchanged. In a followPage 18 of 31

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Banking Globalization: Cross-border Entry, Complexity,and Systemic Risk up study, Buch and DeLong (2008) look further into the determinants of risk following bank acquisitions: strong bank supervision is associated with banks reducing risk after acquisitions. The results suggest banks subject to strong supervision use cross-border ac­ quisitions to diversify risk rather than to shift risk to banks in countries with weaker su­ pervision. Whereas the focus in Amihud, DeLong, and Saunders (2002) is on the exposure of banks to market risks, research has also addressed the exposure of banks to macroeconomic risks. Méon and Weill (2005) study the impact of acquisitions among large banks in Eu­ rope on the banks’ exposure to macroeconomic risk. They find that loan portfolios of (p. 944) European banks provide a sub-optimal risk-return trade-off. Hence, there are po­ tential gains in risk diversification from cross-border acquisitions, even within the EU, due to imperfect correlations of business cycles. Rich theoretical literature also deals with the risk and regulatory consequences of inter­ national bank acquisitions. Repullo (2001) analyzes the case where a foreign bank be­ comes a branch of the domestic banks. Each bank is initially supervised by the domestic supervisory agency. Under home country control, the takeover moves responsibility to the domestic agency. While cross-border bank acquisitions may reduce risk due to diversifica­ tion, they also shift responsibility for supervision and deposit insurance to the domestic regulatory agency. Harr and Ronde (2005) study the regulatory implications of banks’ or­ ganizational choice between branch and subsidiary, which fall under host country supervi­ sion, respectively. Their results do not show incentives for regulators to engage in a “race to the bottom” by relaxing banking regulations. Karolyi and Taboada (2012) substantiate these results and find that targets engage in less risk-taking after banks from countries with stronger regulatory regimes acquire them. Stricter regulations in the acquirer’s home country are also associated with higher stock market returns to the target upon the announcement of an acquisition. The link between multinational banking and risk-taking is not clear-cut (Dalen and Olsen, 2003). On the one hand, a lack of international coordination of supervision toward subsidiaries of foreign banks tends to lower capital requirements. On the other hand, regulators respond by in­ creasing incentives to improve asset quality. Given that portfolio diversification is a potentially important driver of banks’ international expansions, changes in the structure of global banking operations can be expected to have an impact on bank risk. According to work by Krause, Sondershaus, and Tonzer (2017) bank risk is affected by complexity, while effects differ depending upon the com­ plexity measure used. Their measure of complexity is the same as that used by Cetorelli and Goldberg (2014, 2016).

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Banking Globalization: Cross-border Entry, Complexity,and Systemic Risk

29.6 Summary and Outlook for Future Work In this chapter, we have reviewed the empirical literature on the determinants and effects of cross-border acquisitions in banking. Generally, the determinants of international bank­ ing activities are quite well understood. While empirical work on determinants of crossborder banking has led the way, theoretical research applying tools that are useful for un­ derstanding the behavior of multinationals has been successfully applied to the banking industry. Implicit barriers such as information costs and cultural differences, but also dif­ ferent types of regulation, add to explicit barriers to the integration of markets and can hold back cross-border acquisition activity. Also, bank acquisitions tend to take place mostly between large and developed countries, between countries in close (p. 945) region­ al proximity, and between countries that share a common cultural background. Consider­ ing the bank-level determinants of cross-border bank acquisitions, there is clear evidence for larger and more profitable banks to be the acquirers. Several studies have also looked into the effects of international bank acquisitions in terms of competition and efficiency. One common finding of this literature is that foreignowned banks—which are often the result of acquisitions—outperform domestically owned banks in emerging markets. The comparative advantages of foreign banks in developed countries are less evident. As regards the link between cross-border entry and bank risk, there has been extensive literature already, and well before the crisis, that described misaligned incentives due to a mispriced deposit insurance system, regulatory arbitrage, and the risk-shifting incen­ tives faced by domestic and foreign regulators. Assessing the importance of these effects empirically has been more difficult. Relatively few empirical studies analyze the risk ef­ fects of bank acquisitions, including effects on financial stability. At the bank level, stud­ ies find little evidence for a systemic change in risk following bank acquisitions. More recent work has started to look into the measurement, the drivers, and the effects of bank complexity. This literature is in its infancy and does not (yet) tell a clear story concerning the trends in complexity or the welfare effects of changing patterns. In terms of future research in the field, we see three main gaps in the literature. First, an improved understanding of entry and exit in the banking sector, the implications for market structure, and risk, both at the bank and the system level, should be high on the research agenda, both empirically and theoretically (Buch, 2018; Corbae and Levine, 2018). One stated objective of the post-crisis reform agenda is the ability to restructure and, eventually, resolve even large, complex, and internationally active financial institu­ tions. Also, low profitability of domestic financial institutions can be the result of excess capacities, and it can trigger foreign entry through acquisitions. Market entry, but also exit and the ensuing structural changes in the banking industry, are important drivers of risk and performance. An improved understanding of regulatory incentives for these structural changes is thus crucial.

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Banking Globalization: Cross-border Entry, Complexity,and Systemic Risk Second, improving our understanding of the risk-return trade-offs in international bank acquisitions requires the more extensive use of bank-level data. Looking into the portfolio structures of internationally active banks and assessing the impact of foreign activities on risks and returns could provide important insights into the effects of cross-border acquisi­ tions. Third, theoretical work has looked into the regulatory consequences of multinational banking, the organizational choice between branches and subsidiaries, and the costs and benefits of home and host country control. To the best of our knowledge, though, few of these papers have been put to an empirical test. This would be the natural next step. Ultimately, linking empirical and theoretical work on international bank acquisitions more closely together and making use of new bank-level datasets is not only of academic inter­ est. It will also pay off in terms of improved information for policymakers. The increase in cross-border financial institutions raises some important policy issues, such (p. 946) as the transmission of systemic risk across borders, the governance and supervision of multina­ tional financial institutions, and the extent to which foreign-owned institutions will pro­ vide sufficient services in times of local crises. Regulators must react via adjustments in the supervisory framework, information sharing among supervisors, and the development of supervisory skills.

Acknowledgments This chapter has been prepared for the Third Edition of the Oxford Handbook of Banking. We would like to thank Benedikt Fritz and the editors of the Handbook for comments on an earlier draft. It represents the view of the authors and not of the Deutsche Bundes­ bank. All errors and inconsistencies are our own.

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Banking Globalization: Cross-border Entry, Complexity,and Systemic Risk Berger, A.N., Dai, Q., Ongena, S., and Smith, D.C. (2003). “To What Extent Will the Bank­ ing Industry be Globalized? A Study of Bank Nationality and Reach in 20 European Na­ tions,” Journal of Banking and Finance, 27(3), 383–415. Berger, A.N., Demsetz, R.S., and Strahan, P.E. (1999). “The Consolidation of the Financial Services Industry: Causes, Consequences, and Implications for the Future,” Journal of Banking and Finance, 23(2–4), 135–94. Berger, A.N., DeYoung, R., Genay, H., and Udell, G.F. (2000). “The Globalization of Finan­ cial Institutions: Evidence from Cross-Border Banking Performance,” Brookings-Wharton Papers on Financial Services, 3, 23–158. Berger, A.N., DeYoung, R., and Udell, G.F. (2001). “Efficiency Barriers to the Consolida­ tion of the European Financial Services Industry,” European Financial Management, 7(1), 117–30. Berger, A.N., Hasan, I., and Zhou, M. (2010). “The Effects of Focus versus Diversification on Bank Performance: Evidence from Chinese Banks,” Journal of Banking and Finance, 34(7), 1417–35. Berger, A.N., Hunter, W.C., and Timme, S.G. (1993). “The Efficiency of Financial Institu­ tions: A Review and Preview of Research Past, Present, and Future,” Journal of Banking and Finance, 17(2–3), 221–49. Blandon, J.G. (2000). “Cross-Border Banking in Europe: An Empirical Investigation,” Eco­ nomics Working Paper No. 509, Department of Economics and Business, Universitat Pom­ peu Fabra Working Paper, Barcelona. Bonin, J.P. and Abel, I. (2000). “Retail Banking in Hungary: A Foreign Affair?” Working Pa­ per No. 356, Economics Department, Wesleyan University, Middletown. Boot, A.W.A. (1999). “European Lessons on Consolidation in Banking,” Journal of Banking and Finance, 23(2–4), 609–13. Boot, A.W.A. and Marinc, M. (2009). “Competition and Entry in Banking: Implications for Capital Regulation,” University of Amsterdam and CEPR, mimeo. Brealey, R.A. and Kaplanis, E.C. (1996). “The Determination of Foreign Banking Loca­ tion,” Journal of International Money and Finance, 15(4), 577–97. Brüggemann, B., Kleinert, J., and Prieto, E. (2012). “A Gravity Equation for Bank Loans,” Universities of Graz and Tuebingen, mimeo. Buch, C.M. (2003). “Information versus Regulation: What Drives the International Activi­ ties of Commercial Banks?” Journal of Money, Credit, and Banking, 35(6), 851–69. Buch, C.M. (2005). “Distance and International Banking,” Review of International Economics, 13(4), 787–804. (p. 948)

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Banking Globalization: Cross-border Entry, Complexity,and Systemic Risk Buch, C.M. (2018). “Competition, Stability, and Efficiency in Financial Markets,” discus­ sion of “Changing Market Structure and Implications for Monetary Policy,” a paper by Dean Corbae and Ross Levine prepared for the 2018 Jackson Hole Symposium. Buch, C.M. and DeLong, G.L. (2004). “Cross-Border Bank Mergers: What Lures the Rare Animal?” Journal of Banking and Finance, 28(9), 2077–102. Buch, C.M., and DeLong, G.L. (2008). “Do Weak Supervisory Systems Encourage Bank Risk-Taking?” Journal of Financial Stability, 4(1), 23–39. Buch, C.M. and Lipponer, A. (2006). “Clustering or Competition? The Foreign Investment Behaviour of German Banks,” International Journal of Central Banking, 5(2), 135–68. Buch, C.M. and Lipponer, A. (2007). “FDI versus Exports: Evidence from German Banks,” Journal of Banking and Finance, 31(3), 805–26. Buch, C.M., Koch, C.T., and Koetter, M. (2011). “Size, Productivity, and International Banking,” Journal of International Economics, 85(2), 329–34. Carbo, S. and Rodríguez, F. (2007). “The Determinants of Bank Margins in European Banking,” Journal of Banking and Finance, 31, 2043–63. Carletti, E., Hartmann, P., and Ongena, S. (2007). “The Economic Impact of Merger Con­ trol: What Is Special About Banking?” European Central Bank, Working Paper Series No. 786. Frankfurt. Carletti, E., Hartmann, P., and Spagnolo, G. (2007). “Bank Mergers, Competition and Liq­ uidity,” Journal of Money, Credit and Banking, 39(5), 1067–105. Carmassi, J. and Herring, R. (2016). “The Corporate Complexity of Global Systemically Important Banks,” Journal of Financial Services Research, 49(2–3), 175–202. Cetorelli, N. and Goldberg, L. (2014). “Measuring Complexity in Global Banks,” Federal Reserve Bank of New York, Economic Policy Review, 20(2, December), 107–26. Cetorelli, N. and Goldberg, L. (2016). “Organizational Complexity and Balance Sheet Management in Global Banks,” NBER Working Paper No. 22169, Cambridge, MA. Chang, C.E., Hasan, I., and Hunter, W.C. (1998). “Efficiency of Multinational Banks: An Empirical Investigation,” Applied Financial Economics, 8(6), 1–8. Choi, S.-R., Tschoegl, A.E., and Yu, E.-M. (1986). “Banks and the World’s Major Financial Centers, 1970–1980,” Weltwirtschaftliches Archiv, 122(1), 48–64. Cihák, M., Demirgüç-Kunt, A., Martínez Pería, M.S., and Mohseni-Cheraghlou, A. (2012). “Banking Regulation and Supervision Around the World: A Crisis Update,” World Bank, Policy Research Working Paper No. 6286, World Bank, Washington, DC.

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Banking Globalization: Cross-border Entry, Complexity,and Systemic Risk Claessens, S. and van Horen, N. (2007). “Location Decisions of Foreign Banks and Com­ petitive Advantage,” International Monetary Fund, World Bank, Policy Research Working Paper Series No. 4113, Washington, DC. Claessens, S. and van Horen, N. (2013). “Impact of Foreign Banks,” The Journal of Finan­ cial Perspectives, 1(1), 1–18. Claessens, S. and van Horen, N. (2014). “Foreign Banks: Trends and Impacts,” Journal of Money, Credit, and Banking, 46(S1), 295–326. Claessens, S., Ganum, P., and Minoiu, C. (unpublished). “Are Diversified Banks Better In­ termediaries?” Claeys, S. and Hainz, C. (2007). “Acquisition versus Greenfield: The Impact of the Mode of Foreign Bank Entry on Information and Bank Lending Rates,” Sveriges Riksbank, Work­ ing Paper Series No. 210, Stockholm. Committee on the Global Financial System (CGFS) (2018). “Structural Changes in Banking after the Crisis,” CGFS Papers No. 60. (p. 949)

Corbae, D. and Levine, R. (2018). “Competition, Stability, and Efficiency in Financial Mar­ kets,” Paper prepared for the 2018 Jackson Hole Symposium, Changing Market Structure and Implications for Monetary Policy. Correa, R. (2009). “Cross-Border Bank Acquisitions: Is there a Performance Effect?” Jour­ nal of Financial Services Research, 36(2–3), 169–97. Cybo-Ottone, A. and Murgia, M. (2000). “Mergers and Shareholder Wealth in European Banking,” Journal of Banking and Finance, 24(6), 831–59. Dalen, D.M. and Olsen, T.E. (2003). “Regulatory Competition and Multinational Banking,” CESifo, Working Paper Series No. 971, Munich. De Blas, B. and Russ, K. N. (forthcoming). “All Banks Great, Small, and Global: Loan Pric­ ing and Foreign Competition,” International Review of Economics and Finance, NBER Working Paper No. 16029, Cambridge, MA. De Haas, R. and Naaborg, I. (2006). “Foreign Banks in Transition Countries: To Whom Do They Lend and How Are They Financed?” Financial Markets, Institutions and Instruments, 15(4), 159–99. De Haas, R. and van Lelyveld, I. (2006). “Foreign Banks and Credit Stability in Central and Eastern Europe: A Panel Data Analysis,” Journal of Banking and Finance, 30(7), 1927–52. DeLong, G.L. (2001). “Stockholder Gains from Focusing versus Diversifying Bank Merg­ ers,” Journal of Financial Economics, 59(2), 221–52.

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Banking Globalization: Cross-border Entry, Complexity,and Systemic Risk DeLong, G.L. (2003). “Does Long-Term Performance of Mergers Match Market Expecta­ tions? Evidence from the U.S. Banking Industry,” Financial Management, 32(2), 5–26. Demirgüç-Kunt, A. and Huizinga, H. (1999). “Determinants of Commercial Bank Interest Margins and Profitability: Some International Evidence,” World Bank Economic Review, 13(2), 379–408. Deng, S.E. and Elyasiani, E. (2008). “Geographic Diversification, Bank Holding Company Value, and Risk,” Journal of Money, Credit and Banking, 40(6), 1217–38. De Nicolò, G. (2001). “Size, Charter Value and Risk in Banking: An International Perspec­ tive,” in The Financial Safety Net: Costs, Benefits and Implications for Regulation, Pro­ ceedings of the 37th Annual Conference on Bank Structure and Competition, Federal Re­ serve of Chicago, 197–215. DeYoung, R. and Nolle, D.E. (1996). “Foreign-Owned Banks in the U.S.: Earning Market Share or Buying It?” Journal of Money, Credit, and Banking, 28(4), 622–36. Elsas, R., Hackethal, A., and Holzhäuser, M. (2010). “The Anatomy of Bank Diversifica­ tion,” Journal of Banking and Finance, 34(6), 1274–87. Emter, L., Schmitz, M., and Tirpák, M. (2018). “Cross-Border Banking in the EU Since the Crisis: What Is Driving the Great Retrenchment?” European Central Bank, Working Paper No. 2130, February, European Central Bank, Frankfurt. European Commission (2005). “Cross-Border Consolidation in the EU Financial Sector,” Commission Staff Document SEC (2005) 1398, Brussels. Faia, E. and Ottaviano, G. (2017). “Global Banking: Risk Taking and Competition,” Centre for European Policy Research, Discussion Paper No. 11940, London. Faia, E., Ottaviano, G., and Sanchez Arjona, I. (2017). “International Expansion and Riski­ ness of Banks,” Centre for European Policy Research, Discussion Paper No. 11951, Lon­ don. Fecht, F. and Grüner, H.P. (2008). “Limits to International Banking Consolidation,” Open Economies Review, 19(5), 651–66. Financial Stability Board (FSB) (2017). “Implementation and Effects of the G20 Financial Regulatory Reforms,” 3rd Annual Report, Basel. (p. 950)

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Banking Globalization: Cross-border Entry, Complexity,and Systemic Risk Gai, P., Haldane, A., and Kapadia, S. (2011). “Complexity, Concentration and Contagion,” Journal of Monetary Economics, 58(5), 453–70. Giddy, I., Saunders, A., and Walter, I. (1996). “Alternative Models for Clearance and Set­ tlement: The Case of the Single European Capital Market,” Journal of Money, Credit and Banking, 28(4), 986–1000. Goddard, J., Molyneux, P., and Wilson, J.O.S. (2001). European Banking: Efficiency, Tech­ nology and Growth (Chichester: John Wiley and Sons). Goldberg, L. (2004). “Financial-Sector FDI and Host Countries: New and Old Lessons,” NBER Working Paper No. 10441, Cambridge, MA. Goldberg, L.G. and Saunders, A. (1981). “The Determinants of Foreign Banking Activity in the United States,” Journal of Banking and Finance, 5(1), 17–32. González, F. (2005). “Bank Regulation and Risk-Taking Incentives: An International Com­ parison of Bank Risk,” Journal of Banking and Finance, 29(5), 1153–84. Gray, J.M. and Gray, H.P. (1981). “The Multinational Bank: A Financial MNC?,” Journal of Banking and Finance, 5(1), 1–153. Guillén, M. and Tschoegl, A.E. (2000). “The Internationalization of Retail Banking: The Case of the Spanish Banks in Latin America,” Transnational Corporations, 9(3), 63–97. Harr, T. and Ronde, T. (2005). “Branch or Subsidiary? Capital Regulation of Multinational Banks,” University of Copenhagen and CEPR, mimeo. Haselmann, R. (2006). Performance and Strategies of Banks in Transition Economies (Marburg: Metropolis Verlag). Hellwig, M. (2008). “The Causes of the Financial Crisis,” CESifo Forum, Ifo Institute for Economic Research at the University of Munich, 9(4), 12–21. Hughes, J.P. and Mester, L.J. (2013). “Who Said Large Banks Don’t Experience Scale Economies? Evidence from a Risk–Return-Driven Cost Function,” Journal of Financial In­ termediation, 22(4), 559–85. Huizinga, H.P., Nelissen, J.H.M., and Vander Vennet, R. (2001). “Efficiency Effects of Bank Mergers and Acquisitions in Europe,” Tinbergen Institute Discussion Paper No. 088/3, Rotterdam. Jayaratne, J. and Strahan, P. (1998). “Entry Restrictions, Industry Evolution, and Dynamic Efficiency: Evidence from Commercial Banking,” Journal of Law and Economics, 41(1), 239–73. John, K., John, T., and Senbet, L. (1991). “Risk Shifting Incentives of Depository Institu­ tions: A New Perspective on Federal Deposit Insurance Reform,” Journal of Banking and Finance, 15(45), 895–915. Page 27 of 31

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Banking Globalization: Cross-border Entry, Complexity,and Systemic Risk John, K., Saunders, A., and Senbet, L. (2000). “A Theory of Bank Compensation and Man­ agement Regulation,” Review of Financial Studies, 3(1), 95–126. Karolyi, G.A. and Taboada, A.G. (2012). “The Role of Regulation in Cross-Border Bank Ac­ quisitions: Is It Really a ‘Race to the Bottom’?,” Cornell University Working Paper. Kirschenmann, K. and Steinrücke, L. (2017). “The Fight Against Financial Crime: How Global Banks’ De-Risking Affects Trade and the Local Economy,” ZEW Center for Economic Research. Mannheim, mimeo. (p. 951)

Kiymaz, H. (2004). “Cross-Border Acquisitions of US Financial Institutions: Impact of Macroeconomic Factors,” Journal of Banking & Finance, 28(6), 1413–39. Köhler, M. (2009). “Transparency of Regulation and Cross-Border Bank Mergers,” Inter­ national Journal of Central Banking, 5(1, March), 39–73. Krause, T., Sondershaus, T., and Tonzer, L. (2017). “Complexity and Bank Risk During the Financial Crises,” Economics Letters, 150, 118–21. Laeven, L. and Levine, R. (2007). “Is There a Diversification Discount in Financial Con­ glomerates?” Journal of Financial Economics, 85(2), 331–67. Lannoo, K. and Gros, D. (1998). “Capital Markets and EMU: Report of a CEPS Working Party,” Centre for European Policy Studies. Liu, F.H., Norden, L., and Spargoli, F. (2018). “Does Uniqueness in Banking Matter?” Uni­ versity of Glasgow, Brazilian School of Public and Business Administration, and Rotter­ dam School of Management, mimeo. Markusen, J.R. and Venables, A.J. (1995). “The Increased Importance of Multinationals in North American Economic Relationships: A Convergence Hypothesis,” in M.W. Canzoneri, W.J. Ethier, and V. Grilli (eds.), The New Transatlantic Economy (London: Cambridge Uni­ versity Press). Méon, P.G. and Weill, L. (2005). “Can Mergers in Europe Help Banks Hedge Against Macroeconomic Risk?” Applied Financial Economics, 15(5), 315–26. Niepmann, F. (2011). “Banking Across Borders,” De Nederlandsche Bank, Research De­ partment, Amsterdam, DNB Working Paper No. 325. Nier, E. and Baumann, U. (2006). “Market Discipline, Disclosure and Moral Hazard in Banking,” Journal of Financial Intermediation, 15(3), 332–61. Peek, J., Rosengren, E.S., and Kasirye, F. (1999). “The Poor Performance of Foreign Bank Subsidiaries: Were the Problems Acquired or Created?” Journal of Banking and Finance, 23(2–4), 579–604. Peristiani, S. (1993). “The Effects of Mergers on Bank Performance,” in Studies on Excess Capacity in the Financial Sector, Federal Reserve Bank of New York, New York. Page 28 of 31

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Banking Globalization: Cross-border Entry, Complexity,and Systemic Risk Portes, R. and Rey, H. (2005). “The Determinants of Cross-Border Equity Flows,” Journal of International Economics, 65(2), 269–96. Repullo, R. (2001). “A Model of Takeovers of Foreign Banks,” Spanish Economic Review, 3, 1–21. Sagari, S.B. (1992). “United States Foreign Direct Investment in the Banking Industry,” Transnational Corporations, 1(3), 93–123. Saunders, A. (1999). “Consolidation and Universal Banking,” Journal of Banking and Fi­ nance, 23(2–4), 693–95. Segal, Z. (1974). “Market and Industry Factors Affecting Commercial Bank Stocks: An Analysis of the Price Behavior of Bank Stock Prices,” unpublished doctoral dissertation, New York University, New York. Seth, R., Nolle, D.E., and Mohanty, S.K. (1998). “Do Banks Follow Their Customers Abroad?” Financial Markets, Institutions, and Instruments, 7(4), 1–25. Stanley, T.O., Roger, C., and McManis, B. (1993). “The Effects of Foreign Ownership of U.S. Banks on the Availability of Loanable Funds to Small Business,” Journal of Small Business Management, 31(1), 51–66. (p. 952)

Stiroh, K. and Rumble, A. (2006). “The Dark Side of Diversification: The Case of

US Financial Holding Companies,” Journal of Banking and Finance, 30(8), 2131–61. Ter Wengel, J. (1995). “International Trade in Banking Services,” Journal of International Money and Finance, 14(1), 47–64. Valkanov, E. and Kleimeier, S. (2007). “The Role of Regulatory Capital in International Bank Mergers and Acquisitions,” Research in International Business and Finance, 21(1), 50–68. Vander Vennet, R. (1996). “The Effect of Mergers and Acquisitions on the Efficiency and Profitability of EC Credit Institutions,” Journal of Banking and Finance, 20(9), 1531–58. Vander Vennet, R. (1998). “Causes and Consequences of EU Bank Takeovers,” in S. Ei­ jffinger, K. Koedijk, M. Pagano, and R. Portes (eds.), The Changing European Landscape (Brussels: Centre for Economic Policy Research), 45–61. Wagner, W. (2011). “Systemic Liquidation Risk and the Diversity–Diversification TradeOff,” Journal of Finance, 66, 1141–75. Wheelock, D.C. and Wilson, P.W. (2000). “Why Do Banks Disappear? The Determinants of U.S. Bank Failures and Acquisitions,” Review of Economics and Statistics, 82(1), 127–38. Williams, B. (1997). “Positive Theories of Multinational Banking: Eclectic Theory versus Internalisation Theory,” Journal of Economic Surveys, 11(1), 71–100. Page 29 of 31

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Banking Globalization: Cross-border Entry, Complexity,and Systemic Risk Winton, A. (1999). “Don’t Put All Your Eggs in One Basket? Diversification and Specializa­ tion in Lending,” Working Paper, University of Minnesota.

Notes: (1) The Committee on the Global Financial System (CGFS) has recently published a report on changes in global banking activities (CGFS, 2018). (2) This and the following figures are taken from Thomson Financial. (3) See Emter, Schmitz, and Tirpák (2018) for an analysis of the European case. (4) See Buch (2018). (5) This section partly draws on Buch and DeLong (2004) and Berger et al. (2004). (6) A detailed database on banking regulations around the world can be found at: https:// www.worldbank.org/en/research/brief/BRSS. See Cihák et al. (2012) and Barth, Caprio, and Levine (2001, 2008) for details. (7) See Goldberg (2004) for a thorough discussion of the relevant literature. (8) This section draws partly on Amihud, DeLong, and Saunders (2002).

Claudia M. Buch

Claudia M. Buch is the Vice-President of the Deutsche Bundesbank. She is responsi­ ble for Financial Stability, Statistics, and Internal Audit. She is the accompanying person of the President of the Bundesbank on the ECB Governing Council and a member of the German Financial Stability Committee (FSC). Prior to joining the Bun­ desbank in May 2014, she was the President of the Institute for Economic Research (IWH) in Halle (2013–14), Professor of Economics at the Otto von Guericke Universi­ ty Magdeburg (2013–14), and Professor of Economics for “International Finance and Macroeconomics” at the University of Tübingen (2004–13). From 2012 to 2014, she was a member of the German Council of Economic Experts. She was Scientific Direc­ tor at the Institute for Applied Economic Research (IAW) in Tübingen (2005–13), and worked at the Institute for World Economics in Kiel (IfW) from 1992 until 2013. She habilitated at the University of Kiel (2002) after receiving her doctorate there in 1996. Between 1985 and 1991, she studied Economics at the University of Bonn and she graduated from the University of Wisconsin (Eau Claire) with a Master of Busi­ ness Administration degree in 1988. Her fields of specialization are financial stability, international banking, international finance and macroeconomics, and financial inte­ gration. Gayle L. Delong

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Banking Globalization: Cross-border Entry, Complexity,and Systemic Risk Gayle L. DeLong is an Associate Professor in the Economics and Finance Department of Baruch College in the City University of New York. She earned a Ph.D in Interna­ tional Business and Finance from New York University and a Masters in International Business Studies from the University of South Carolina. Her research interests in­ clude banking, public–private partnerships, and the implications of regulations. In 2012, she won the Abraham J. Briloff Prize in Ethics at Baruch College, New York.

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Banking and Real Economic Activity: Foregone Conclusions and Open Chal­ lenges

Banking and Real Economic Activity: Foregone Conclu­ sions and Open Challenges   Nicola Cetorelli and Michael Blank The Oxford Handbook of Banking (3rd edn) Edited by Allen N. Berger, Philip Molyneux, and John O. S. Wilson Print Publication Date: Oct 2019 Subject: Economics and Finance, Financial Economics Online Publication Date: Nov 2019 DOI: 10.1093/oxfordhb/9780198824633.013.30

Abstract and Keywords This chapter reviews insights about how the banking system affects real economic perfor­ mance. After arguing that the causality debate—the high-level question of whether the characteristics of a banking system have causal consequences for the real economy—has essentially been settled, we evaluate the specific channels through which banking activity may exert real effects. We focus on the rich empirical literature spawned by the theoreti­ cally ambiguous impact of greater banking competition, which has found concentration of the banking system to be a significant determinant of the structure and health of non-fi­ nancial industries. We also discuss how, after the 2007–9 financial crisis, there has been revitalized interest in modeling the role that financial intermediaries play in amplifying aggregate shocks and initiating crises. We conclude by noting the importance of account­ ing for the changing institutional, structural, and technological properties of the financial sector in understanding the interplay between financial and real activity. Keywords: competition, economic growth, financial intermediation, financial stability, general equilibrium models, market structure

30.1 Introduction ON December 12 AD 56, Lucius Caecilius Jucundus recorded a transaction related to a loan for 11,039 sesterces, which he had extended for the completion of an auction sale that took place in the city of Pompeii.1 Wax tablets recording this and sixteen other simi­ lar loan contracts were found, charred but still legible, in an archeological excavation of his house, partially destroyed after the Vesuvius eruption on August 24–5 AD 79. L. Caecilius Jucundus was a very wealthy banker in Pompeii, the son of a freedman, who had become a banker himself. They were bankers in the basic definition of the term, in that they would accept deposits from clients and extend loans using part of the received deposits. The standard terms for such loan contracts implied a commission plus an inter­

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Banking and Real Economic Activity: Foregone Conclusions and Open Chal­ lenges est rate that was normally about 2 percent a month, with a typical duration of up to one year but normally no more than a few months. Their main role, and the one documented in the above-mentioned tablet, was to provide credit at auctions for the sale of property, harvests, and slaves. In many cases they would arrange the sale of the very same collateral that had been pledged on past due loans that could not be repaid. They would also act as assayers of coins, provide foreign exchange services, extend types of loans other than those related to auction transactions, and en­ gage in activities resembling what would currently be defined as trust management (An­ dreau, 1999, p. 36). While there is significant written evidence of banking activity in the first and sec­ ond centuries AD in Rome, professional bankers were already in operation in Athens in the fifth century BC and were found at about the same time in Egypt and Palestine (An­ dreau, 1999, pp. 30–2). (p. 954)

Banks have thus been present even in the earliest instances of pre-modern, pre-capitalist societies, their role so pervasive and ingrained in the basic functioning of markets and economies that one almost wonders about the need to discuss the importance of banking institutions for the real economy. However, a debate on the basic determinants of the process of economic development has been alive and kicking at least throughout the en­ tire twentieth century. Within this debate, the role of banks, and the financial sector in general, has been either readily dismissed (see, e.g., Robinson, 1952; Lucas, 1988) or al­ ternatively recognized as “too obvious for serious discussion” (Miller, 1998, p. 14). The start of the modern analysis of this issue is normally associated with the work of Joseph Schumpeter, who synthesized the idea that credit, especially bank credit, does create real value, in his Theory of Economic Development (1911). In fact, Schumpeter himself drew on an even older debate when he challenged, for instance, the view of Ricardo that “bank­ ing operations cannot increase a country’s wealth” (Schumpeter, 1911, p. 98). This chap­ ter first illustrates the reasons why the debate went on for so long, and goes on to make the claim that perhaps scholars have finally reached a consensus. Second, it presents the most current directions of research on this topic.

30.2 The Causality Debate Perhaps the main reason for the persistence of this debate is that it has been very diffi­ cult to pin down the issue of causality.2 Anecdotal evidence from historical case studies, or even broader informal observations from cross-country data, will normally show a strong, positive correlation between any standard measure of real economic activity—per capita output growth, per capita capital growth, and productivity growth—with standard measures of development of financial markets. For instance, in what is widely recognized as the first contribution to reignite the most current interest in this debate, King and Levine (1993) drew on data from seventy-seven countries from 1960 to 1989 to show that a basic measure of the “depth” of the financial system—the aggregate value of currency Page 2 of 24

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Banking and Real Economic Activity: Foregone Conclusions and Open Chal­ lenges demand and interest-bearing liabilities of banks and non-bank intermediaries—had a posi­ tive and economically very significant association with real economic activity. The underlying idea behind this and related measures of the size of the financial sector is that a broader, deeper financial sector increasingly facilitates firms’ access to capital. This is the basic “financial engine” of growth. More precisely, King and Levine show that if a country could increase the size of its financial sector from the bottom (p. 955) quartile to the top quartile of the distribution, the resulting superior access to capital would be re­ flected in an increase in per capita income growth by almost 1 percent per year. Given that the difference in income growth between countries in the top and the bottom quar­ tile of the distribution for the countries in this dataset over this sample period was about 5 percent, the change in financial depth would contribute to an impressive 20 percent re­ duction of such a gap (King and Levine, 1993, table 7). In subsequent work, a more specific link between just bank credit and real economic ac­ tivity was also confirmed using similar data and empirical methodology. Levine and Zer­ vos (1998) show with a dataset for forty-two countries between 1976 and 1993 that an in­ crease in bank credit by one standard deviation results in an increase in real per capita income growth of 0.7 percentage points per year (Levine and Zervos, 1998, table 3). The basic message of such studies is that the economic magnitude of increasing the overall scale of the banking industry is potentially very significant. However, despite the robust­ ness and the strength of such results, skeptics in the underlying debate have always maintained that, while this empirical evidence clearly indicates an important correlation between finance and real activity, it cannot address the fundamental issue at stake, name­ ly whether banking activity—and by extension activity of the financial sector—is some­ what exogenously determined and, if it is, whether it exerts an independent impulse on real economic sectors. Critics of the role of finance in real economic activity have always argued that characteristics of financial markets are endogenously determined—that is, the existence and the development of anything financial is simply a reflection of real eco­ nomic activity. The empirical evidence mentioned above cannot disprove the argument that financial markets simply develop simultaneously to accommodate the expanding needs of a growing economy, or even that measures to deepen financial activity could be undertaken in anticipation of predicted future economic growth. Much subsequent work, most of it by Levine and coauthors, has addressed specifically this issue of endogeneity and causality. It has done so by departing from basic cross-sec­ tional analysis and embracing the more sophisticated econometric tools of dynamic panel estimation techniques (see, e.g., Beck, Levine, and Loayza, 2000; Levine, Loayza, and Beck, 2000) and instrumental variables (Levine, 1998; Levine, 1999; Levine, Loayza, and Beck, 2000). In essence, the basic strategy involves trying to identify an exogenous com­ ponent of financial development. This is achieved assuming that the level of development of the financial sector in a country is very much a reflection of the quality of the basic in­ stitutional setting that has developed in that country over time. In turn, such institutional setting (reflected in the degree of protection of property rights, in the quality of the legal enforcement system, in the overall level of trust, in the degree of corruption, etc.) is Page 3 of 24

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Banking and Real Economic Activity: Foregone Conclusions and Open Chal­ lenges found to be highly determined by the legal origin of that country (see La Porta et al., 1998). More specifically, the nature and quality of basic institutions appear to be highly correlat­ ed with whether the legal system of a country has roots in the British, German, French, or Scandinavian traditions of rule of law. Since the basic activity of financial markets relies on the possibility of writing well-defined contracts describing transactions based on promises of future payments, financial markets will be more (p. 956) or less developed to the extent to which the legal system allows protection and enforcement of such contracts. And, since the establishment of a given legal system in a country is, to a large extent, the result of past events, such as experiences of colonization, it is plausible to consider this feature as exogenously determined. Thus, by either augmenting basic cross-sectional studies with instrumental variable analysis, or by using instrumental variables in dynamic panel models, the studies men­ tioned above came to conclusions that were remarkably similar to the earlier ones that relied on simpler identification techniques. That is (the exogenous component of) finan­ cial development has a substantial economic impact on the real economy. While this represented an important step in addressing the causality issue, questions could still be raised regarding the quality of the instruments and, perhaps most impor­ tant, the fact that both the quality of the financial sector and that of other important insti­ tutions could all be determined by still other omitted factors. Hence, the doubt remains, following this approach, that an observed positive effect of financial sector variables could in fact be the reflection of something else affecting simultaneously the financial and the real side (see Zingales, 2003). No less important, however, is the interpretation that we can give to studies that have used the measures of depth illustrated earlier to capture the importance of financial mar­ kets for the real economy. Depth, or size, is really an outcome measure, meaning that whatever it is that is done or could be done to improve the financial industry is then re­ flected in its relative size, which is what is observed. Yet, by focusing on this end-result variable, we are at least one step removed from addressing causality in that we do not di­ rectly investigate how banks or other parts of the financial industry generate an indepen­ dent impact on real economic activity. This leaves unanswered the above-mentioned criti­ cisms that financial markets evolve hand in hand with other economic variables and that those are the ones actually responsible for real sector growth. What is more, by maintain­ ing the focus on the depth variables, the analysis is also much constrained in terms of the quality of its normative content: if it is probably the case that going from the bottom to the top quartile in the banking size distribution is associated with considerably higher in­ come growth, these studies are not able to prescribe exactly how deepening can be achieved.

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Banking and Real Economic Activity: Foregone Conclusions and Open Chal­ lenges

30.3 Banks Matter Both the issue of causality and of normative content were directly addressed in another highly influential study, Jayaratne and Strahan (1996), which represented another signifi­ cant leap forward in the quest for the ultimate word on the role of banking for the real sector. The authors narrowed the focus of analysis down from a cross-country perspective to a country-specific case study, that of the US. While the choice may seem deficient with respect to the broader cross-country variability of previous studies, it actually comes with a tremendous payoff for a study on the role of banking: as a result of (p. 957) decades of regulatory restrictions preventing or limiting bank expansion within and/or across states, until the mid-1970s the US featured what was in effect fifty separate banking markets (Morgan, Rime, and Strahan, 2004), with state lines demarcating the boundaries of each individual market. Hence, studies limited to US banking alone still allow substantial cross-sectional variation. At the same time, the narrower focus on one country also re­ duces potentially important sources of unobservable heterogeneity that are more likely to plague multi-country data. Moreover, and most importantly, the end of the 1970s marks the beginning of an intense process of deregulation, in which individual states—at differ­ ent points in time—removed regulatory barriers that had prevented bank entry. By the mid-1990s the process had concluded, allowing banks originally headquartered anywhere from that point on to expand potentially anywhere else without restriction. As a result of this process of deregulation, banking markets have become increasingly more competitive and efficient. This should in turn translate into more credit availability, a clear and direct effect on the real economy. This is exactly what Jayaratne and Strahan (1996) test. The simultaneous existence of cross-sectional and over-time variation con­ cerning individual states’ timing of deregulation represents a unique opportunity to con­ duct analysis in conditions that approximate those of a “natural experiment,” a scenario notoriously hard to achieve in social science inquiry. More precisely, it is possible to mea­ sure the impact of bank deregulation—and the associated changes in competition and ef­ ficiency—comparing state-specific real economic variables before and after deregulation. In the language of natural experiment analysis, the control group is represented by obser­ vations in a state before deregulation, including observations in other states that have not deregulated yet, while the treatment group is represented by all observations in years fol­ lowing deregulation. Because deregulation is not implemented at the same time in all states, unobserved state-specific omitted factors and time-specific events common across states that could explain the dependent variable can be absorbed by state and time indi­ cator variables, still leaving sufficient variation to identify the specific effect of deregula­ tion. This identification strategy makes an important step forward in dealing with causality for at least two reasons: first, it does not capture developments in the financial sector, bank­ ing in particular, by looking at an ex post outcome performance such as credit size; in­ stead it captures the effect of a specific event, bank deregulation, that is supposed to gen­ erate developments in the sector. And, because theory would suggest that the resulting improvement in competition and efficiency should be associated with more and better al­ Page 5 of 24

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Banking and Real Economic Activity: Foregone Conclusions and Open Chal­ lenges located capital, the causal link is now much more direct. Second, the event in question can be plausibly considered to be exogenous and occurring independently of current or expected developments in the real economy. For example, studies have indicated that small banks had been very influential in establishing tight restrictions to expansion as early as the 1930s and that their influence remained strong through the early 1980s (Economides, Hubbard, and Palia, 1996; White, 1998). Also, the extensive failure of thrifts in the 1980s has been considered another cause of deregulation, as large, better-diversi­ fied banks were allowed to acquire the failing banks (Kane, 1996). Finally, (p. 958) Kroszn­ er and Strahan (1999) find that technological changes in both deposit and lending activity were among the leading factors behind deregulation. With these premises, Jayaratne and Strahan (1996) were able to find evidence confirming a causal link between banking deregulation and state income growth. In particular, using a panel from 1972 to 1992, they find that income growth in a state was more than half a percentage point higher, per year, after deregulation of its banking industry. Their contri­ bution should be recognized both methodologically, for the important tightening in the strategy to address causality, but also because it focused on a specific characteristic of the banking industry, thereby bringing the data closer to theory and at the same time en­ hancing the normative content of the analysis. Their evidence represents, in our opinion, the closest to a nail in the coffin of the causality debate.3 After their paper, it has become very difficult to counter Schumpeter’s assertion that “bank credit does create value,” or at the very least the burden of proof has shifted squarely to the other side of the debate.4

30.4 How Do Banks Matter? From this point on, the research frontier advances forward. No longer is it necessary to expend effort making the point that banks are important for the real economy. Taking that as a given, scholars have focused on the perhaps richer and more satisfying quest of fully understanding the mechanisms through which banks can affect the real economy. The op­ erative questions at stake are what specific characteristics of banks and of the banking industry are likely to matter the most for real output variables, such as income or produc­ tivity growth? And, similarly, from the other end, what specific elements or features of the real sectors of the economy are really affected by banks’ activity, so that ultimately such activity is reflected in an impact on real output? Delving deeper into the micro details governing the banking–real economy relationship, it is now possible to really put to the test specific theories of banking. Moreover, and as mentioned earlier, the normative value of the newest studies of banking and the real economy increases tangibly. As economists fine tune what works the most, policymakers are increasingly able to navigate the some­ times turbulent waters of banking regulatory activity.

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Banking and Real Economic Activity: Foregone Conclusions and Open Chal­ lenges (p. 959)

30.5 The Role of Bank Competition

In the decade following Jayaratne and Strahan (1996), research work in this field evolved in multiple directions, in which emphasis was directed at the explicit features and charac­ teristics of the banking industry. A relatively large amount of work, in particular, has been —and continues to be—dedicated to studying the role played by bank competition for the real economy. The reasons for the attention paid to this characteristic of the industry are twofold. First, in contrast to most industries, where the default is that market structure and competitive conduct evolve endogenously, the banking industry has historically been heavily regulated, and for the most varying reasons, both in the US and in other coun­ tries. Hence, it is plausible to make the case that this is an exogenously determined char­ acteristic of the industry when studying the impact on the real economy. Second, and not less important, there is a fascinating contrast of theoretical conjectures that can be for­ mulated about the effects of bank competition.5 Petersen and Rajan (1995) expressed very clearly the essence of this contrast. The authors challenged the conventional view that enhancing bank competition necessarily leads to better loan terms and better access to credit. The theoretical argument is that in fact banks need at least some degree of mar­ ket power to have the right incentives to undertake the proper investments in screening and monitoring necessary to resolve uncertainty about the quality of new entrepreneurs. The intuition is that in the absence of some ability to “capture” the client firm over time, a bank anticipates that an entrepreneur who turns out to be successful has the possibility to seek better terms from competing banks that would not need to incur any additional cost of screening and monitoring (or would spend just a fraction of what the original bank had to). Hence, in a highly competitive banking environment, banks would be required to charge loan terms reflecting the high intrinsic risk of the entrepreneurs. A bank with market power could instead offer better initial terms knowing that any upfront cost in starting such a lending relationship could be recuperated at later stages. The unconventional pre­ diction that follows is that firms, especially young ones, might have better access to cred­ it if they operate in more concentrated banking markets. This tension between incentives to screen and competition was formalized in a fullfledged, general equilibrium dynamic model of capital accumulation in Cetorelli and Peretto (2012). They show that because of this tension, the banking market structure that maximizes long-term economic growth is in fact neither perfect competition nor monop­ oly. Moreover, the “optimal” market structure itself varies at different stages of economic developments, and too much competition may also lead to the emergence of development traps in economies that otherwise would be characterized by unique equilibria. Another paper to focus on the role of bank competition for the real economy is Ce­ torelli and Gambera (2001). This paper explored the empirical relevance of the market structure of the banking sector for industrial growth. The authors took the basic crosssectional work initiated by King and Levine (1993) and then asked: if it is agreed that the size of the banking industry is important to capital accumulation, does it matter whether (p. 960)

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Banking and Real Economic Activity: Foregone Conclusions and Open Chal­ lenges the underlying industry structure is unconcentrated, thus approximating perfectly com­ petitive conditions, or whether instead market power is concentrated among a few bank­ ing institutions? From a theoretical standpoint, Cetorelli and Gambera played with the same antagonism of conjectures presented in Petersen and Rajan (1995). Their method­ ological approach built on the contribution of Rajan and Zingales (1998), in that they used a cross-country dataset but looked at the differential impact of bank concentration in a country across industrial sectors that, for their own idiosyncratic reasons, display a varying degree of dependence on external sources of finance for capital investment. The identification strategy is then based upon the intuition that if bank competition has a role, it should matter more for firms in sectors that are highly dependent on external finance availability. As in Rajan and Zingales (1998), by seeking such a differential effect, the identification strategy considerably raises the bar for potential objections on grounds of endogeneity, omitted variable biases, and reverse causality. The findings suggest a nontrivial impact of bank concentration on industrial growth and in fact simultaneous sup­ port for both sides of the theoretical controversy. First, there is evidence that bank con­ centration has a first-order negative effect on growth. This finding is consistent with the theoretical prediction that higher bank concentration results in a lower amount of credit available in the economy as a whole. Regardless of their external financial dependence, this effect is common to all industrial sectors. However, the paper also finds evidence that bank concentration has a heterogeneous effect across industries. In particular, sectors where young firms are more dependent on external finance enjoy a beneficial effect from a concentrated banking sector, which could actually more than compensate the first-or­ der, negative effect. This finding supports the basic argument in Petersen and Rajan (1995) predicting that concentration of market power in banking facilitates the develop­ ment of lending relationships, which have in turn an enhancing effect on firms’ growth.

30.6 Banks and Industry Dynamics in Product Markets As the research agenda on bank competition and the real economy picked up momentum, it also became more ambitious. Much current work has been done, for example, on under­ standing how bank competition can actually affect the life cycle dynamics of industrial sectors of production. For instance, does more bank competition mean more entry in nonfinancial industries? And what is the related impact for incumbent firms? (p. 961) Would changes in bank competition lead to structural changes in other industries, such as affect­ ing average firm size, or the whole firm size distribution? The framework proposed by Petersen and Rajan (1995) described above offers key in­ sights to develop conjectures regarding the role of bank concentration on industry con­ centration. In their reasoning, banks with market power have stronger incentives to fund unknown young firms. This would then suggest that entry should be enhanced when cred­ it markets are less competitive, and consequently industry competition should be fostered by market power in the credit sector. At the same time, the same setting could also pro­ Page 8 of 24

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Banking and Real Economic Activity: Foregone Conclusions and Open Chal­ lenges duce opposite predictions: the bank with market power facilitates entry of young firms with the expectations of rent extractions at later stages in their lifecycle. This rent extrac­ tion ability will be enhanced if those young firms maintain their own profitability at later stages, but that may imply in fact that banks with market power, once lending relation­ ships are established, will have incentives to preserve those relationships to firms that have become industry incumbents and constrain access to credit of newer entrants. As recognized in Petersen and Rajan (1995), market power gives banks an implicit equity stake in the firms they are already financing, and this implicit equity stake distorts their incentive to lend across firms in product markets. Using this alternative argument, then banking market power should lead to industry concentration. These alternative conjectures have been brought to the data. A first example is represent­ ed by Black and Strahan (2002).6 Regulatory action that removes entry barriers and leads to a more efficient and competitive banking industry should be reflected in a direct effect on entrepreneurship. More precisely, the entry rates of business entrepreneurships should be higher if the kind of deregulation illustrated above is followed. Using data on new business incorporations between 1976 and 1996, Black and Strahan compare the number of new incorporations, and the growth rate of new incorporations before and af­ ter deregulation, using the same identification methodology used in Jayaratne and Stra­ han (1996). The authors find that after deregulation, which first allowed banks freely to branch within a state, the number of new businesses increased by almost 10 percent, and its growth rate between 3 percent and 4 percent. Subsequent to deregulation that also al­ lowed banks to expand across state lines, the number of new businesses increased fur­ ther by about 6 percent, while there was no significant effect on the growth rate. The eco­ nomic impact on new business creation of opening up banking markets is therefore very large. Moreover, allowing more businesses to be in operation (p. 962) may be reflected in increasing output accumulation. Hence, analyzing the relationship between banking deregulation and business formation puts substance in the original goal of understanding the mechanism through which banking activity can affect real economic activity and ulti­ mately long-term economic growth. At the same time, going back to the theoretical conjectures outlined in section 30.5, while it is certainly consistent with theory that bank competition enhances business entry, it may not be inconsistent to speculate that banks may also have, as noted earlier, dimin­ ished incentives to screen and monitor entrepreneurs. Consequently, more entry may also be associated with higher mortality of young firms. A first take on this issue was present­ ed in Cetorelli (2003). The author used a public version of the US Bureau of the Census dataset on business establishments that contains information on age categories to test— among other things—the impact of banking deregulation on entry, but also on the persis­ tence rates of young businesses, as measured by rates of job destruction. The evidence was consistent with that presented by Black and Strahan (2002) on entry. Moreover, it suggested that the persistence of younger businesses was actually higher after deregula­ tion (hence, lower job destruction). In contrast, using the more detailed, confidential ver­ sion of the census data, Kerr and Nanda (2008) find that the failure rates (complete busi­ ness shutdown) of enterprises three years and younger are actually higher after deregula­ Page 9 of 24

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Banking and Real Economic Activity: Foregone Conclusions and Open Chal­ lenges tion. Since the authors also find evidence consistent with more entry, they interpret the combination of results as suggesting that improvements in bank competition favor a “de­ mocratization” of the entry process. That is, potential entrepreneurs have a greater chance to start a business but they do not necessarily have a greater chance of surviving and remaining in business. More work has been conducted related to the effects of bank competition on life cycle dy­ namics. In the above-mentioned paper, Cetorelli (2003) also looks at the growth rates of incumbent enterprises and at their own persistence rates. The evidence there suggests that less bank competition meant delayed exit of incumbent firms, a finding consistent with the idea exposed before that monopolistic banks may have distorted incentives in fa­ voring their older clients, thus preventing a healthier process of creative destruction. Still with a focus on life cycle dynamics, Cetorelli and Strahan (2006) attempted a broad analysis of the impact of more bank competition on a complete set of metrics of the mar­ ket structure of non-financial industries. The authors use US Census data between 1977 and 1994 on the number of business establishments and their size—measured by employ­ ment level—located in the different states and operating in any of the twenty two-digit Standard Industrial Classification (SIC) manufacturing sectors. Consistent with previous findings, they show evidence that more vigorous competition leads to more firms in oper­ ation. In addition, they also find that the average firm size decreases as banks become more competitive. Lower average firm size is consistent with the finding of more firms in operation, and both add strength to the idea that more bank competition favors entry and allows entry at a smaller scale. Moreover, they find that the whole firm size distribution is shifted, with an increase in mass toward smaller-size firms. The additional evidence on the size distribution adds con­ tent to the conjecture that the impact of improved competition may be felt differently by different firms—young or old, small or large—and in different sectors. More firms in operation and smaller average size could reflect entry by very small establish­ (p. 963)

ments. If that were simply the case, one would expect an increase in mass at the smallest end of the size distribution and declines in mass elsewhere in the distribution. If better bank competition also helps the existing small firms to grow (due to an overall increased supply of financial resources), then we ought to see a greater proportion not only of the smallest but also of medium-sized establishments as well. Moreover, testing for shifts in the whole size distribution allows us to compare how the shares of small and mediumsized (presumably bank-dependent) establishments behave relative to another sort of con­ trol group—namely, the share of the very largest establishments. These establishments (those with 1,000 or more employees) should not be affected by banking conditions be­ cause very large firms have access to nationwide (and competitive) securities markets. Thus, their fortunes should not vary with local credit conditions (Cetorelli and Strahan, 2006, p. 455). Finally, Cetorelli (2014) investigates whether the process of banking deregulation could be so important as to render firms after deregulation intrinsically different from those Page 10 of 24

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Banking and Real Economic Activity: Foregone Conclusions and Open Chal­ lenges that started their operations prior to deregulation. This idea, commonly referred to in cor­ porate demography as the “imprinting” effect, posits that in a time when external capital was relatively harder to obtain, prospective firms needed a set of organizational and man­ agerial characteristics that would increase their chance not only to obtain (scarcer) fi­ nancing, but also to survive in the event of constraints to obtaining additional credit. Con­ versely, after deregulation, and the removal of important frictions to credit supply, new firms may not need to develop the set of characteristics that were previously required, thus resulting in a group of intrinsically more fragile units. Cetorelli finds evidence con­ sistent with this conjecture. Firms born prior to deregulation seem to have a “thicker skin” than firms with similar characteristics born after deregulation. The material reviewed in this chapter has been developed using datasets drawn almost exclusively from US banks and US sectors of production. A legitimate criticism could be made about whether these conclusions have broader, international validity. Recent work based on specific country studies or cross-sections of non-US countries seems to confirm the findings examined so far. A very ingenious paper drawing extensively on the compari­ son of many decades of economic history is Haber (1991). The author essentially presents a horse race between Mexico, Brazil, and the US starting from the earliest stages of in­ dustrialization and then following the evolution of industrial structure in response to de­ velopments in capital markets. Haber focuses his attention on the evolution of the textile industry between approximately the 1840s and the 1930s. The reason to focus on such an industry is that, aside from the fact that it had a much higher relevance in the past, it also had specific characteristics (including low entry barriers, divisibility of capital, and scale efficiencies exhausted at small size) such that the industry was not naturally prone to en­ courage concentration. The only substantial barrier to entry was the ability to access ex­ ternal capital. Focusing on such industry represents a good case study to understand the finance–real economy relationship, because any change in the financial sector that may have occurred (p. 964) in the three countries could convincingly be argued not to be en­ dogenously determined by events in the textile industry. Haber documents very persuasively the relationship between efficiency, regulatory re­ forms—or lack thereof—in the financial sector, and the structure of the textile industry. Specifically, he shows that the US adopted important reforms of both the banking indus­ try and capital markets early on. In particular, the National Banking Act of 1863 induced significant entry in the banking industry that facilitated access to credit in the production sector. As Haber remarks, “by the end of World War I the textile industry was awash in fi­ nance and many companies took advantage of the swollen credit markets to float numer­ ous securities issues” (Haber, 1991, p. 564). The experience of Mexico was just the opposite. The textile industries, and production in general, had no access either to bank finance or to capital markets throughout a large part of the nineteenth century. When banks eventually emerged, they actually developed as institutions tightly connected to a limited number of entrepreneurs, who were them­ selves connected to government officials. Hence, external finance remained severely lim­ ited and differentially available in the market. The result was a textile industry that Page 11 of 24

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Banking and Real Economic Activity: Foregone Conclusions and Open Chal­ lenges evolved as highly concentrated. Brazil had a very similar experience and developmental trajectory as Mexico, at least initially. Financial markets were extremely underdeveloped, but in 1890 important reforms sowed the seeds for significant expansions of the banking sector and capital markets. As a result, the structure of the textile industry in Brazil in the first decades of the twentieth century looked a lot more like that of the US than that of Mexico. Another example of a non-US country study is the experience of France in response to the reform of the banking industry of 1985, analyzed by Bertrand, Schoar, and Thesmar (2007). The French reform reduced significantly government intervention in banks’ lend­ ing activity. This reform led naturally to a boost in efficiency in private banks and en­ hanced competition in the credit market. The reforms to the banking industry, the au­ thors document, generated important changes in the microeconomic behavior of firms and had a related strong impact on the structure of industries. In relation to the topics analyzed in this chapter, the authors show that the regulatory reform of the banking sec­ tor in France had a positive effect on firm entry and exit rates and a negative effect on product market concentration. Still in the field of banking reforms, but with a focus on Europe, Cetorelli (2004) investi­ gated the effect of the implementation of the Second Banking Directive of the European Union—a regulatory reform that essentially created the conditions for an integrated Euro­ pean banking market—on industrial structure. Cetorelli used a panel of manufacturing in­ dustries in twenty-nine Organisation for Economic Co-operation and Development (OECD) countries, both European Union and non-European Union members. The evi­ dence showed that enhanced competition in European Union banking markets led to mar­ kets in non-financial sectors characterized by lower average firm size. This conclusion is consistent with the findings in Cetorelli and Strahan (2006) and points at a beneficial ef­ fect of bank competition on credit access to young firms. (p. 965)

Finally, Beck, Demirgüç-Kunt, and Maksimovic (2004) use data from a World Bank

survey of firms in a large cross-section of countries. One of the questions the survey asked was whether firms had difficulty in obtaining credit. Matching this and other infor­ mation with the specific market structure of the banking sector where those firms were located, the authors found that higher bank concentration was associated with more fi­ nancing obstacles, especially for smaller firms. Two important points can be made regarding the role of bank competition in enhancing real economic activity. First, there does not seem to be a Pareto-dominant policy regard­ ing the optimal banking market structure: competition in banking does not necessarily dominate monopoly, and vice versa. Second, regulation of the financial industry is inti­ mately related to industrial policy. Depending on the level of concentration of the banking industry, ceteris paribus, individual sectors will grow at different speeds. Therefore, bank­ ing market structure plays an important role in shaping cross-industry size distribution within a country.

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Banking and Real Economic Activity: Foregone Conclusions and Open Chal­ lenges

30.7 Unintended Consequences of the Great Recession Both the extent and the geographic scope of economic destruction measured in the after­ math of the financial crisis of 2007–9 was only second to that experienced during the Great Depression. The event led to the reawakening of debates in the economic profes­ sion that had laid dormant for quite some time. Interestingly, it also led to a significant expansion in interest over the role of banks in the real economy.7 Perhaps most notably, this increase in popularity is found in the well-established literature that has attempted to account for and calibrate the impact of financial frictions in macroeconomic models. This literature goes at least as far back as Bernanke and Gertler (1989), Kiyotaki and Moore (1997), and Bernanke, Gertler, and Gilchrist (1999). The common theme is the at­ tempt to recognize explicitly the importance of financial market frictions as drivers of sig­ nificant cyclical behavior in real variables. However, these models feature financial fric­ tions that result from constraints on non-financial borrowers, with little focus, if any, on the roles played by financial intermediaries. This limitation was explicitly recognized in Gertler and Kiyotaki’s own words: “[this] literature with financial frictions emphasized credit market constraints on non-financial borrowers and treated intermediaries largely as a veil” (Gertler and Kiyotaki, 2010, emphasis added). In response to this deficiency, several papers have more recently augmented with finan­ cial intermediaries otherwise standard macroeconomic models. As the papers (p. 966) show, even relatively basic introductions of intermediaries into standard models can pro­ vide insights into the crisis and subsequent policy responses that earlier macro models could not touch. These powerful insights include: how financial intermediaries can ampli­ fy the effects of negative real shocks and delay recovery from them (Gertler and Kiyotaki, 2010); how the optimal practice of conventional monetary policy might be affected by the imperfections of intermediation (Cúrdia and Woodford, 2016); why the ex-post unconven­ tional stabilization policies practiced during the crisis can have beneficial macroeconomic effects (Gertler and Karadi, 2011); and how, in terms of the primitive demands of house­ holds for liquid assets, banking might be inherently unstable and within the purview of ex ante regulatory intervention (Stein, 2012). Gertler and Kiyotaki (2010) put “banks”—specialized entities that are by assumption nec­ essary to channel savings from households to investing firms—into a dynamic stochastic general equilibrium (DSGE) model. Banks can only raise funds by issuing short-term de­ posits to households, on which there is a friction similar to Bernanke and Gertler (1989) and Kiyotaki and Moore (1997)—namely, there is a moral hazard problem that creates an endogenous leverage constraint. They show that applying this friction to banks leads to standard financial accelerator effects: a real shock depletes the net worth of banks, which because of the leverage constraint and inability to raise outside equity forces banks to in­ termediate less loans, thereby decreasing investment and amplifying and delaying recov­ ery from the initial shock. As such, in Gertler and Kiyotaki’s (2010) model, rather than be­ Page 13 of 24

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Banking and Real Economic Activity: Foregone Conclusions and Open Chal­ lenges ing mere “veils,” banks are entities whose health (in particular, their net worth) is critical to the response of the economy to real shocks. Given that intermediaries can matter in such a way for the real allocation of resources, it is crucial to understand how policymakers should respond to the distortions caused by imperfections in the intermediation process. Cúrdia and Woodford (2016) analyze how bank financing frictions may alter the optimal conduct of conventional monetary policy. They augment a standard DSGE New Keynesian model with two features: heterogeneity in households, which creates a role for banks in transferring funds from saving house­ holds to borrowing households, and imperfections in intermediation (production costs and asymmetric information between the bank and borrowers) that induce a spread between the rate available to savers and that available to borrowers. They show that under certain conditions, though the central bank should still try to hit a flexible inflation target, it should put the saver–borrower spread into a forward-looking Taylor rule. In this way, Cúr­ dia and Woodford (2016) show that even in conventional monetary policy, a central bank that is looking to successfully meet a given inflation target should take financial imperfec­ tions into account. Aside from just factoring intermediary frictions into the conduct of standard monetary policy, central banks may be able to mitigate the effects of intermediary instability via un­ conventional policies—namely, direct asset purchases. Within a framework similar to Gertler and Kiyotaki (2010) that contains an identical bank financing friction, Gertler and Karadi (2011) show that direct purchases of risky assets by the central bank can have positive stabilization effects. Following a negative real shock that induces disintermedia­ tion by the same mechanism as in Gertler and Kiyotaki (2010), the central bank can use its unique ability to elastically raise funds to effectively replace at least part of the lost intermediation activity, lowering credit spreads and raising investment. Given the ex­ (p. 967)

tensive use of such a policy of direct asset purchases during the crisis (for instance, the Fed’s QE1 program) and the irrelevance of such a policy in models without financial fric­ tions (e.g., Wallace, 1981), Gertler and Karadi (2011) demonstrate the importance of con­ sidering intermediaries in understanding the full spectrum of policies employed by cen­ tral banks during the recent crisis. The instability of intermediaries may also create room for ex ante policies (as opposed to ex post ones like asset purchases) aimed at reducing bank risk-taking. Stein (2012) exam­ ines how banks’ role as creators of liquid liabilities may make them inherently unstable and within the purview of such ex ante stabilization policies. He assumes that households derive non-pecuniary benefits from liquid assets, and that only banks can supply these as­ sets. This creates a positive spread between risk-free bond rates and the rate on shortterm bank deposits, incentivizing banks to issue these deposits. But doing so is risky: de­ positors can refuse to roll over their debt following the realization of a negative shock, at which point banks will have to costly liquidate some of their assets at fire-sale prices. Within this framework, Stein (2012) shows that banks tend to produce more short-term debt than is socially optimal, since issuing more short-term debt, by worsening the firesale losses of other sellers, constrains the ex ante behavior of other banks and thus im­ Page 14 of 24

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Banking and Real Economic Activity: Foregone Conclusions and Open Chal­ lenges poses a negative externality. This creates a clear policy rationale for regulation that limits banks’ ability to create as much short-term debt as they otherwise would. Though Stein (2012) focuses on how conventional monetary policy (by changing the supply of reserves) can accomplish this objective, the point is broader: to the extent that banks satisfy some underlying demand for liquid assets, the banking sector inherently produces more finan­ cial risk than is socially optimal, justifying policy intervention that restricts banks’ behav­ ior. The preceding papers described in this section do not provide much insight on the role of intermediaries in inducing crisis dynamics within an economy. By this, we mean that al­ though these papers show how frictions imposed on bank intermediation can amplify and prolong the negative effects of a real shock, they are not as helpful in understanding how these frictions on intermediaries can force economies to move from normal steady states to environments characterized by non-linear effects of small shocks and widespread (“sys­ temic” as called by He and Krishnamurthy, 2017) financial risk. This is because the above papers (other than Stein (2012), which does not contain a full-fledged macro model) are solved with log-linearization techniques, which ensure that following a shock, the econo­ my must drift back toward its original steady state rather than change regimes or become unstable. This is unsatisfactory, given that the arguably distinguishing feature of financial crises is the transition from a state of normality to one of extreme risk, breakdown, and panic.8 (p. 968)

More sophisticated models of intermediation and financial frictions are thus need­

ed to capture the severity and suddenness that are characteristic of financial crises. Sev­ eral recent papers have shown how financial frictions can lead to drastic and abrupt breakdowns in intermediation that cause economies to spiral downward into panics and prolonged recessions. As a technical matter, allowing for regime changes and/or non-lin­ earity involves either considering the global dynamics of models (deriving stochastic steady states) and/or putting richer features of intermediation that generate non-linearity into the models. Brunnermeier and Sannikov (2014) and He and Krishnamurthy (2013) do the former by modeling financial constraints that only sometimes bind and solve for glob­ al dynamics, while Gertler and Kiyotaki (2015) do the latter by putting a variant of the classic bank run of Diamond and Dybvig (1983) into a macro model. Employing continuous-time methods, Brunnermeier and Sannikov (2014) extend the fi­ nancial accelerator models of Bernanke and Gertler (1989) and Kiyotaki and Moore (1997) to allow for persistent movements away from the steady state. Real shocks are found to have highly non-linear (and asymmetric) interactions with the financial frictions put on firms. Small shocks do not reduce firms’ net worth enough to knock the economy off its steady state, limiting the extent to which the frictions amplify the shock. But very large fundamental shocks destroy firms’ net worth to the point that the leverage con­ straint binds, putting the economy in a crisis regime in which the negative effects of the initial shock are very persistent and in which small additional shocks can have very large effects. Brunnermeier and Sannikov’s (2014) global analysis, combined with the endoge­ nous reaction of firms to different risk environments, also produces richer dynamics than Page 15 of 24

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Banking and Real Economic Activity: Foregone Conclusions and Open Chal­ lenges in past literature. For instance, they find a “volatility paradox,” wherein lower fundamen­ tal risk induces firms to increase their leverage by more during normal times, worsening the amplification of real shocks when they do occur. He and Krishnamurthy (2013) use similar techniques to build a model that shows how frictions on intermediaries’ outside funding can cause the economy to enter a crisis state in which even small real shocks induce spikes upward in risk premia. Similar to the fi­ nancing frictions in Brunnermeier and Sannikov (2014), the constraints on outside equity financing (derived as an optimal contract in He and Krishnamurthy (2012)) only bind once intermediary owners’ net worth has been sufficiently lowered. Since it is assumed that only intermediary owners have the expertise to invest in risky assets, in equilibrium intermediaries must hold the entire supply of risky assets on their balance sheets. When the constraint on outside equity binds, a negative shock forces intermediary owners to in­ crease their leverage (substituting outside debt for outside equity), which increases own­ ers’ exposure to the risky asset and thus leads to a higher equilibrium risk premium. As such, when the equity constraint starts to bind, the economy enters into a crisis region in which the relationship between real shocks and risk premia is much sharper and in which certain government policies employed during the (p. 969) crisis (such as equity injections into intermediaries and direct asset purchases) can have stabilizing effects. Occasionally binding financing constraints are not the only way that intermediary insta­ bility can generate non-linear crises. Gertler and Kiyotaki (2015) show how a potential feature of intermediation, much studied at the micro-level—bank runs—can also be a source of non-linear economic downturns. Their model features the same financing fric­ tion—one that causes an endogenous leverage constraint—as Gertler and Kiyotaki (2010). Banks fund themselves with short-term deposits, such that when households wish to re­ deem their deposits, banks must sell some of their assets. Because the households that banks sell assets to are assumed to be less efficient in managing capital, redemption of deposits causes losses to banks through fire-sale dynamics. If banks’ initial net worth is sufficiently low following a negative real shock, then there is a sunspot run equilibrium that would force banks to costly liquidate their entire asset holdings: the losses caused by all depositors running is enough to increase the banks’ leverage beyond the constrained (moral hazard-solving) level, incentivizing a depositor to run if she believes others will as well. In this way, Gertler and Kiyotaki (2015) show that banks’ financing frictions and re­ liance on short-term debt can together turn a small negative shock into a calamitous eco­ nomic downturn through the run-driven destruction of the banking system, particularly when the banking system is in a less than healthy shape to begin with. The above-mentioned studies have contributed to bridging the gap between macroeco­ nomics and banking and are testimony of a stronger and broader recognition of the role of financial intermediation activity in general for the real economy. And yet banking, and intermediation activity more broadly, are in continuous evolution. Many recent papers have shed light on the unique institutional, regulatory, and competitive micro-level char­ acteristics of intermediaries that seem most salient to their current interplay with real economy activity. A full survey of these papers is beyond the scope of this chapter. One Page 16 of 24

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Banking and Real Economic Activity: Foregone Conclusions and Open Chal­ lenges important and revealing example, though, is the emerging literature on how the industri­ al organization of the banking industry influences the effectiveness of monetary policy. Some papers in this literature have considered the impact of intermediary concentration on the markets involving bank assets. For instance, Scharfstein and Sunderam (2016) find that the mortgage rates and refinancing activity of higher-concentration US counties ex­ hibit lower sensitivities to changing yields of mortgage-backed securities, thereby blunt­ ing the transmission of monetary policy (both conventional and unconventional) to house­ holds. Other papers have focused on the market for bank liabilities, namely, deposits. Drechsler, Savov, and Schnabl (2017) develop and find supporting empirical evidence for a simple model in which banks with deposit market power raise the spread between their deposit rate and the risk-free nominal interest rate after a monetary tightening, since such a tightening makes holding cash more costly for households. This leads to deposit outflows and, with imperfect substitution between deposits and non-deposit liabilities, re­ duced loan volume. In this way, Drechsler, Savov, and Schnabl (2017) establish the poten­ tial existence of a “deposits channel” of monetary policy that provides (p. 970) an alterna­ tive to the reserve requirements-based bank lending channel of Bernanke and Blinder (1988). Brunnermeier and Koby (2018) explicitly consider how intermediaries’ deposit market power might affect the optimal conduct of monetary policy. They theoretically show that because such market power creates a positive relationship between nominal in­ terest rates and the net interest margins of banks, there exists a “reversal interest rate” below which additional interest rate cuts exert a contractionary effect on bank capitaliza­ tion and lending as well as, in turn, real activity. Aside from being insightful in their own right about how the competitive environment of intermediation may affect monetary poli­ cy, papers in this literature demonstrate the value and growing prevalence of studies that drill down into the interactions between the micro-level characteristics of intermediaries and real economic activity. But from an industry-wide perspective, the precise nature and structure of intermediation is subject to continuous and sometimes drastic change. Banking scholars must confront this “moving target” aspect of the mechanisms by which intermediation can affect real economic activity. Analyses of the financial crisis have indicated the rising importance of a model of intermediation based on a complex system of interconnected markets and enti­ ties operating, to a large extent, outside the perimeter of the banking regulator (what be­ came popularly known as shadow banking).9 The next step in the research agenda will re­ quire allowing for the endogenous emergence and evolution of financial intermediaries, and the evolution of their roles for real economic activity.10

30.8 Conclusions It is not by chance that Lucius Caecilius Jucundus established himself and prospered in the city of Pompeii. Pompeii was a well-developed center with close proximity to the sea and where markets were held on a regular basis. It is well recognized that bankers like him were instrumental in facilitating and developing commercial activity. And, while the contours of entrepreneurship in ancient Rome may not fit a modern profile, it is clear that Page 17 of 24

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Banking and Real Economic Activity: Foregone Conclusions and Open Chal­ lenges Jucundus and others still played a role in assisting productive activity (Andreau, 1999, pp. 145–52). The tale of Lucius Caecilius Jucundus serves as a good example to illustrate the crux of the debate around the role of banks for the real economy. It is certainly the case that banks—and financial activity—follow where real activity goes. The direction of causality (p. 971) from economics to finance, in other words, has never been seriously questioned. Much harder to prove is that banking can develop independently of what goes on in the real economy and that developments in the banking industry can in fact alter economic activity. The impulse to map these dynamics has inspired a lively body of literature, one that re­ flects not only the intrinsic intellectual interest on the issues at stake but also their vast policy implications. After all, the pervasive nature of policy control of the banking indus­ try rests on certain assumptions about banks’ fundamental role in the real economy. After more than two decades of rigorous research, we are now in a position to assert that bank­ ing does matter for real economic activity. We have not only learned that banking activity has a large impact on various measures of output growth but have also made important progress in understanding exactly how that happens. Developments in the way banks op­ erate bring with them far-reaching implications for economic activity. Pushing research further in this direction is expected to continue to yield significant results with no dimin­ ishing returns yet in sight.

References Andreau, J. (1999). Banking and Business in the Roman World (Key Themes in Ancient History), (trans. J. Lloyd) (Cambridge: Cambridge University Press). Beck, T. (2008). “Econometrics of Finance and Growth,” in T. Mills and K. Patterson (eds.), Palgrave Handbook of Econometrics (Basingstoke: Palgrave), 1180–212. Beck, T., Demirgüç-Kunt, A., and Maksimovic, V. (2004). “Bank Competition and Access to Finance: International Evidence,” Journal of Money, Credit, and Banking, 36, 627–48. Beck, T., Levine, R., and Loayza, N. (2000). “Finance and the Sources of Growth,” Journal of Financial Economics, 58, 261–300. Bernanke, B. and Blinder, A. (1988). “Credit, Money, and Aggregate Demand,” American Economic Review, 78, 435–9. Bernanke, B. and Gertler, M. (1989). “Agency Costs, Net Worth and Business Fluctua­ tions,” American Economic Review, 79, 14–31. Bernanke, B., Gertler, M., and Gilchrist, S. (1999). “The Financial Accelerator in a Quanti­ tative Business Cycle Framework,” in J. Taylor and M. Woodford (eds.), Handbook of Macroeconomics (Amsterdam: Elsevier), 1341–93.

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Banking and Real Economic Activity: Foregone Conclusions and Open Chal­ lenges Bertrand, M., Schoar, A., and Thesmar, D. (2007). “Banking Deregulation and Industry Structure: Evidence from the French Banking Reforms of 1985,” The Journal of Finance, 62, 597–628. Black, S.E. and Strahan, P.E. (2002). “Entrepreneurship and Bank Credit Availability,” Journal of Finance, 57, 2807–33. Boot, A.W.A. and Thakor, A.V. (2000). “Can Relationship Banking Survive Competition?” Journal of Finance, 55, 679–713. Boyd, J. and De Nicolo, G. (2005). “The Theory of Bank Risk-Taking and Competition Re­ visited,” Journal of Finance, 60, 1329–43. Brunnermeier, M. and Koby, Y. (2018). “The Reversal Interest Rate,” Working Paper. Brunnermeier, M. and Sannikov, Y. (2014). “A Macroeconomic Model with a Financial Sec­ tor,” American Economic Review, 104(2), 379–421. (p. 972)

Cameron, R. (1967). Banking in the Early Stages of Industrialization (New York:

Oxford University Press). Capie, F. and Rodrik-Bali, G. (1982). “Concentration in British Banking, 1870–1920,” Busi­ ness History, 24, 280–92. Cecchetti, S.G. and Kharroubi, E. (2012). “Re-assessing the Impact of Finance on Growth,” Bank of International Settlements Working Paper No. 382. Cetorelli, N. (2003). “Life-Cycle Dynamics in Industrial Sectors. The Role of Banking Mar­ ket Structure,” Federal Reserve Bank of St. Louis Review, 85, 135–47. Cetorelli, N. (2004). “Real Effects of Bank Competition,” Journal of Money, Credit and Banking, 36, 543–58. Cetorelli, N. (2014). “Surviving Credit Market Competition,” Economic Inquiry, 52, 320– 40. Cetorelli, N. and Gambera, M. (2001). “Banking Market Structure, Financial Dependence and Growth: International Evidence from Industry Data,” Journal of Finance, 56, 617–48. Cetorelli, N. and Peretto, P.F. (2012). “Credit Quantity and Credit Quality: Bank Competi­ tion and Capital Accumulation,” Journal of Economic Theory, 147, 967–88. Cetorelli, N. and Strahan, P. (2006). “Finance as a Barrier to Entry: Bank Competition and Industry Structure in Local US Markets,” Journal of Finance, 61, 437–61. Cohen, J. (1967). “Financing Industrialization in Italy, 1894–1914,” Journal of Economic History, 27, 363–82.

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Banking and Real Economic Activity: Foregone Conclusions and Open Chal­ lenges Cúrdia, V. and Woodford, M. (2016). “Credit Frictions and Optimal Monetary Policy,” Jour­ nal of Monetary Economics, 84, 30–65. Dell’Ariccia, G. and Marquez, R. (2004). “Information and Bank Credit Allocation,” Jour­ nal of Financial Economics, 72, 185–214. Diamond, D. and Dybvig, P. (1983). “Bank Runs, Deposit Insurance, and Liquidity,” Journal of Political Economy, 91(3), 401–19. Drechsler, I., Savov, A., and Schnabl, P. (2017). “The Deposits Channel of Monetary Poli­ cy,” Quarterly Journal of Economics, 132, 1819–76. Economides, N., Hubbard, G.R., and Palia, D. (1996). “The Political Economy of Branching Restrictions and Deposit Insurance: A Model of Monopolistic Competition Among Small and Large Banks,” Journal of Law & Economics, 39, 667–704. Gertler, M. and Gilchrist, S. (2018). “What Happened: Financial Factors in the Great Re­ cession,” Journal of Economic Perspectives, 32, 3–30. Gertler, M. and Karadi, P. (2011). “A Model of Unconventional Monetary Policy,” Journal of Monetary Economics, 58, 17–34. Gertler, M. and Kiyotaki, N. (2010). “Financial Intermediation and Credit Policy in Busi­ ness Cycle Analysis,” Handbook of Monetary Policy, 3, 547–99. Gertler, M. and Kiyotaki, N. (2015). “Banking, Liquidity, and Bank Runs in an Infinite Horizon Economy,” American Economic Review, 105, 2011–43. Haber, S. (1991). “Industrial Concentration and the Capital Markets: A Comparative Study of Brazil, Mexico, and the United States, 1830–1930,” Journal of Economic History, 51, 559–80. Hauswald, R. and Marquez, R. (2006). “Competition and Strategic Information Acquisi­ tion in Credit Markets,” Review of Financial Studies, 19, 967–1000. He, Z. and Krishnamurthy, A. (2012). “A Model of Capital and Crises,” Review of Econom­ ic Studies, 79, 735–77. He, Z., and Krishnamurthy, A. (2013). “Intermediary Asset Pricing,” American Economic Review, 103, 732–70. He, Z. and Krishnamurthy, A. (2017). “A Macroeconomic Framework for Quantifying Sys­ temic Risk,” Working Paper. Jayaratne, J. and Strahan, P.E. (1996). “The Finance–Growth Nexus: Evidence from Bank Branch Deregulation,” Quarterly Journal of Economics, 111, 639–70. (p. 973)

Kane, E.J. (1996). “De Jure Interstate Banking: Why Only Now?” Journal of Money, Credit, and Banking, 28, 141–61. Page 20 of 24

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Banking and Real Economic Activity: Foregone Conclusions and Open Chal­ lenges Kerr, W. and Nanda, C. (2008). “Democratizing Entry: Banking Deregulation, Financing Constraints and Entrepreneurship,” Journal of Financial Economics, 94, 124–49. King, R.G. and Levine, R. (1993). “Finance and Growth: Schumpeter Might Be Right,” Quarterly Journal of Economics, 108, 717–37. Kiyotaki, N. and Moore, J. (1997). “Credit Cycles,” Journal of Political Economy, 105, 211– 48. Kroszner, R.S. and Strahan, P.E. (1999). “What Drives Deregulation? Economics and Poli­ tics of the Relaxation of Bank Branching Restrictions,” Quarterly Journal of Economics, 114, 1437–67. La Porta, R., Lopez-de-Silanes, F., Shleifer, A., and Vishny, R. (1998). “Law and Finance,” Journal of Political Economy, 106, 1113–55. Levine, R. (1998). “The Legal Environment, Banks, and Long Run Economic Growth,” Journal of Money, Credit, and Banking, 30, 596–613. Levine, R. (1999). “Law, Finance and Economic Growth,” Journal of Financial Intermedia­ tion, 8, 8–35. Levine, R. and Zervos, S. (1998). “Stock Markets, Banks, and Economic Growth,” Ameri­ can Economic Review, 88, 537–58. Levine, R., Loayza, N., and Beck, T. (2000). “Financial Intermediation and Growth: Causal­ ity and Causes,” Journal of Monetary Economics, 46, 31–77. Lucas, R. (1988). “On the Mechanics of Economic Development,” Journal of Monetary Economics, 22, 3–42. Manove, M., Padilla, J., and Pagano, M. (2001). “Collateral vs. Project Screening: A Model of Lazy Banks,” RAND Journal of Economics, 32, 726–44. Marquez, R. (2002). “Competition, Adverse Selection, and Information Dispersion in the Banking Industry,” Review of Financial Studies, 15, 901–26. Mayer, C. (1988). “New Issues in Corporate Finance,” European Economic Review, 32, 1167–83. Miller, M.H. (1998). “Financial Markets and Economic Growth,” Journal of Applied Corpo­ rate Finance, 11, 8–14. Morgan, D.P., Rime, B., and Strahan, P.E. (2004). “Bank Integration and State Business Cycle,” Quarterly Journal of Economics, 119, 1555–85. Pagano, M. (1993). “Financial Markets and Growth. An Overview,” European Economic Review, 37, 613–22.

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Banking and Real Economic Activity: Foregone Conclusions and Open Chal­ lenges Petersen, M.A. and Rajan, R.G. (1995). “The Effect of Credit Market Competition on Lend­ ing Relationships,” Quarterly Journal of Economics, 110, 407–43. Rajan, R.G. (1992). “Insiders and Outsiders: The Choice Between Informed and Arm’sLength Debt,” Journal of Finance, 47, 1367–400. Rajan, R.G. and Zingales, L. (1998). “Financial Dependence and Growth,” American Eco­ nomic Review, 88, 559–86. Robinson, J. (1952). The Rate of Interest and Other Essays (London: Macmillan). Scharfstein, D. and Sunderam, A. (2016). “Market Power in Mortgage Lending and the Transmission of Monetary Policy,” Working Paper. Schumpeter, J. (1911). The Theory of Economic Development: An Inquiry into Profits, Cap­ ital, Interest, and the Business Cycle (trans. Redverse Opie) (Brunswick, NJ: Transaction Books, 1983). (p. 974)

Shaffer, S. (1998). “The Winner’s Curse in Banking,” Journal of Financial Interme­

diation, 7, 359–92. Stambaugh, J.E. (1988). The Ancient Roman City (Baltimore, MD: Johns Hopkins Universi­ ty Press). Stein, J. (2012). “Monetary Policy as Financial Stability Regulation,” Quarterly Journal of Economics, 127, 57–95. Wallace, N. (1981). “A Modigliani-Miller Theorem for Open-Market Operations,” American Economic Review, 71, 267–74. White, E. (1998). “The Legacy of Deposit Insurance: The Growth, Spread, and Cost of In­ suring Financial Intermediaries,” in M. Bordo, C. Goldin, and E.N. White (eds.), The Defin­ ing Moment: The Great Depression and the American Economy in the Twentieth Century (Chicago, IL: University of Chicago Press), 87–124. Woodford, M. (2010). “Financial Intermediation and Macroeconomic Analysis,” Journal of Economic Perspectives, 24(4), 21–44. Zingales, L. (2003). “Commentaries to More on Finance and Growth: More Finance More Growth? by Ross Levine,” Federal Reserve Bank of St. Louis Review, 85, 31–46.

Notes: (1) As a term of reference, in that same period, a laborer’s wage was 2–4 sesterces per day, and the average price for the purchase of a slave was 2,000 sesterces (Stambaugh, 1988). (2) For a good illustration of the econometrics of the finance and growth literature, see Beck (2008). Page 22 of 24

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Banking and Real Economic Activity: Foregone Conclusions and Open Chal­ lenges (3) In a related paper, Morgan, Rime, and Strahan (2004) focused on the impact of bank deregulation for macroeconomic stability, testing the response of state-specific measures of business cycle volatility to the deregulation events. They find that volatility drops sub­ stantially, between 30 and 40 percent, after deregulation. (4) A parallel paper that should also be considered as a turning point, although focusing on the broader relationship between overall financial development and economic growth, is Rajan and Zingales (1998). (5) The basic ideas behind the Petersen and Rajan contribution were already present in Schumpeter (1911) and formulated in Mayer (1988). For additional theoretical work see, e.g., Rajan (1992), Pagano (1993), Shaffer (1998), Manove, Padilla, and Pagano (2001), Marquez (2002), Dell’Ariccia and Marquez (2004), Boot and Thakor (2000), Boyd and De Nicolo (2005), and Hauswald and Marquez (2006). (6) Studies in economic history had previously addressed the relationship between bank­ ing and industry concentration, usually finding a positive link. Examples are the study of Italian industrialization in the late nineteenth century by Cohen (1967), Capie and RodrikBali (1982) on British banking in the early 1890s, Haber (1991) on Mexico between 1830 and 1930, and Cameron (1967), summarizing that “competition in banking is related to the question of competition in industry. In general the two flourish—and decline—togeth­ er. Whether this phenomenon is a joint by-product of other circumstances, or whether it results from the decline or restriction of competition among banks, is a matter worthy of further research. It is a striking coincidence, in any case, that industrial structure—com­ petitive, oligopolistic, or monopolistic—tends to mirror financial structure” (Cameron, 1967, p. 313). (7) And also to some suggestions that “too much” banking in fact may not be good for the real economy (see, e.g., Cecchetti and Kharroubi, 2012). (8) Gertler and Gilchrist (2018) summarize this point, and how it has been informed by the recent crisis, as follows: “Financial crises are highly nonlinear events. They feature sharp increases in credit spreads and sharp contractions in asset prices and output. There is no symmetric movement in these variables during booms. Further, the sharp con­ traction of the economy during a financial crisis often occurs in the absence of an imme­ diate large non-financial shock to the economy, as was the case recently for the U.S. econ­ omy following the Lehman Brothers bankruptcy.” (9) See, for example, Chapter 17, of this volume. (10) Woodford (2010) recognizes this explicitly: “Neither standard macroeconomic models that abstract from financial intermediation nor traditional models of the ‘bank lending channel’ are adequate as a basis for understanding the recent crisis. Instead, we need models in which intermediation plays a crucial role, but in which intermediation is mod­ eled in a way that better conforms to current institutional realities. In particular, we need models that recognize that a market-based financial system—one in which intermediaries Page 23 of 24

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Banking and Real Economic Activity: Foregone Conclusions and Open Chal­ lenges fund themselves by selling securities in competitive markets, rather than collecting de­ posits subject to reserve requirements—is not the same as a frictionless system.”

Nicola Cetorelli

Nicola Cetorelli is a Vice President at the Federal Reserve Bank of New York and the Head of the Financial Intermediation Function in its Research Group. His research has focused on the industrial organization and the corporate finance characteristics of the banking industry and the relationships with real economic activity. More re­ cently he has worked on themes of international banking and on the evolution of fi­ nancial intermediation. He represents the New York Fed on various Financial Stabili­ ty Boards’ international working groups. He has published in a number of scholarly journals, among which the Journal of Finance, Journal of Economic Theory, American Economic Review, and Journal of International Economics. He has also written many articles in various policy journals and book chapters. He received his Ph.D in Eco­ nomics from Brown University and a B.A. from the University of Rome, Italy. Michael Blank

Michael Blank is a Ph.D candidate in Business Economics at Harvard Business School. Previously, he served as a senior research analyst at the Federal Reserve Bank of New York.

Page 24 of 24

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Banking in the United States

Banking in the United States   Robert DeYoung The Oxford Handbook of Banking (3rd edn) Edited by Allen N. Berger, Philip Molyneux, and John O. S. Wilson Print Publication Date: Oct 2019 Subject: Economics and Finance, Financial Economics, Urban, Rural, and Regional Economics Online Publication Date: Nov 2019 DOI: 10.1093/oxfordhb/9780198824633.013.31

Abstract and Keywords The past forty years has witnessed a near total transformation of the US banking indus­ try, as well as a near total disaster. The bank regulatory framework established during the Great Depression was dismantled, new technologies revolutionized how banks produce and distribute financial services, and dramatic increases in competition have pressured banks to operate more efficiently. The population of commercial banks has been halved by a wave of acquisitions and the largest banks have increased ten-fold in size. A strategic dichotomy has emerged, with small ‘community’ banks providing person-to-person retail and small business banking services, and large commercial banks providing high-volume retail banking services in domestic markets and corporate and investment banking ser­ vices around the world. These changes have brought great efficiencies to the banking in­ dustry and its customers, but have also introduced new instabilities to the system. A decade of historically high profits was followed by large investment losses and govern­ ment bailouts during the financial crisis of 2008–9. A partial re-regulation of the industry has followed, and both bankers and policymakers seek to balance market efficiencies with financial stability as this dynamic industry moves further into the twenty-first century. Keywords: bank regulation, banking strategies, commercial banks, financial crisis, United States banks

31.1 Introduction IN the United States, the concept of “banking” has meant different things at different times. For much of the twentieth century, financial services were delivered by a potpourri of rigidly regulated financial institutions operating in largely non-overlapping industry sectors. Commercial banks and other depository institutions offered the greatest array of financial services and held the majority of industry assets. More specialized sectors, such as insurance companies, pension funds, and brokerage firms, offered narrower menus of financial services and held smaller shares of the nation’s financial assets.

Page 1 of 29

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Banking in the United States Now almost two decades into the twenty-first century, the US financial services landscape looks quite different. Commercial banks and savings institutions—referred to generically as “banks” in this chapter—accounted for 52 percent of all privately held financial assets in 1980, three and four times the shares of the next two largest sectors, insurance compa­ nies and pension funds (see Table 31.1). But by 2017 banks’ share of financial assets had slid to just 27 percent, about the same as the share of total assets held by mutual funds.

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Banking in the United States Table 31.1 Distribution of Financial Assets in the US Across Private Sector Financial Intermediaries in 1980 and 2017 % Share of US financial assets

% Annualized growth rate

1980

2017

Banksa

51.9

27.1

6.5

Insurance companies

15.6

11.4

7.5

Pension funds

13.5

11.5

7.9

Mortgage companies and fundsb

7.5

13.2

10.1

Finance companies

5.1

1.8

5.4

Mutual funds

3.5

27.3

14.6

Securities firmsc

1.5

6.1

12.7

Credit unions

1.4

1.6

8.8

Total US financial as­

100.0

100.0

8.6

Growth rate of GDP

–

–

5.2

Growth rate of non-de­ posit-related non-inter­ est income at commer­ cial banksd

–

–

8.1

sets Memo:

a

Includes US-chartered commercial banks and bank holding compa­ nies, US-chartered savings institutions, and foreign banking offices operating in the US or in US-affiliated areas.

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Banking in the United States b

Includes financial assets held by government-sponsored enterprises (GSEs) and other issuers of asset-backed (predominantly mortgagebacked) securities, the mortgage pools that they sponsor, and real es­ tate investment trusts (REITs). c

Includes financial assets held by brokers, dealers, investment banks, and funding corporations. d

Includes all non-interest income less service charges on deposit ac­ counts. Note: All data are expressed in nominal terms (not adjusted for infla­ tion). Sources: Federal Reserve System Flow of Funds Accounts, National Information Center (call reports), Bureau of Economic Analysis, and author’s calculations. There was no single cause for these substantial changes in the distribution of US finan­ cial assets. New information and communications technologies, changes in bank produc­ tion functions, deregulation, expanded financial markets, increased competition among fi­ nancial institutions, and changes in the US tax code all played a role. Assets held by mutual funds—still a relatively new investment option for small savers in 1980—grew at an astounding 14.6 percent annual rate from 1980 through 2017. The de­ mand for mutual funds was driven largely by the onset of tax-preferred treatment for selfmanaged retirement savings (individual retirement accounts, or IRAs), and coincided with a secular shift from defined-benefit to defined-contribution pension programs in the US. With more households managing their own retirement funds, the share of (p. 978) finan­ cial assets held by private pension funds (defined-benefit plans) and insurance companies (annuities) have both declined, despite greater overall demand for retirement finance from an aging US population. The rise of credit scoring and mortgage securitization fu­ eled increases in home ownership and mortgage indebtedness; as a result, mortgage-re­ lated financial intermediaries grew by 10 percent per year and nearly doubled their share of US financial assets. The high-yield bond market, the commercial paper market, the syndicated loan market, and the NASDAQ stock exchange all grew by orders of magni­ tude from 1980 to 2017, providing large commercial firms with alternative non-bank funding sources. When the dust had settled, large portions of banks’ retail bank deposits, mortgages, and business loans had migrated, respectively, to mutual funds, securitized mortgage pools, and market-based funding sources. It is important to note that as these shifts were taking place, the US banking sector still managed to expand in real terms between 1980 and 2017. Banks grew at a 6.5 percent average annual rate, faster than the 5.2 percent annual growth rate of US GDP. The de­ cline in banks’ relative share of financial assets merely reflects the even more rapid Page 4 of 29

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Banking in the United States expansion of US financial markets in general, and more specifically the extraordi­ nary growth of financial assets held by mutual funds, securities firms, and mortgagebased financial intermediaries. Additionally, this narrow focus on assets understates banks’ importance in the US financial system. For example, let us compare banks with mutual funds, each of which hold similar shares of US financial assets. Mutual funds pro­ vide their customers with investment returns in exchange for limited liquidity and varying amounts of principal risk. In contrast, banks provide their customers with low-risk, lowreturn investment services (time deposits, money market accounts), complete liquidity (transactions accounts), safe-keeping (insured deposits), and access to credit (commer­ cial, real estate, and consumer loans and lines). Moreover, banks provide a range of finan­ cial services not reflected by the assets on their balance sheets, such as securities broker­ age and underwriting, asset securitization, wealth management, insurance policies and annuities, loan servicing, foreign exchange, as well as mutual fund sales. Income from banks’ fee-for-service activities grew at a roughly 8.1 percent annual rate between 1980 and 2017, nearly as fast as the overall growth rate of US financial assets at 8.6 percent. (p. 979)

Hence, commercial banks are broad financial intermediaries that compete directly with the product offerings of nearly every other type of financial intermediary in the US. De­ spite holding a reduced share of financial assets in today’s highly competitive, post-dereg­ ulation environment, commercial banks remain arguably the most important single inter­ mediaries in the US financial system. Because of this, in this chapter we will use commer­ cial banks as the prism through which to view the larger US “banking” industry.

31.2 The Evolution of the US Banking Industry A full understanding of the US banking industry today requires knowledge of the shocks that the industry has experienced over the past four decades. Today’s banks and the con­ ditions under which they operate would be barely recognizable to a banker from the 1970s. Still, change continues and it is often rapid. Two decades after Berger, Kashyap, and Scalise (1995) alluded to it as such, the US banking industry is still on “a long, strange trip.”

31.2.1 Restrictive Government Regulations For the better part of the twentieth century, US banks were insulated from geographic competition, product competition, and price competition. The McFadden Act of 1927 pro­ tected banks from competitors outside their home states by prohibiting interstate (p. 980) branch banking, and most states imposed at least some restrictions on intrastate branch­ ing. By prohibiting commercial banks from engaging in insurance, underwriting, and bro­ kerage activities, the Glass–Steagall Act of 1933 effectively prevented competition be­ tween commercial banks and non-depository institutions (insurance companies, invest­ ment banks, brokerage firms). Furthermore, depository institutions that made residential mortgage loans (thrifts, credit unions) were not permitted to make commercial loans. And

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Banking in the United States the Federal Reserve’s Regulation Q imposed interest rate ceilings on most deposit ac­ counts, effectively prohibiting price competition for deposit accounts. Largely shielded from competition, commercial banks and other depository institutions were remarkably stable places from the 1930s into the 1980s. Of the five basic financial needs of a typical household—credit, investments, payments, safekeeping, and insurance —commercial banks were dominant providers of all but insurance products. In 1983 (the first year these data were available from the Federal Reserve’s Survey of Consumer Fi­ nance), US households kept approximately 23 percent of their total assets at depository institutions—in deposit certificates, savings accounts, and checking accounts—and ob­ tained approximately 60 percent of their mortgage and consumer credit from depository institutions. Most large and mid-sized businesses relied on commercial banks as their main source of long-term debt and short-term credit; so-called “community banks” with less than $1 billion of assets (about $1.55 billion in 2018 dollars) specialized in small busi­ ness lending. Despite their small size, community banks were strategically dominant in most cities and states, accounting for 98 percent of all commercial bank charters and 39 percent of all commercial bank assets in 1980. The US payments system was largely pa­ per-based at the time, and with tens of thousands of brick-and-mortar branch locations, community banks provided much of the infrastructure necessary for processing checks and distributing and collecting cash. The US commercial banking industry was a crucially important sector, but it was any­ thing but dynamic. Indeed, the phrase “3-6-3 banking” was sometimes used to character­ ize the industry, in which bankers paid 3 percent on deposits, charged 6 percent on loans, and were on the golf course by 3 o’ clock.

31.2.2 Innovation and Change The quiet life ended for US commercial bankers when a parade of financial innovations began to erode their traditional competitive advantages. The earliest of these innovations was the money market mutual fund (MMMF). MMMFs transform large-denomination money market instruments—for example, commercial paper, negotiable CDs, and Trea­ sury bills—into smaller denomination investments that are affordable by the average household. MMMFs allowed investors limited check-writing privileges and unlike banks were not subject to regulatory interest rate ceilings. When tight Federal Reserve mone­ tary policy pushed money market interest rates as much as 10 percentage points above the Regulation Q rate ceilings in the late 1970s, household funds flowed out of bank de­ posit accounts and into MMMFs. Deposit outflows limited the amount of loans that banks could hold on their bal­ ance sheets. Banks addressed this problem by utilizing three other financial innovations that emerged in the US between 1970 and 1990: Retail loan securitization (mortgage se­ curitizations in 1970, automobile loan securitizations in 1985), personal credit scoring (Fair Isaac FICO scores in 1989), and syndicated lending (leveraged buyout loans in the mid-1980s). (p. 981)

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Banking in the United States In the most common type of retail loan securitization, a free-standing investment pool or trust issues mortgage-backed securities (MBS) to investors and uses the proceeds to pur­ chase hundreds of residential mortgage loans from the banks that originate them. MBS investors earn returns based on the interest and principal payments generated by the mortgage loans in the pool. Banks earn loan origination fees and loan servicing fees, avoid the interest expense of funding the mortgages, and largely avoid exposure to credit risk and prepayment risk. If banks wish to capture some of the interest income from the securitized mortgages, they can do so by purchasing MBS for their own balance sheets— as many banks did. Loan securitization essentially allowed banks to expand their mortgage lending business without having to raise new equity capital; under these new conditions, many banks found it attractive to ramp-up their mortgage originations (Frame, Srinivasan, and Woosley, 2001; Berger, Frame, and Miller, 2005). As long as banks’ variable expenses of originating and servicing mortgage loans were lower than the fees they collected for per­ forming these tasks, the net difference would contribute directly to higher returns on their existing equity capital. Thus, securitizing banks had strong incentives to drive down their costs of screening new mortgage loan applications and drive up the number of mort­ gage applications they processed. Traditional methods for deciding which mortgage ap­ plicants should be accepted or rejected were expensive because they were labor-inten­ sive; instead, banks began making these decisions based on the personal credit scores of the loan applicants, leaving increased mistakes in credit risk assessment to be diversified away in the MBS pools and/or priced into the MBS contracts.1 Large retail banks enjoyed substantial economies of scale by adopting this “originate-and-sell” model for all of their retail credit operations (i.e., mortgages, auto loans, credit cards). The expansion of public debt (bonds) and credit (commercial paper) markets in the 1980s and 1990s provided new financing options for the largest business clients of US commer­ cial banks. But the development of syndicated loan markets in the mid-1980s allowed commercial banks to remain competitive in large business finance. A loan “syndicate” is comprised of multiple financial institutions, which provide the financing for a large loan that is underwritten and arranged by a single lead bank. This structure replicates many of the characteristics of market finance. A syndicated loan typically (p. 982) combines a term loan (more like a bond) with a revolving line of credit (more like commercial paper). By spreading the funding across multiple financial institutions, the loan syndicate can provide debt finance comparable to the size of a bond issue, while allowing each syndi­ cate member to diversify its own credit risk exposures. Moreover, syndicated loans trade in over-the-counter secondary markets, which reduces the liquidity risk of syndicate members. During this same time frame, advances in information and communications technologies were laying the foundation for a revolution in payments services. Automated teller ma­ chines (ATMs) provided increased convenience for retail deposit customers by allowing them to withdraw cash or deposit checks around the clock. And because ATMs provided a cheap substitute for human tellers, and served as a revenue center when used by cus­ Page 7 of 29

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Banking in the United States tomers of other banks, they increased the efficiency of bank branches. DeYoung, Hunter, and Udell (2004) showed that commercial bank branches became markedly more produc­ tive during the 1980s—assets, operating income, and the number of transactions per banking office all increased—which in part explains why the total number of bank branch­ es in the US kept increasing even as the total number of banks was decreasing (see Fig­ ure 31.1). But ATMs were just the first of a series of cost-reducing payment innovations. During the 1990s, the number of checks processed in the US declined by about 3 percent per year, replaced by an increase in electronic payments. Credit card transactions in­ creased by 7 percent per year, debit card transactions increased by 36 percent per year, and bill payments and paycheck deposits through the Federal Reserve’s automated clear­ inghouse (ACH) increased by 14 percent per year (Gerdes and Walton, 2002; Humphrey, 2002; Berger, 2003). More recently, Internet-based payments are burgeoning. Not only do bank cus­ tomers increasingly prefer to make payments online, this trend has reduced banks’ costs of producing payments services. The variable cost of a basic Internet banking transaction is just a tiny fraction of the cost of an in-person banking transaction, and there is evi­ dence that having an Internet banking presence enhances the bank’s profitability (DeY­ (p. 983)

oung, 2005; DeYoung, Lang, and Nolle, 2007). The rapid growth of online banking is an important reason why the number of US bank branches has finally stopped increasing.

Figure 31.1 Number of Commercial Banks and Com­ mercial Bank Branch Offices* in the US between 1940 and 2017. Source: Federal Deposit Insurance Corporation. *Excludes

the main bank office.

31.2.3 Deregulation By the early 1980s, it became clear that banking regulations designed during the 1920s and 1930s were inappropriate for the new financial, technological, and competitive land­ scapes—not to mention the historically high interest rates engineered by Paul Volcker’s Federal Reserve. Federal and state legislatures responded by dismantling fifty years of re­ strictive bank regulations. Price controls on bank deposit rates were removed, geograph­

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Banking in the United States ic barriers to bank expansion were lifted, and constraints on bank product powers were relaxed. The Depository Institutions Deregulation and Monetary Control Act of 1980 began a sixyear process of removing the Federal Reserve’s Regulation Q ceilings on bank interest rates, while the Garn–St. Germain Depository Institutions Act of 1982 authorized both banks and thrifts to begin offering money market deposit accounts (MMDAs).2 These two pieces of legislation allowed banks to compete with MMMFs, staunching the outflow of bank deposits. Between 1980 and 1994, thirty-two states liberalized geographic restrictions on banking and branching within and across their borders; by the end of the 1980s, all but six states allowed some sort of interstate banking. In 1994, the US Congress passed the Riegle-Neal Interstate Banking and Branching Efficiency Act, which effectively repealed federal geo­ graphic banking restrictions (the McFadden Act) and harmonized the patchwork of stateby-state banking and branching rules. These changes set off an historic wave of commer­ cial bank mergers and acquisitions. According to the Federal Deposit Insurance Corpora­ tion (FDIC), there were about 346 commercial bank M&As (of non-failing banks) in the US per year during the 1980s, about 495 bank M&As per year during the 1990s, and about 286 bank M&As per year during the 2000s (see Figure 31.2). Most of these transac­ tions were market-extension mergers in which banks both increased their assets and ex­ panded their geographic footprints. For the first time, the US had large multi-state bank­ ing companies. (p. 984) 3

Figure 31.2 Aggregate Return-on-Equity and Equityto-Assets Ratios for the US Commercial Banking In­ dustry, 1934 to 2017. Source: Federal Deposit Insurance Corporation.

An expansion of commercial banks’ product powers followed. In 1987, the Federal Re­ serve permitted commercial bank holding companies to underwrite limited amounts of corporate equity and debt securities. In 1999, Congress effectively repealed the Glass– Steagall Act when it passed the Graham–Leach–Bliley Financial Services Modernization Act, which granted broad-based securities and insurance powers to commercial banking companies. Large multi-state banks were quicker than community banks to take advan­ Page 9 of 29

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Banking in the United States tage of these new powers—especially in investment banking, which the overseas units of US commercial banks had been providing for some time. Importantly, these new powers included underwriting mortgage-backed securities, which allowed large US banks to launch fully integrated originate-and-sell banking businesses.

31.2.4 The Financial Crisis The US commercial banking industry appeared to be healthy, safe, and sound in the mid-2000s. On the aggregate, returns on assets and equity had been historically high for over a decade, and retained earnings had boosted equity capital ratios 75 percent higher than they had been in 1980 (see Figure 31.3). If banks were about to suffer a large set­ back, these large reservoirs of equity capital were thought to be more than adequate to cushion the blow. This was a mistaken notion. (p. 985)

Figure 31.3 Merged Banks, Newly Chartered Banks, and Failed Banks, Expressed as a Percentage of the US Commercial Bank Population, each Year from 1970 to 2017. Source: Federal Deposit Insurance Corporation.

Home real estate prices increased dramatically in the US starting in the late-1990s—as measured by the Case-Shiller Home Price Index, single-family residential properties more than doubled in price from 1998 to 2006—but inevitably the bubble burst. US home prices began a steep decline in 2007, and homeowners began defaulting on their mort­ gage loans in record numbers. Trillions of dollars of MBS backed by subprime loans—that is, loans to households with poor credit histories, little collateral, and questionable longrun abilities to service the loans—plunged in value, imposing large losses on the portfo­ lios of commercial banks, investment banks, and other institutional investors that held them. Aggregate earnings of commercial banks fell to around zero in both 2008 and 2009, and the banks that were most exposed to residential real estate failed in large numbers. The collateral damage to the US economy was enormous. The residential construction sector collapsed. Investors refused to roll over the short-term commercial paper and Re­ po financing that had been keeping large investment banks afloat, sending shock waves through financial markets. Commercial banks rationed credit to small and medium-sized businesses (DeYoung et al., 2015). Real GDP growth was negative in both 2008 and 2009 Page 10 of 29

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Banking in the United States and the official US unemployment rate hit 10 percent in October 2009. The damage spread quickly to European economies, where many financial institutions had invested heavily in securities (MBS) backed by US real estate loans. US bank regulators took a series of unprecedented policy actions to prevent a systemic collapse of the financial sector. The Federal Reserve (among other actions too numerous to detail here) opened wide its discount window and created new lending facilities; tem­ porarily guaranteed all investments in money market mutual funds against (p. 986) losses; pledged to purchase up to $600 billion in GSE-issued MBS from financial institutions; and for the first time since the Great Depression began lending directly to non-financial firms by purchasing their newly issued commercial paper.4 The era of the large investment bank business model was brought to an end: The Fed subsidized JPMorgan Chase’s acqui­ sition of the insolvent Bear Stearns, but oddly offered no assistance to Lehman Brothers, which ended up filing for bankruptcy. Both Goldman Sachs and Morgan Stanley convert­ ed themselves into financial holding companies—in essence, accepting the costs of being regulated and supervised by the Federal Reserve, in exchange for access to the Fed’s dis­ count window and the ability to issue inexpensive insured deposits. The US Treasury na­ tionalized Fannie Mae and Freddie Mac; provided $150 billion in loans and other support to prop up and eventually nationalize American International Group, the largest insur­ ance company in the US; and gained authority under the Troubled Assets Relief Program (TARP) to inject up to $700 billion into commercial banks via equity injections and pur­ chases of mortgage-backed securities. The FDIC increased deposit insurance coverage from $100,000 to $250,000 per bank account; provided billions of dollars of open bank as­ sistance to prevent the insolvency of Citigroup, at the time the largest banking company in the world; and used a variety of innovative approaches to seize and resolve hundreds of insolvent banks and thrifts without bankrupting its Bank Insurance Fund. The above actions were ad hoc and largely temporary, aimed at calming investor fears and keeping financial markets open and operating. More permanent legislative responses to the financial crisis came only later. The new laws were predicated on the twin beliefs that US banking companies were to blame for the financial crisis and that the harmful ac­ tions taken by banks would not have happened if banks had not earlier been deregulated. But this is only half of the story. To be sure, commercial banks and other mortgage-lend­ ing firms did greatly increase the supply of mortgage credit, taking advantage of the highly efficient originate-and-sell lending model.5 And these lenders were assisted in their actions by the Riegle–Neal and Gramm–Leach–Bliley Acts. The former allowed banks to grow across state lines, achieving the large size needed to fully exploit the efficiencies of credit scored, high-volume mortgage origination. The latter gave banks the investment banking powers needed to securitize those mortgage loans, and hence integrate the en­ tire transactions banking model in-house and keep the fee income generated at each stage of the process. But other players also bear a large portion of the responsibility for the housing bubble. The initial impetus came from federal government housing policies aimed at making home ownership universally possible across all US households. Crucially, during the Page 11 of 29

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Banking in the United States 1990s both Fannie Mae and Freddie Mac (the two largest mortgage GSEs) re­ ceived mandates to make large investments in affordable (i.e., low-income) mortgage loans and MBS. This channeled hundreds of billions of dollars of new funding into mort­ gage markets, laying the foundation for increased mortgage borrowing and higher home prices. Homeownership rates rose from 64 percent in the early 1990s to a peak of 69 per­ cent just prior to the financial crisis, and much of this increase was financed with sub­ prime loans. The Federal Reserve ran an especially accommodative monetary policy dur­ ing much of 2001 through 2005, and these low interest rates encouraged households of all income levels to purchase higher priced homes and/or take on greater amounts of mortgage debt. And finally, the demand to purchase houses was further stoked by a bub­ ble psychology that convinced homeowners and real estate speculators alike that home prices could only go up. (p. 987)

31.2.5 Re-regulation Having approved spending in the neighborhood of $1 trillion to help stabilize financial in­ stitutions in the short-term, the US Congress took long-term actions with the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010. Stated simply, Dodd–Frank reregulated the US banking system. It was aimed at reducing the likelihood of commercial bank failures, safeguarding retail purchasers of financial services, and insulating US tax­ payers from the private risks taken by commercial banking companies. Among other changes, Dodd–Frank: Limited proprietary trading at large commercial banks and encour­ aged banks to use central clearing houses for derivatives contracts; required banks that securitize their loans to hold a portion of those securitized assets on their own balance sheets; imposed capital penalties for banks that make mortgage loans that carry monthly payments that stress borrowers’ financial capacities; gave the new Consumer Financial Protection Bureau (CFPB) broad regulatory and enforcement powers over the design and terms of consumer financial products; under Federal Reserve oversight, required large commercial banks to pass annual macroeconomic stress tests; obligated commercial banks, not taxpayers, to replenish any future losses incurred by the Bank Insurance Fund; and granted the FDIC “orderly liquidation authority” to seize, operate, and eventually liq­ uidate large insolvent commercial banking and financial holding companies without bail­ ing out shareholders, bondholders, or bank management. The tighter capital and liquidity rules in the 2010–11 Basel III accords complemented the tighter operating regulations in Dodd–Frank. Under Basel III, all banks must maintain higher capital ratios; systemically important banks face extra-high capital thresholds; and banks are required to accumulate larger capital buffers during economic expansions, to be drawn upon during economic downturns. Basel III for the first time imposes liquidity requirements on banks: A minimum liquidity coverage ratio (LCR) to guard against liquid­ ity runs in the short-term, and a minimum net stable funding ratio (NSFR) to prevent banks from developing structural liquidity imbalances in the longer term. (p. 988) It is im­ portant to note that US bank regulators, unlike their European counterparts, are exempt­ ing small banks from complying with the new liquidity rules in Basel III. Page 12 of 29

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Banking in the United States

31.3 Two Strategic Groups At this point in the evolution of the financial services industry, most of the commercial banks in the US are practicing one of two different broad business strategies. Figure 31.4 offers a highly stylized version of this strategic landscape (DeYoung, Hunter, and Udell, 2004). While this framework overlooks many of the subtleties found in the US banking in­ dustry, we shall see that it is quite consistent with the observable structure, behavior, and performance of US commercial banks.

Figure 31.4 Strategic Map of the Banking Industry.

A bank can choose to locate anywhere on this strategic map. If it wants to practice origi­ nate-and-sell banking, then it will locate near the bottom of the map on the left-hand side. This business model requires a bank to be large enough to exploit the scale economies available from credit-scored lending and other standardized financial products.6 Despite their large sizes, these banks ironically have very little pricing power, (p. 989) because they sell essentially the same commodity-like products as their large bank competitors, that is, loans that are so similar that they can be securitized and sold in secondary mar­ kets. But these large banks have very low unit costs, so this low-price strategy is finan­ cially viable. If a bank wants to practice traditional originate-and-hold banking, then it will locate near the top of the map on the right-hand side. This business model requires a bank to be small, which prevents them from achieving scale economies. But small size is essential for this model: It allows banks to establish in-person customer relationships, from which the bank can extract the idiosyncratic information necessary to produce customized products and services. The customers that are attracted to these banks value this personalized treatment—but moreover, the personalized treatment creates switching costs (inelastic demand) that banks can exploit by actually charging higher prices. This offsets the high unit costs of these banks, so this high value-added strategy is also financially viable.

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Banking in the United States There are three other strategic locations in Figure 31.4, but each of these is logically un­ tenable. The upper left-hand corner is financially unsustainable, because small banks with high unit costs cannot earn profits by selling standardized financial products at low prices. The lower right-hand corner is a strategic contradiction, because (given current technology) operating at large size is antithetical to establishing and sustaining in-person relationships. And banks operating at the very center of the map are, in the words of Michael Porter (1985), “stuck in the middle” without any strategy at all. This strategic map conforms closely to financial data from US commercial banks. Table 31.2 compares “small” commercial banks with assets between $500 million and $2 billion to “large” banks with assets greater than $10 billion. The data in the table suggest that small banks are in fact using a traditional relationship-based approach. They hold their loans on-balance rather than securitize them, make more loans to small businesses that require in-person financial attention, and rely more on customer deposits to fund their lending. Consistent with a high value-added approach, they are able to earn higher inter­ est income from their loans. And they derive their profits largely from net interest in­ come, and rely less on non-interest income.

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Banking in the United States Table 31.2 Comparing the Average Values of Selected Financial Ratios between 434 Small and 56 Large US Commercial Banks in 2017a “Small” banks

“Large” banks

Number of banks

424

65

Asset range

$500 million to $2 billion

more than $10 billion

Average assets

$0.949 billion

$121.5 billion

Net income (% of assets, ROA)

0.96

0.98

Net income (% of equity, ROE)

9.07

8.68

Book equity (% of assets)

10.59

11.98***

Net interest income (% of

4.24***

3.42

Interest income (% of as­ sets)

3.82***

3.10

Interest expense (% of as­

0.41***

0.32

17.04

24.80***

Deposit service charges (%)

27.51***

21.07

Fiduciary income (%)

7.82

11.72*

Trading income (%)

0.12

4.82***

Fee for service incomeb (%)

8.90

11.97**

assets)

sets) Non-interest income (% of operating income) Composition of non-inter­ est income (sums to 100%):

Page 15 of 29

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Banking in the United States Other non-interest income (%)

55.65**

50.42

Loans (% of assets)

69.67***

64.08

Deposits (% of assets)

83.66***

76.01

Small business loans (% of loans)

6.32***

3.79

Securitized loans (% of consumer loans)

0.98

15.17**

a

Each of the banks in this analysis operated with either a state or a federal commercial banking charter. If a bank was affiliated with a bank holding company, it was included only if it was the largest bank (i.e., the “lead bank”) in their organization. Banks less than ten years old were excluded to insure that all banks in the analysis were finan­ cially mature. Banks investing more than ten percent of their assets in either agricultural loans or credit card loans were also excluded, as these banks tend to face idiosyncratic market conditions and/or use more specialized production functions. b

Fee income from investment banking, insurance sales and under­ writing, loan servicing, and mutual fund sales. The superscripts *** and ** indicate that the number is statistically larger than the number in the opposing column at the 1% and 5% lev­ els, respectively. Source: National Information Center (call reports) and author’s calcu­ lations. In contrast, the data suggest that large banks are using a less traditional transactionsbased approach. They securitize a large portion of their loans and they rely less than small banks on customer deposits to fund their balance sheets. The net interest margins at these banks are thin, consistent with a commodity-based lending approach carried out in highly competitive product markets. But their low interest earnings are offset by their high non-interest income, generated in large part from providing fiduciary activities, se­ curities trading and brokerage, investment banking activities, loan servicing, and selling insurance and mutual fund products. Despite the fundamental strategic differences between these two sets of banks, they are equally profitable as measured by return on assets (ROA) and return on equity (ROE). (p. 990) This suggests a strategic equilibrium in which both business models are financial­ Page 16 of 29

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Banking in the United States ly viable—a large number of small relationship-based banks existing alongside a small number of large transactions-based banks. Goddard et al. (2014) analyzed the changes in the number and relative sizes of US commercial banks between 1980 and 2010, and found that banks were clustering over time in patterns consistent with this strategic di­ chotomy. While this strategic analysis captures the fundamental forces acting in the US commer­ cial banking industry both today and over the past several decades, like most good mod­ els it is an oversimplification of reality. Some interesting and potentially important counter-examples exist. For example, most large banking companies offer customized, re­ lationship-based services to a subset of their customers, such as investment banking (p. 991) services for corporate clients and private banking services for high wealth house­ holds. Along similar lines, most small banks employ hard information—such as personal credit scores, audited financial statements, or posted collateral—to complement their oth­ erwise relationship-based approach to small business lending. Banks in both strategic groups have incentives to creep closer to the lower right-hand corner of the map whenever possible. Small banks encourage their customers to use on­ line banking and other impersonal delivery channels, in an attempt to reduce the high costs of delivering otherwise in-person relationship banking. Large banks run imagebased advertising campaigns to differentiate themselves in the minds of their customers, in an attempt to support higher prices for their otherwise standardized financial prod­ ucts. In the longer run, one can imagine a bank production function that combines big da­ ta with artificial intelligence to deliver relationship banking to households and small busi­ nesses without the necessity of a physical person-to-person service. If this ever comes to pass, then the strategic dichotomy illustrated in Figure 31.4 and demonstrated in Table 31.2 would collapse, and the industry would converge to the lower right-hand corner of the map, with large banks offering customized banking services at low costs.

31.4 Industry Consolidation Continues The US commercial banking industry continues to consolidate. During the short 2010 to 2017 time period, the population of commercial banks declined by nearly one-quarter, as the industry continued to shift from very small banks to mid-sized and larger banks (see Figure 31.5). About 44 percent of the banks with assets less than $100 million in 2010 ei­ ther exited or outgrew this size category, as did about 17 percent of the banks with assets between $100 and $500 million. But the number of banks with assets between $500 mil­ lion and $2 billion increased by about 8 percent, which suggests the following regarding the most efficient size for banks practicing relationship-based community banking: Scale economies appear to be economically large for banks with assets less than $100 million; scale economies remain important for larger banks but diminish considerably as banks approach the $500 million mark; and scale economies have at most second-order impor­ tance for community banks that are larger than this.

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Banking in the United States

(p. 995)

Figure 31.5 The Changing Distribution of US Commercial Banks by Asset Size (in 2009 dollars) between 1980 and 2017. Source: National Information Center (call reports) and author’s calculations.

Small commercial banks also face increasingly fierce competition from credit unions in the US. Credit unions are cooperatively owned, not-for-profit depository institutions that have historically specialized in consumer lending. Credit unions also tend to be very small (about 75 percent of credit unions have assets below $100 million) but they are exempt from paying corporate income taxes. Credit unions use their tax savings to offer higher interest rates to their members, which attracts depositors away from small commercial banks. Moreover, in recent years credit unions have gained permission (p. 992) from regu­ lators to expand their membership bases and to increase lending to small businesses. Kim and McKillop (Chapter 11, this volume) provide a deeper discussion of credit unions and other financial cooperatives. Thus, there is every reason to believe that the number of very small community banks will dwindle further in the coming decade. While some of these tiny banks may remain prof­ itable as dominant banks in small rural towns—where they can use their local market pricing power to offset their very high unit costs—they are simply too small to be finan­ cially viable in most competitive settings. In very sharp contrast, between 2010 and 2017 the number of commercial banks with assets greater than $2 billion increased by about 35 percent (see Figure 31.5). Banks in this size class comprise only about 3 percent of the population of all depository institutions, but they hold about 87 percent of all depository assets in the US (see Figure 31.6). While this heavy concentration of assets raises con­ cerns about systemic risk, there is little evidence of pricing power in local banking mar­ kets. For the most part, banks became this large by making market-extension mergers, in which they purchased banks in states where they did not previously operate. This method of expansion changed the ownership of the acquired banks but had no impact on local Page 18 of 29

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Banking in the United States market shares. Hence, US antitrust authorities have little justification for halting industry consolidation, even though the largest US banks have increased by about ten times in size since 1990. (p. 993) 7

Figure 31.6 Commercial Banks, Savings Banks, and Credit Unions in the US in 2017. Note: Panel A shows the relative number of firms. Panel B shows the distribution of assets across those firms. Commercial banks are split into small banks with assets < $2 billion and large banks with assets > $2 billion. Source: Federal Deposit Insurance Corporation and Credit Union National Association.

The very largest US banking companies are also large by global standards. At year-end 2017, eleven US banks were ranked among the top 100 banking companies in the world (see Table 31.3).8 And US banking companies dominate global investment banking. The five largest investment banks in the world are all US banking companies, with a com­ bined 33 percent global market share (see Table 31.4).

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Banking in the United States Table 31.3 Largest US Banking Companies as of December 31, 2017 by Total Assets ($ billions) Assets ($ billions)

World ranking (derivatives netted)

World ranking (derivatives not netted)

JPMorgan Chase & Co.

2,533

6

4

Bank of America Corp.

2,281

9

7

Wells Fargo & Co.

1,951

11

12

Citigroup Inc.

1,842

13

10

Goldman

917

35

23

951

38

24

US Bancorp

462

63

64

PNC Finan­ cial Services

391

71

71

Bank of New York Mellon Corp.

372

73

72

Capital One Financial Corp.

366

76

76

State Street Corp

238

100

100

Sachs Group Inc. Morgan Stanley

Group Inc.

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Banking in the United States Note: World rankings based on two accounting methods: US account­ ing standards which allows banks to net counterparty derivative expo­ sures, and international accounting standards under which counter­ party derivative exposures are not netted. Source: S&P Global Market Intelligence. Table 31.4 Global Investment Banking Revenue in 2017 Rank

Bank

Global revenue ($ billions)

% Global mar­ ket share

1

JP Morgan

6.61

8.1

2

Goldman Sachs & Co

5.84

7.2

3

Bank of America Merrill Lynch

4.99

6.1

4

Morgan Stanley

4.74

5.8

5

Citi

4.36

5.4

6

Credit Suisse

3.69

4.6

7

Barclays

3.47

4.3

8

Deutsche Bank

2.63

3.2

9

UBS

1.81

2.2

10

RBC Capital Mar­ kets

1.78

2.2

Note: US Banking Companies are in bold. Source: Dealogic. Despite their competitive success both at home and abroad, large US banks have histori­ cally exhibited substantial levels of risk. With their high and largely un-hedged exposures to real estate-backed investments, their liberal use of financial leverage, their dispropor­ tionate reliance on noninterest income (see Table 31.2), and the illiquidity of their bal­ ance sheets, large US banks were far riskier than small banks going into the 2008–9 fi­ Page 21 of 29

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Banking in the United States nancial crisis.9 Four of the ten largest commercial banking companies in the US became insolvent during the financial crisis and either had to be acquired (Wachovia, Washington Mutual) or bailed out by government capital injections (Bank of America, Citigroup). Three of the five largest investment banks in the US (Merrill Lynch, Bear Stearns, Lehman Brothers) became illiquid and/or insolvent during the crisis. By contrast, only about 6 percent of commercial banks smaller than these behemoths failed during or after the crisis. The primary objective of bank re-regulation discussed above was to reduce the riskiness of large banking companies. The data plotted in Figure 31.3 show how re-regulation has affected large bank condition and performance. (Given that the largest banks in the US hold the lion’s share of industry assets, these aggregate industry data closely track large banks.) While financial leverage had been on the decline at US banks since the late-1980s, there was a clear and sustained jump to higher equity-to-assets ratios in (p. 994) expectations of the coming Basel III Accords (2010–11). At the same time, indus­ try ROA declined to the 1 percent range, from its higher pre-crisis range of about 1.2 per­ cent, a change that is consistent with bank activity restrictions imposed in the Dodd– Frank Act (2010). Taken together, these data are consistent with a reduction in large bank risk due to both less financial risk (lower leverage) and less business risk (lower ROA).

31.5 The Future of Banking in the US In your author’s opinion, two issues stand out as most important for the future of the US banking industry: The impact of FinTech on competition among all commercial banks, and the regulatory challenges of large insolvent commercial banks.

31.5.1 FinTech The greatest unknown facing commercial banks is the extent to which advancements in information and communications technologies will alter the competitive landscape of the banking industry. “FinTech” is a catch-all term for new technologies that allow non-bank­ ing companies to produce and/or deliver financial services from outside the traditional banking system. It is a fearsome word that keeps some bankers awake at night. Among other potential disruptors, FinTech’s leading edge includes new payments systems that circumvent the banking system, “big data” models for screening loan applications, substi­ tuting cryptocurrencies for fiat currencies, and the inexorable expansion of mobile fi­ nance applications.10 To predict how banks are likely to respond to the current competitive threats posed by FinTech, it is useful to review banks’ past reactions to similar phenomena. Two examples are instructive: credit scoring and discount brokerage.

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Banking in the United States Credit scores can be thought of as early antecedents of using big data to measure credit risk. The initial credit-scoring model was introduced in 1989 by the data analytics firm Fair Isaac and Company (FICO), based on consumer information from the credit bureaus Experian, Equifax, and TransUnion. US banks rapidly adopted FICO scores to screen, or help screen, their mortgage and consumer loan applications. Eventually, some of the larg­ er banks entered the market, using internal data on customer credit histories to build their own credit scoring models. Banks used consumer credit scores to reduce the amount of skilled labor time necessary to screen consumer loan applications (i.e., mort­ gages, credit cards, auto loans), and in competitive markets these production efficiencies were passed along as lower interest rates and fees on consumer loans. Thus, credit scor­ ing was instrumental in expanding the size of consumer credit markets for both banks and non-bank lenders. Discount brokerage is a low cost, low value-added business strategy for producing retail securities trading services. Traders do their own research, go online to enter their buy or sell orders, and are charged a low fixed fee per trade. These online trading platforms be­ gan appearing in the late-1980s, and enabled non-banking companies like (p. 996) Charles Schwab, Fidelity, and E*Trade to rapidly grow their retail brokerage businesses. Although these low-price firms did take away some business from higher priced traditional finan­ cial institutions, the primary effect was to expand the retail brokerage market by making trading affordable for moderate-income households. A number of large US commercial banking companies (e.g., Wells Fargo, US Bancorp, Bank of America) responded by launching their own online discount brokerage platforms. These examples illustrate that, while new financial technologies developed outside of the banking industry may at first appear to pose a competitive threat, the efficiencies gener­ ated by these innovations can end up benefiting banks nimble enough to adapt. And while large banks—with greater R&D resources and financial expertise—have adapted more quickly than small banks, these technologies have nonetheless spread quickly to smaller banks, via competition among financial services venders. As FinTech innovators begin to operationalize big data credit risk models, and introduce the next generation of platforms for the delivery and analysis of financial services, this history is likely to repeat itself. The future of FinTech in payments services is less predictable. Commercial banks have long had a legal near-monopoly on payments services, because (a) bills and other finan­ cial obligations are paid with money, (b) households and businesses store their money in bank accounts where it is safe from theft and bank failure, and (c) the money in question is the US dollar which has stable value in the short- to moderate-run. These advantages have made commercial banks and other depository institutions the central players in pay­ ments services such as check clearing, direct deposit, automatic bill pay, and debit cards.11 Moreover, even the largest nonbank payments providers—such as Visa, Master­ Card, and American Express—cannot operate without banks. Merchants that accept cred­ it cards receive payments into their bank accounts from their customers’ banks, and cred­ it card users have the option of financing their purchases with loans from their banks.

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Banking in the United States However, if a FinTech payments innovation allowed merchants and customers to bypass the banking system—and thus not require users to have bank deposit accounts—this would pose a serious competitive threat to commercial banks. New electronic monies, known as “cryptocurrencies,” could make non-bank payments systems possible. Cryp­ tocurrencies can be stored in non-bank “wallets,” transferred to merchants in exchange for goods and services over the web, and, if necessary, converted to and from dollars on independent cryptocurrency exchanges. But these non-bank payments systems have thus far failed to gain much traction, largely because of the instability of the electronic curren­ cies on which they are based. The value of a Bitcoin, the best known of the cryptocurren­ cies, has fluctuated wildly. Over the two-year period from July 2016 to July 2018, Bitcoin rose from a low of $600 to a high of $19,000 and then back down to $6,000. Non-bank payments systems based upon cryptocurrencies cannot be viable (p. 997) until the curren­ cies upon which they are based stop being speculative investments and start being stores of value.

31.5.2 Resolving Large Banks Despite regulators’ best efforts to make banks failure-proof by mandating high levels of equity capital and low levels of business risk, bank failures are inevitable. Eventually, one or more large complex banks will fail due to risks that are unforeseen today—just like the risks associated with real estate securitization were unforeseen by bankers and regula­ tors prior to the financial crisis. To prepare for this eventuality, the Dodd–Frank Act gave the FDIC new “orderly liquidation authority (OLA)” to seize systemically important finan­ cial institutions (SIFIs) upon their insolvency and then resolve these institutions without bailing them out. The key objective is to defuse the systemic riskiness of the failed finan­ cial institution while shutting it down, and thus avoid financial market disruptions or fi­ nancial damage to other banks. To implement OLA, the FDIC has proposed a “single point of entry” approach in which it will: (1) seize the insolvent holding company, (2) fire senior management, (3) impose a 100 percent loss on stockholders, (4) impose further losses on bondholders and other creditors, and (5) place the assets and remaining liabilities of the holding company into a temporary bridge bank structure with a three-year charter. The FDIC will hire new man­ agers to run the bridge holding company and its affiliates (e.g., the commercial bank, the investment bank, the brokerage, or the insurance company). These temporary managers will use the information contained in the “resolution plans” (which under Dodd–Frank must be revised annually and kept on file) to wind down financial contracts and otherwise stabilize the holding company and its affiliated firms. The bridge institution will receive additional funding from the FDIC as needed to finance the affiliate operations while they are being stabilized. The FDIC will interfere as little as possible with the day-to-day oper­ ations of these affiliated firms, other than to make sure that insured bank deposits suffer no losses. Once stabilized, management will sell off the holding company, as a whole or in parts, to healthy financial institutions without any further expense to the FDIC.

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Banking in the United States Ordinary liquidation authority is designed to resolve failed systemically important banks in a transparent, credible, and disciplinary fashion. If allowed to work, OLA would yield four substantial benefits. Because none of the principal players at the failed bank (share­ holders, uninsured creditors, or senior managers) would be bailed out or receive any sub­ sidies, a sense of fairness would be re-established with the banking public. Because no banking company would any longer be too-big-to-fail or too-complex-to-resolve, moral hazard incentives would decline and bank risk-taking associated with those incentives would be reduced. Because actually shutting down large insolvent banks would establish regulatory credibility, participants in financial markets would know what to expect (and what not to expect) during financial downturns, and this reduction in market uncertainty would limit systemic risk. And because it would identify (p. 998) and minimize the spillover costs from large bank failures, a credible post-failure resolution policy would make room for less pre-failure prudential regulation, thus easing regulatory burden on the industry. But there is a real danger that the OLA resolution approach will not be fully and faithfully implemented during a crisis. The Dodd–Frank Act requires that the Treasury Department, the Federal Reserve, and the FDIC must mutually agree to implement OLA on an insol­ vent banking company; if one or more of these agencies feels that a bailout is the prefer­ able course of action, then an OLA resolution will not occur. This eventuality is most plau­ sible during a severe financial crisis when the fear of short-run disruptions from multiple large bank insolvencies is considered more costly than the long-run damage from allow­ ing large banks to operate with too-big-to-fail incentives.

31.6 In Summary The past forty years has witnessed a near total transformation of the US banking indus­ try, punctuated by the near total disaster of the financial crisis. The bank regulatory framework established during the Great Depression was dismantled, new technologies revolutionized how banks produce and distribute financial services, and dramatic increas­ es in competition have pressured banks to operate more efficiently. The population of commercial banks has been halved by a wave of acquisitions and the largest banks have increased ten-fold in size. A strategic dichotomy has emerged, with small “community” banks providing person-to-person retail and small business banking services, and large commercial banks providing high-volume retail banking services in domestic markets and corporate and investment banking services around the world. These changes have brought great efficiencies to the banking industry and its customers, but have also intro­ duced new instabilities to the system. A decade of historically high profits was followed by large investment losses and government bailouts during the financial crisis of 2008–9. A partial re-regulation of the industry has followed, and both bankers and policymakers now seek to balance market efficiencies with financial stability as this dynamic industry moves further into the twenty-first century.

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Banking in the United States

References Berger, A.N. (2003). “The Economic Effects of Technological Progress: Evidence from the Banking Industry,” Journal of Money, Credit, and Banking, 35, 141–76. Berger, A.N., Frame, W.S., and Miller, N.H. (2005). “Credit Scoring and the Availability, Price, and Risk of Small Business Credit,” Journal of Money, Credit, and Banking, 37, 191– 222. Berger, A.N., Kashyap, A.K., and Scalise, J.M. (1995). “The Transformation of the US Banking Industry: What a Long, Strange Trip It’s Been,” Brookings Papers on Economic Activity, 2, 55–218. (p. 999)

Clark, T., Dick, A., Hirtle, B., Stiroh, K., and Williams, R. (2007). “The Role of Re­

tail Banking in the US Banking Industry: Risk, Return, and Industry Structure,” Economic Policy Review—Federal Reserve Bank of New York, 13, 39–56. Davies, R. and Tracey, B. (2014). “Too Big To Be Efficient? The Impact of Implicit Funding Subsidies on Scale Economies in Banking,” Journal of Money, Credit and Banking, 46(s1), 219–53. Demirgüç-Kunt, A. and Huizinga, H. (2010). “Bank Activity and Funding Strategies: The Impact on Risk and Returns,” Journal of Financial Economics, 98, 626–50. DeYoung, R. (2005). “The Performance of Internet-based Business Models: Evidence from the Banking Industry,” Journal of Business, 78, 893–947. DeYoung, R. and Roland, K.P. (2001). “Product Mix and Earnings Volatility at Commercial Banks: Evidence from a Degree of Total Leverage Model,” Journal of Financial Intermedi­ ation, 10, 54–84. DeYoung, R., Gron, A., Torna, G., and Winton, A. (2015). “Risk Overhang and Loan Portfo­ lio Decisions: Small Business Loan Supply Before and During the Financial Crisis,” Jour­ nal of Finance, 70, 2451–87. DeYoung, R., Hunter, W.C., and Udell, G.F. (2004). “The Past, Present, and Probable Fu­ ture for Community Banks,” Journal of Financial Services Research, 25, 85–133. DeYoung, R., Lang, W.W., and Nolle, D.L. (2007). “How the Internet Affects Output and Performance at Community Banks,” Journal of Banking and Finance, 31, 1033–60. Federal Deposit Insurance Corporation (2012). FDIC Community Banking Study, Decem­ ber. Frame, W.S., Srinivasan, A., and Woosley, L. (2001). “The Effect of Credit Scoring on Small Business Lending,” Journal of Money, Credit, and Banking, 33, 813–25.

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Banking in the United States Gerdes, G.R. and Walton, J.K. (2002). “The Use of Checks and Other Retail Noncash Pay­ ments in the United States,” Federal Reserve Bulletin, August, 360–74. Goddard, J., Liu, H., McKillop, D., and Wilson, J.O.S. (2014). “The Size Distribution of US Banks and Credit Unions,” International Journal of the Economics of Business, 21, 139– 56. Hughes, J. and Mester, L. (2013). “Who Said Banks Don’t Experience Scale Economies? Evidence From a Risk–Return-Driven Cost Function,” Journal of Financial Intermediation, 22, 559–85. Humphrey, D. (2002). “US Cash and Card Payments Over 25 Years,” Florida State Univer­ sity, unpublished manuscript. Kroszner, R.S. and Melick, W. (2009). “The Response of the Federal Reserve to the Recent Banking and Financial Crisis,” University of Chicago Booth School of Business, December. Porter, M.E. (1985). Competitive Advantage: Creating and Sustaining Superior Perfor­ mance (New York: The Free Press). Rossi, C.V. (1998). “Mortgage Banking Cost Structure: Resolving an Enigma,” Journal of Economics and Business, 50, 219–34. Wheelock, D. and Wilson, P. (2012). “Do Large Banks Have Lower Costs? New Estimates of Returns to Scale for US Banks,” Journal of Money, Credit and Banking, 44, 171–200.

Notes: (1) Credit scoring is a statistical process that transforms quantitative information about individual borrowers (e.g., income, employment, payment history) into a single numerical credit score. Personal credit scores are central to all stages of the retail loan securitiza­ tion processes: Lenders use credit scores to quickly screen large numbers of loan applica­ tions; investment banks use credit scores to construct pools of loans to be securitized; and bond-rating companies use credit scores to assign risk ratings to asset-backed securi­ ties. (2) Garn–St. Germain also permitted thrift institutions to make commercial loans and thus compete more directly with small commercial banks. (3) Berger, Kashyap, and Scalise (1995) provide an excellent overview of the first fifteen years of this transformation. FDIC (2012) provides an analysis of structural change in the US commercial banking industry from 1984 through 2011. (4) Kroszner and Melick (2009) provide a detailed overview of the policy actions taken by the Federal Reserve during the crisis.

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Banking in the United States (5) The originate-and-sell mortgage model was introduced and perfected first by mort­ gage banking institutions, and only adopted later by large and super-regional commercial banks to augment their existing operations. Some of the more prominent examples of these mortgage banks are American Home Mortgage, New Century Financial, Country­ wide Financial, and Washington Mutual, all of which failed relatively early during the fi­ nancial crisis. (6) For example, Rossi (1998) found that mortgage banking companies (non-depository, originate-and-sell) exhibit larger economies of scale than traditional mortgage lenders, while DeYoung (2005) found that Internet-only banks exhibit larger-scale economies than traditional branch-based banks. For the industry as a whole, the most recent econometric cost studies find that even the largest US banking companies exhibit economies of scale (Wheelock and Wilson, 2012; Hughes and Mester, 2013), although Davies and Tracey (2014) suggest that these estimated scale economies mainly reflect the reduced cost of fi­ nance enjoyed by large banks that have too-big-to-fail (TBTF) status. (7) In 1990, CitiCorp was the largest US banking company with assets of $217 billion. In 2017 CitiCorp (now known as CitiGroup) was the fourth largest US banking company with assets over $1.8 trillion. (8) JPMorgan Chase, Bank of America, Wells Fargo, Citigroup, US Bancorp, PNC Financial Services, and Bank of New York Mellon are long-time commercial banking companies. Goldman Sachs and Morgan Stanley are long-time investment banks that more recently reorganized as financial holding companies. Capital One specializes in credit card and consumer lending, while State Street provides investment services (securities custody, ac­ counting, asset valuation, asset management, investment advice) for other large financial services firms. (9) See DeYoung and Roland (2001), Clark et al. (2007), and Demirgüc-Kunt and Huizinga (2010) for theory and evidence that non-interest income tends to be less stable than net interest income. (10) Frame, Wall and White (Chapter 9, this volume) provide an in-depth discussion of fi­ nancial innovation in banking, including “FinTech.” Humphrey (Chapter 10, this volume) provides an overview of retail and wholesale payment systems. (11) Banks seldom charge explicit fees for these payments services. By providing pay­ ments services for their depositors, banks are able to attract low cost (federally insured) deposits to fund their lending operations, and earn non-interest income by cross-selling other financial services to their captive depositors.

Robert DeYoung

Robert DeYoung is the Koch Distinguished Professor of Business Economics and holds the Harold Otto Chair in Economics at the University of Kansas School of Busi­ ness. He is also co-editor of the Journal of Money, Credit and Banking. Prior to join­ Page 28 of 29

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Banking in the United States ing the KU faculty, he was an Associate Director of Research at the Federal Deposit Insurance Corporation, an Economic Advisor at the Federal Reserve Bank of Chica­ go, a Senior Economist at the Office of the Comptroller of the Currency, and a Joyce Foundation Teaching Fellow at Beloit College. He worked his way to an undergradu­ ate degree at Rutgers University-Camden, and holds a Ph.D in economics from the University of Wisconsin-Madison.

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Banking in Europe: Integration, Reform, and the Road to a Banking Union

Banking in Europe: Integration, Reform, and the Road to a Banking Union   John Goddard, Philip Molyneux, and John O. S. Wilson The Oxford Handbook of Banking (3rd edn) Edited by Allen N. Berger, Philip Molyneux, and John O. S. Wilson Print Publication Date: Oct 2019 Subject: Economics and Finance, Financial Economics Online Publication Date: Nov 2019 DOI: 10.1093/oxfordhb/9780198824633.013.32

Abstract and Keywords This chapter focuses on the evolution of the banking industry in the European Union since the signing of the Treaty of Rome in 1957 to the present day. We provide an overview of developments in the regulation, financial integration, and the structure and performance of the European banking industry. A brief discussion of the global financial crises and their resultant impact on European banks together with coverage of the later Eurozone sovereign debt crisis is also presented, along with structural reforms, and the ongoing progress in creating a fully integrated banking and financial services industry throughout the Eurozone. A major challenge for the industry relates to restoring prof­ itability back to pre-crises levels. At present, many banks remain encumbered by regula­ tory demands that, while helping their solvency, act as a drag on performance. Given the regulatory and economic environment under which European banks currently operate, their performance will be subdued for some time to come. Keywords: banking union, credit crisis, deregulation, performance, regulation, ring-fencing, risk

32.1 Introduction THIS chapter provides an overview of the evolution of the banking industry in the Euro­ pean Union since the signing of the Treaty of Rome in 1957 to the present day. We pro­ vide an overview of developments in the regulation, financial integration, and the struc­ ture and performance of the European banking industry. A brief discussion of the global financial crisis and its resultant impact on European banks together with coverage of the later Eurozone sovereign debt crisis is also presented, along with structural reforms, and the ongoing progress in creating a fully integrated banking and financial services indus­ try throughout the Eurozone. The signing of the Treaty of Rome in 1957 by six countries (Belgium, France, Italy, Lux­ embourg, the Netherlands, and West Germany) forming the European Economic Commu­ nity (EEC) was a major historical moment in the foundation of modern Europe. The Treaty Page 1 of 56

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Banking in Europe: Integration, Reform, and the Road to a Banking Union of Rome proposed the establishment of a customs union as well as the free flow of goods, services, and capital across member states. Over the following three decades the EEC ex­ panded, and by the next major landmark event, the introduction of the Maastricht Treaty in 1993, member countries had increased to twelve.1 The Treaty marked the official start of the European Union (EU) single market project leading to the establishment of the sin­ gle currency, the euro (€), a single monetary policy and the establishment of a European Central Bank (ECB) in 1999. The constitutional basis of (p. 1001) the EU changes some­ what infrequently, and it is currently enshrined in the Treaty of Lisbon that came into force in 2009. Since its inception, the EU has expanded and now comprises twenty-eight member states2 with combined GDP (in 2016) of €14.8 trillion. This equates to just over 20 percent of global GDP.3 Similarly, the Eurozone has also grown, with nineteen member countries, which account for approximately three-quarters of EU GDP. Notable non-mem­ bers of the Euro Area are Sweden and the UK (which voted to leave the EU in June 2016).4 Since the late 1970s a major theme of the EU legislative process has focused on the har­ monization of rules and regulations aimed at creating a more integrated financial system where banks in individual member states would be regulated in a similar fashion. This would facilitate greater cross-border banking activity either with or without physical es­ tablishment. The EC First Banking Directive of 1977 (77/780/EEC) aimed to harmonize banking supervision by establishing the concept of home country control with regulatory responsibility being shifted from the host to home country for banks operating in multiple EU member states. Integration was expected to boost trade in financial services as well. Moreover, integration would increase competition if rules were harmonized sufficiently so that banks from different member states competed on a “level playing field.” Integration therefore went hand-in-hand with product market and geographic deregulation. The inte­ gration process was given further impetus in 1985 when the European Commission pub­ lished a White Paper on The Completion of the Internal Market. This White Paper provid­ ed for the free circulation of persons, goods, and capital throughout the EU. In the case of banking, the White Paper called for a single banking license, home country control, and mutual recognition. These principles were incorporated into the 1989 Second Banking Di­ rective (89/646/EEC), which had to be implemented in member states by the end of 1992. Under the terms of the Second Banking Directive, all credit institutions authorized in a given EU member state would be able to establish branches or supply cross-border finan­ cial services in the other members of the EU without further authorization, provided that the bank was authorized to provide such services in the home state. This became known as the single banking license (Dermine, 2006). The Second Banking Directive also defined banking business based on the German system. From 1992, banks operating in EU coun­ tries were permitted to adopt a universal banking business model, which allowed them to undertake investment banking, insurance, wealth management and other non-bank finan­ cial activities. The (p. 1002) new legislation left it up to national regulators to oversee fi­ nancial conglomerates and the ownership structure of banks.5

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Banking in Europe: Integration, Reform, and the Road to a Banking Union As the Second Banking Directive legislation was about to be implemented across member states in 1992, the European Commission had already announced that the next phase of integration would feature the establishment of the Economic and Monetary Union (EMU). The EMU entailed the: coordination of economic policymaking between EU member states; coordination of fiscal policies (notably through limits on government debt and deficits); an independent monetary policy run by the European Central Bank (ECB); sin­ gle rules and supervision for financial institutions operating within the Eurozone; and es­ tablishment of a single currency. The aforementioned changes were expected to facilitate more robust economic conditions across EU member states as well as: furthering finan­ cial and non-financial market integration; and creating a more competitive and efficient Single Market for banking and other financial services. These initiatives, combined with a relatively buoyant macroeconomic environment, helped spur banking sector growth. Ac­ cording to Liikanen (2012) total EU banking sector assets increased from around €35 tril­ lion in 2001 (230 percent of GDP) to €43 trillion in 2008 (€32 trillion in the Eurozone), or approximately 350 percent of EU GDP. There were marked differences in banking sector growth across member states. Inside the Eurozone, Ireland and Spain experienced dou­ ble-digit annual growth between 2001 and 2008. High growth rates in banking sector as­ sets were also experienced in France and the UK. Other member states grew more slowly in the years preceding the global financial crisis. As a consequence, there were also sub­ stantial differences in the impact of the financial crisis across member states. This is dis­ cussed later in this chapter. The European banking industry has been subject to major shocks since the mid-2000s, in­ cluding the turmoil that ensued following the US subprime crisis of 2007–8, and the Euro­ pean sovereign debt crisis between 2010 and 2013. The former led to large losses and the failure and closure of many banks, and forced large-scale interventions by central banks and governments on an unprecedented scale (Goddard, Molyneux, and Wilson, 2009, 2010, 2014). Government interventions to deal with the financial crisis included: guaran­ tees for bank liabilities; bank recapitalizations; asset support (measures to provide relief for troubled assets); and increased deposit insurance coverage. Between 2008 and 2016 the European Union’s European Commission approved €5 trillion (approximately 34 per­ cent of EU gross domestic product (2016 nominal GDP)) in government support to the banking sector (EU State Aid Scoreboard, 2017). In 2008 alone, €3.5 trillion was ap­ proved, mainly in the form of guarantees, afterwards the main emphasis of state support shifted toward recapitalization and impaired asset relief. Major changes to deposit insur­ ance schemes (increased limits of coverage) were also introduced in 2008. EU member states did not take up their full quota of approved aid. The amount of state support actually deployed between 2008 and 2016 stood at €1.94 trillion (around 13 percent of EU 2016 GDP, the equivalent of 4.5 percent of EU 2016 banking sector assets). Around €1.3 trillion took the form of guarantees and other liquidity measures, and the re­ mainder (around €654 billion) took the form of recapitalizations and support to banks with impaired assets. Between October 2008 and the end of 2016, almost 300 decisions were taken regarding state support to the banking industry. The large-scale injection of state funds, coupled with an array of regulatory reforms aimed at bolstering capital and (p. 1003)

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Banking in Europe: Integration, Reform, and the Road to a Banking Union liquidity and curtailing excessive risk, was successful in averting a collapse of the bank­ ing system.6 By 2017, a substantial proportion of the aid granted since 2008 had been re­ paid to public authorities in the form of dividends, guarantee fees and interest (EU State Aid Scoreboard, 2017). From late 2009 through 2013, the aforementioned financial crisis evolved into a Euro­ pean sovereign debt crisis. Since the introduction of the euro in 1999, the financial sector (in both the Eurozone as well as in countries including the UK and Switzerland) experi­ enced rapid expansion. At this time several southern European economies, including Greece, Italy, Portugal, and Spain, ran large current account deficits, in contrast to the surpluses generated in Germany and some other northern European countries (Arnold, 2012; Lane, 2012; Correa and Sapriza, 2014; Correa, Sapriza, and Zlate, 2016). Credit ex­ tended within the financial systems at the core of the Eurozone fueled property market price bubbles in several EU member states, including Ireland and Spain. Spiraling gov­ ernment deficits and debt, exacerbated by the bailouts of troubled banks, triggered a cri­ sis of confidence, reflected in a widening of bond yields and credit default swap spreads. The first crisis hit Greece in May 2010. The Eurozone authorities and the International Monetary Fund (IMF) agreed a €110 billion loan, conditional on the implementation of tough austerity measures. Later in May, the European Financial Stability Facility (com­ prising a broad rescue package amounting to $1 trillion) was established with the aim of ensuring financial stability in the Eurozone. Following this, further support programs were approved for Ireland (€85 billion in November 2010) and Portugal (€78 billion in May 2011). This benefited many banks, which were substantial holders of sovereign debt. In some countries, however, banks were forced to raise large amounts of new capital, which impacted adversely on subsequent performance. In March 2013, Cyprus was awarded a €10 billion bailout to stabilize its financial system and finance a large fiscal deficit. The support provided to the aforementioned countries was relatively successful with Ireland and Portugal exiting their bailout programs in the summer of 2014. Other countries such as Greece and Cyprus, both managed to gain market access to sovereign bond financing over 2014–15. Eurozone ministers announced the end of the Greek debt crisis in June 2018. Spain never formally had a bailout package, but did rely on funding from the ECB for the establishment of a bank recapitalization fund. The Eurozone sovereign debt crisis has been described as a continuation of the global financial crisis of 2007–9 by alternative means. On the one hand, the perception that bank balance sheets remained contaminated by hidden or undeclared delinquent lending raised concerns over the implications for fiscal sustainability in the context of fu­ ture bank bailouts. On the other hand, banks themselves were (and indeed continue to be) major investors in government debt, and recognition of the possibility that a euro member state might default on its debt and withdraw from the single currency height­ ened the prospects of additional bank failures. To address these concerns the EU an­ nounced in 2012 that it was to establish a banking union, which would entail pooling re­ sponsibility at EU level for the rescue of ailing banks. The aim being to break the symbiot­ ic relationship that had developed between distressed banks and distressed member (p. 1004)

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Banking in Europe: Integration, Reform, and the Road to a Banking Union states. The banking union comprises a single supervisory mechanism (SSM) and a single resolution mechanism (SRM) for banks. In late 2015, the European Commission proposed the introduction of a European deposit insurance scheme (EDIS) as a further step to com­ pleting the banking union. The banking union applies to countries in the Eurozone, al­ though non-Eurozone countries can also join. In October 2017, the European Commission announced further measures to facilitate greater financial sector integration. This includ­ ed developing a fiscal backstop to the banking union. In the remainder of the chapter we provide an overview of the structure and performance of the European banking industry (section 32.2); a brief discussion of the global financial crises and its impact on European banks, together with coverage of the later Eurozone crisis (section 32.3); and a discussion of the key features of the banking union and the on­ going push to create a fully integrated banking and financial system throughout the Euro­ zone (section 32.4). Section 32.5 provides a summary.

32.2 Structure and Performance of European Banking 32.2.1 Deregulation and Integration European banking has changed dramatically since the passing of the First Banking Direc­ tive in 1977 (77/780/EEC). In response to financial deregulation, the creation of the sin­ gle market in financial services and the introduction of a single currency, banks have in­ creased the range of products and services offered to customers. This blurred the distinc­ tion between banks, investment firms, insurance companies, and other financial services firms. Market entry by foreign-owned banks led to increased competition in some seg­ ments of the financial services industry. This placed additional pressure on banks to re­ duce costs, and find ways of increasing revenues via the sale of new types of products and services. Since the passing of the First Banking Directive, EU legislation covering the banking sys­ tem has been directed consistently toward boosting financial integration by reducing (p. 1005) barriers to cross-border bank ownership and activities. Deregulation of financial markets at member state level has also eroded the lines of demarcation between banks and non-bank financial firms, thus facilitating both domestic and cross-border competi­ tion. From the introduction of the single currency in 1999 to the start of the global financial crisis, wholesale and capital market-related bank activities showed clear signs of increas­ ing integration, while retail banking remained somewhat fragmented (ECB, 2008). Retail banking and small business lending in Western Europe remained primarily nationally ori­ ented, with only limited cross-border ownership or activity. In Eastern Europe, by con­ trast, there was extensive foreign ownership of retail banking. With regard to banking, the financial crisis constituted a major setback to the project of European financial inte­ Page 5 of 56

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Banking in Europe: Integration, Reform, and the Road to a Banking Union gration (Sapir and Wolff, 2013). The scaling back of interbank lending sharply reduced the level of banking activity in the area where integration had been furthest advanced. The fragmentation of bank resolution authorities along national lines engendered diver­ gence, as did home country bias in the arrangements for assistance to distressed banks. Overall, the financial crisis, “ … reduced the cross-border provision of financial services and, in particular, wholesale and securities-related activities. Banks have clearly been re­ lying more on domestic than on foreign counterparties in their transactions” (ECB, 2010a, p. 32). During the 1990s and 2000s, many European banks expanded the scale of their opera­ tions, in some cases through mergers and acquisitions (M&A). Consolidation was motivat­ ed by the objectives of realizing scale and scope economies; reducing labor and other variable costs; cutting operational inefficiencies; and spreading risk through product or geographic diversification. Rapid growth in the loan portfolios of some banks was fi­ nanced via the securitization of prospective cash flows from sources such as mortgages and credit card debt, which commonly took place off-balance sheet. Growth in European banks’ non-interest income reflected the growing use of securities-based financing by pri­ vate sector companies, the increased demand by the household sector for insurance and personal pensions, and the investment in mutual funds. Changes embodied in the European Company Statute allowed banks to form single legal entities operating freely across the EU, and enabled the conversion of subsidiaries to branches. However, subsidiaries remained the predominant cross-border organizational form, suggesting that the benefits associated with risk spreading between various legal entities within a banking group are of strategic importance (ECB, 2007). The introduction of the Financial Services Action Plan between 1999 and 2004 provided further momen­ tum toward increased integration of the banking system, and increased cross-border in­ ter-connections between financial institutions. Technological advances also impacted on bank behavior through the proliferation of Internet banking and the emergence of new payments media. Technology revolutionized delivery systems, and led to the adoption of different business models by small and large banks (Goddard, Molyneux, and Wilson, 2001, 2010, 2014; Goddard et al., 2007). The growing emphasis on performance and shareholder value also encouraged many banks to reappraise their asset and liability management strategies. In the two decades preceding the global financial and sovereign debt crises, European banking was transformed by an array of developments including: globalization, (p. 1006) deregulation, technological change, as well as integration resulting from legislative changes specifically designed to create a European single banking market (Goddard, Molyneux, and Wilson, 2014). These forces impacted on the industrial structure of Euro­ pean banking. Between 1985 and 2007, the total number of banks declined substantially in all major countries. Over the same period the combined nominal total assets of French, German, Italian, Spanish, and UK banks increased by over 350 percent. In addition, in France, Greece, Italy, Spain, and Portugal, the number of bank branches increased owing to the lifting of branching restrictions. The number of branches declined in Belgium and Page 6 of 56

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Banking in Europe: Integration, Reform, and the Road to a Banking Union the UK, where banks sought to increase efficiency by rationalizing branch networks (ECB, 2010b). Banking sector employment also increased by more than 11 percent over the same period, reaching 2.75 million by 2007 with German banks employing the largest number of staff (685,000), followed by the UK (463,000). Typically, employment in the banking industry accounts for around two-thirds of total financial sector employment. An­ other general trend since the 1970s has been the increased presence of female and parttime employees.7 Since the global financial crisis the integration process has stalled somewhat, perhaps not surprising given the extent of the adverse financial shock, which was then followed by the Eurozone sovereign debt crisis. The financial integration of Eurozone banking mar­ kets improved slightly in 2014. However, “The level of integration remains lower than be­ fore the financial crisis, which may reflect financial fragmentation as well as cross-coun­ try differences in the riskiness of banks and borrowers. The wedge between the borrow­ ing costs paid by non-financial corporations (NFCs)—particularly small to medium-sized enterprises (SMEs)—in distressed and non-distressed countries has narrowed, but has not yet returned to pre-crisis levels, suggesting prevailing fragmentation” (ECB, 2015, p. 27). In fact, even by 2018, progress toward further integration in European banking re­ mained somewhat muted.8 The area where there has been least success relates to inte­ gration in retail credit markets, mainly as a consequence of limited cross-border bank mergers and acquisitions (M&A) throughout the Eurozone and Europe more generally. According to the European Central Bank there is a need to facilitate more (and larger) cross-border bank consolidation in the Eurozone area as this is “… the only realistic path toward greater retail bank integration, which could improve risk sharing via credit mar­ kets as well as the functioning of the Monetary Union” (ECB, 2017a, p. 5). Figure 32.1 shows price and quantity indicators of financial sector integration highlighting some of the aforementioned trends.

Figure 32.1 Price-based and Quantity-based Finan­ cial Integration Composite Indicators. Source: ECB (2017a, p. 6).

Following the rapid growth of European banking systems in the run-up to the financial crisis, the post-crisis period has been characterized by an ongoing rationalization (p. 1007) process driven by the ongoing pressure to increase efficiency. Most member states have witnessed a reduction in banking sector capacity, occurring mainly through “… a reduction in business volumes rather than the exit of firms from the market” (BIS, Page 7 of 56

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Banking in Europe: Integration, Reform, and the Road to a Banking Union 2018, p. 1). This can be seen in Table 32.1 which shows an overall decline in Eurozone banking sector assets between 2008 and 2016, most noticeably in Germany, Ireland, Greece, Cyprus, and the Netherlands. For other banking sectors in the Eurozone and the EU, asset growth has been flat. The UK experienced a steep decline in the asset size of the banking sector. The Eurozone also experienced a sizable decline in bank numbers, dropping from 6,768 in 2008 to 5,073 in 2016 (ECB, 2017b; and Table 32.2). Concentra­ tion in the banking sectors of Eurozone member states typically tended to increase in countries which had major restructuring (such as Greece and Spain) as well as in rela­ tively small countries (Malta and Lithuania). However, even in larger systems such as Italy and Germany, concentration increased over the period 2008–16. Overall, for the EU the average five-bank asset concentration level increased from 44 percent in 2008 to just over 47 percent in 2014, but has since declined. Greece has the most concentrated bank­ ing system (97 percent) and Germany the least (31 percent) (ECB, 2017b). Table 32.3 illustrates these structural trends by highlighting the five-bank assets concentration ratio and the Herfindahl index measures. The concentration trend has been fueled mainly by domestic M&A activity. As noted earli­ er, the global financial crisis halted cross-border M&A, which peaked in Europe in 2007, and since then the majority of banking sector consolidation has been forced by regulators to remove capacity. It remains an open question as to whether future large-scale crossborder deals will materialize, albeit policymakers have set a future policy agenda where one aim is to promote this goal (ECB, 2017a). For this to happen, policymakers will have to consider reducing barriers to M&A activity (particularly in retail financial services). Such barriers include: difficulties in selling generic products across borders; differences in competition, employment legislation and practices, regulatory and (p. 1011) supervisory policy; variation in consumer protection legislation, political interference; and a lack of consumer trust in foreign banks.

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Banking in Europe: Integration, Reform, and the Road to a Banking Union (p. 1008)

(p. 1009)

(p. 1010)

Table 32.1 Number of Credit Institutions and Foreign Branches

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Banking in Europe: Integration, Reform, and the Road to a Banking Union Credit Institutions

Foreign Branches

20 08

20 09

20 10

20 11

20 12

20 13

20 14

20 15

20 16

20 08

20 09

20 10

20 11

20 12

20 13

20 14

20 15

20 16

B el gi u m

49

48

48

47

44

39

43

37

33

56

55

58

61

59

64

65

60

57

G er m an y

1, 88 2

1, 84 0

1, 81 9

1, 78 9

1, 76 2

1, 73 4

1, 69 8

1, 66 6

1, 60 0

10 4

10 4

10 8

11 0

10 6

10 8

10 8

10 7

10 2

Es to ni a

6

7

7

7

8

24

30

32

31

11

10

11

10

8

7

7

7

7

Ir el an d

47 2

46 8

46 1

44 8

44 2

43 1

41 4

38 2

33 7

32

33

34

38

36

34

33

34

32

Page 10 of 56

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Banking in Europe: Integration, Reform, and the Road to a Banking Union Gr ee ce

36

36

36

34

30

21

21

18

18

30

30

26

23

22

20

20

22

20

S pa in

28 2

27 1

25 5

24 9

23 0

20 4

14 4

13 4

12 5

87

89

88

87

85

85

84

84

82

Fr an ce

67 2

66 0

63 5

61 1

59 6

57 9

41 3

41 6

39 1

99

98

95

92

87

91

90

91

89

It al y

72 9

71 7

69 7

67 2

63 5

61 1

59 2

57 5

52 7

84

82

77

79

73

81

79

80

83

Cy pr us

13 7

13 0

12 7

11 6

11 0

74

32

32

31

23

25

25

25

27

27

24

24

23

La tv ia

21

21

21

22

20

54

49

51

50

6

6

10

9

9

9

10

10

7

Page 11 of 56

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Banking in Europe: Integration, Reform, and the Road to a Banking Union Li th ua ni a

77

78

77

83

86

84

82

82

80

7

7

9

9

8

7

7

8

8

L ux e m bo ur g

12 0

11 8

11 8

11 4

11 2

12 1

11 0

10 2

98

40

37

37

35

36

37

40

40

42

M al ta

23

23

26

26

28

27

24

25

24

3

3

3

3

3

3

3

3

3

N et he rl an ds

26 6

26 2

25 4

25 0

22 4

20 4

17 7

16 1

51

32

33

33

35

36

39

39

42

40

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Banking in Europe: Integration, Reform, and the Road to a Banking Union A us tri a

77 1

76 0

75 0

73 6

72 1

70 1

67 7

64 8

58 6

30

29

30

30

29

30

30

30

28

Po rt u ga l

14 7

13 9

13 3

13 1

12 9

12 7

13 0

12 7

12 7

28

27

26

24

23

24

22

18

19

Sl ov en ia

21

22

22

22

20

20

20

19

16

3

3

3

3

3

3

4

4

3

Sl ov ak ia

17

15

15

14

14

13

13

13

13

9

11

14

17

14

15

15

14

15

Fi nl an d

33 4

32 8

31 8

30 5

29 0

27 9

24 1

24 9

24 7

22

22

24

24

22

22

25

27

28

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Banking in Europe: Integration, Reform, and the Road to a Banking Union E ur oz on e

6, 06 2

5, 94 3

5, 81 9

5, 67 6

5, 50 1

5, 34 7

4, 91 0

4, 76 9

4, 38 5

70 6

70 6

71 1

71 4

69 1

70 6

70 5

70 5

68 8

E U

8, 57 0

8, 38 3

8, 23 7

8, 06 2

7, 86 8

7, 74 7

7, 33 1

7, 11 1

6, 64 8

98 3

97 6

98 3

99 0

96 5

97 7

98 4

98 1

96 4

Source: ECB (2017b, table 5, p. 72).

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Banking in Europe: Integration, Reform, and the Road to a Banking Union Table 32.2 Total Assets of Domestic Banking Groups and Foreign-Controlled Subsidiaries and Branches

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Banking in Europe: Integration, Reform, and the Road to a Banking Union Domestic Banking Groups

Foreign Subsidiaries and Branches

(E U R bil li­ on s)

20 08

20 09

20 10

20 11

20 12

20 13

20 14

20 15

20 16

20 08

20 09

20 10

20 11

20 12

20 13

20 14

20 15

20 16

B el gi u m

1, 20 1

59 0

59 0

55 6

52 0

46 9

49 5

49 3

51 6

21 9

60 0

56 1

59 1

52 8

49 1

50 1

47 7

50 6

G er m an y

9, 00 5

7, 76 7

7, 51 7

7, 57 7

7, 25 7

6, 45 7

6, 75 0

6, 64 9

6, 58 3

1, 00 5

86 1

37 9

41 9

30 9

27 8

31 2

30 6

50 1

Es to ni a

0

0

0

1

1

1

1

1

2

37

33

30

19

20

20

21

22

23

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Banking in Europe: Integration, Reform, and the Road to a Banking Union Ir el an d

53 8

51 7

44 8

38 1

35 2

27 5

26 0

24 9

22 7

1, 08 3

82 2

73 2

81 2

64 7

51 4

24 3

23 3

21 2

Gr ee ce

35 8

38 6

39 5

34 3

34 6

35 6

35 8

34 4

29 5

10 0

10 4

98

82

63

13

11

6

6

S pa in

3, 28 7

3, 40 4

3, 49 8

3, 60 4

3, 59 5

3, 27 1

3, 34 5

3, 47 1

3, 45 0

35 0

32 8

30 9

30 9

28 9

21 7

23 1

19 3

14 1

Fr an ce

6, 87 4

6, 10 1

6, 17 3

6, 45 1

6, 58 3

6, 15 4

6, 76 0

6, 56 3

6, 85 3

27 6

21 5

21 2

22 3

22 7

18 9

42 7

37 7

36 3

It al y

2, 52 2

2, 47 5

2, 53 6

2, 54 7

2, 60 3

2, 40 5

2, 47 6

2, 51 1

2, 46 9

23 6

23 6

22 9

24 7

25 2

22 7

22 5

21 3

23 1

Cy pr us

87

96

11 1

98

87

51

49

59

53

39

48

44

40

38

26

27

14

14

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Banking in Europe: Integration, Reform, and the Road to a Banking Union La tv ia

11

10

10

10

11

12

15

17

15

22

19

19

16

17

17

16

15

15

Li th ua ni a

4

5

6

2

1

2

2

2

2

25

23

20

21

21

20

22

22

24

L ux e m bo ur g

13 3

91

62

98

90

90

94

98

10 3

87 5

78 3

70 4

69 7

65 0

62 8

71 7

71 3

74 2

M al ta

8

9

10

10

12

13

15

16

19

36

34

41

41

42

38

37

31

28

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Banking in Europe: Integration, Reform, and the Road to a Banking Union N et he rl an ds

2, 87 4

2, 53 0

2, 36 4

2, 51 4

2, 41 5

2, 25 2

2, 35 9

2, 34 6

2, 35 8

12 1

11 6

34 9

31 8

27 3

16 1

16 9

16 2

17 5

A us tri a

83 0

86 8

85 7

87 4

84 8

78 8

75 1

72 0

72 0

34 5

27 2

27 4

29 3

31 6

30 1

32 8

33 7

22 7

Po rt u ga l

37 6

40 1

41 4

39 9

38 5

36 8

33 7

31 3

29 9

10 1

10 9

11 8

11 4

11 2

94

87

93

87

Sl ov en ia

38

41

41

38

35

30

27

27

22

15

15

15

15

14

13

14

14

19

Sl ov ak ia

2

3

4

6

6

7

10

10

12

60

49

50

49

49

50

53

57

61

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Banking in Europe: Integration, Reform, and the Road to a Banking Union Fi nl an d

11 6

11 8

12 6

14 0

14 9

15 0

16 3

17 8

18 5

27 0

26 4

33 7

49 4

45 0

37 2

41 0

36 9

35 2

E ur oz on e

28 , 24 7

25 , 39 7

25 , 14 4

25 , 63 9

25 , 28 3

23 , 13 6

24 , 26 5

24 , 06 6

24 , 18 3

5, 07 1

4, 86 0

4, 45 4

4, 76 1

4, 28 0

3, 65 3

3, 82 9

3, 67 7

3, 72 7

Source: ECB (2017b, table 6, p. 73).

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Banking in Europe: Integration, Reform, and the Road to a Banking Union Table 32.3 Concentration in European Banking Herfindahl index for credit institutions and share of total assets of the five largest credit institutions Herfindahl index for credit institutions1 (index ranging from 0 to 10,000)

Share of total assets of the five largest credit institutions2 (percentage share of the five largest credit institutions)

20 08

20 09

20 10

20 11

20 12

20 13

20 14

20 15

20 16

20 08

20 09

20 10

20 11

20 12

20 13

20 14

20 15

20 16

B el gi u m

1, 88 1

1, 62 2

1, 43 9

1, 29 4

1, 06 1

97 9

98 1

99 8

1, 01 7

81

77

75

71

66

64

66

65

66

G er m an y

19 1

20 6

30 1

31 7

30 7

26 6

30 0

27 3

27 7

23

25

33

34

33

31

32

31

31

Es to ni a

3, 12 0

3, 09 0

2, 92 9

2, 61 3

2, 49 3

2, 48 3

2, 44 5

2, 40 9

2, 40 6

95

93

92

91

90

90

90

89

88

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Banking in Europe: Integration, Reform, and the Road to a Banking Union Ir el an d

66 1

71 4

70 0

64 7

63 2

67 4

67 7

67 8

64 4

50

53

50

47

46

48

48

46

44

Gr ee ce

1, 17 2

1, 18 3

1, 21 4

1, 27 8

1, 48 7

2, 13 6

2, 19 5

2, 25 4

2, 33 2

70

69

71

72

79

94

94

95

97

S pa in

49 7

50 7

52 8

59 6

65 4

71 9

83 9

89 6

93 7

42

43

44

48

51

54

58

60

62

Fr an ce

68 1

60 5

61 0

60 0

54 5

56 8

58 4

58 9

57 2

51

47

47

48

45

47

48

47

46

It al y

30 7

29 8

41 0

40 7

41 0

40 6

42 4

43 5

45 2

31

31

40

39

40

40

41

41

43

Cy pr us

1, 01 7

1, 08 5

1, 12 5

1, 03 0

1, 00 7

1, 64 5

1, 44 5

1, 44 3

1, 37 2

64

65

64

61

63

64

63

68

66

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Banking in Europe: Integration, Reform, and the Road to a Banking Union La tv ia

1, 20 5

1, 18 1

1, 00 5

92 9

1, 02 7

1, 03 7

1, 00 1

1, 03 3

1, 08 0

70

69

60

60

64

64

64

65

67

Li th ua ni a

1, 71 4

1, 69 3

1, 54 5

1, 87 1

1, 74 9

1, 89 2

1, 81 8

1, 93 9

1, 93 8

81

80

79

85

84

87

86

87

87

L ux e m bo ur g

30 9

31 0

34 3

34 6

34 5

35 7

33 0

32 1

26 0

30

29

31

31

33

34

32

31

28

M al ta

1, 23 6

1, 25 0

1, 18 1

1, 20 3

1, 31 3

1, 45 8

1, 64 8

1, 62 0

1, 59 9

73

73

71

72

74

76

81

61

80

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Banking in Europe: Integration, Reform, and the Road to a Banking Union N et he rl an ds

2, 16 7

2, 03 4

2, 04 9

2, 06 7

2, 02 6

2, 10 5

2, 13 1

2, 10 4

2, 09 7

87

85

84

84

82

84

85

85

85

A us tri a

45 4

41 4

38 3

42 3

39 5

40 5

41 2

39 7

35 8

39

37

36

38

36

37

37

36

34

Po rt u ga l

1, 11 4

1, 15 0

1, 20 7

1, 20 6

1, 19 1

1, 19 7

1, 16 4

1, 21 5

1, 18 1

69

70

71

71

70

70

69

72

71

Sl ov en ia

1, 26 8

1, 25 6

1, 16 0

1, 14 2

1, 11 5

1, 04 5

1, 02 6

1, 07 7

1, 14 7

59

60

59

59

58

57

56

59

61

Sl ov ak ia

1, 19 7

1, 27 3

1, 23 9

1, 26 8

1, 22 1

1, 21 5

1, 22 1

1, 25 0

1, 26 4

72

72

72

72

71

70

71

72

73

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Banking in Europe: Integration, Reform, and the Road to a Banking Union Fi nl an d

3, 16 0

3, 12 0

3, 55 0

3, 70 0

3, 01 0

3, 08 0

3, 31 0

2, 73 0

1, 79 0

83

83

84

81

79

84

80

75

66

E ur oz on e

67 6

64 9

68 8

71 0

67 7

68 9

73 0

72 0

69 7

44

44

47

47

47

47

48

48

48

E U

64 8

62 9

66 9

68 5

66 2

67 4

69 2

67 7

66 1

44

44

47

47

47

47

47

46

46

Note: 1. The Herfindahl index (HI) refers to the concentration of banking business. The HI is obtained by adding the squares of the market shares of all the credit institutions in the banking sector. 2. Banking sector and individual figures are reported on an unconsolidated basis. Source: ECB (2017b, table 11, p. 81).

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Banking in Europe: Integration, Reform, and the Road to a Banking Union

32.2.2 Profitability and Efficiency Europe has a varied and dynamic banking sector, highlighted by the Final Report of the High-level Expert Group on Reforming the Structure of the EU Banking Sector (the socalled Liikanen Report): The EU banking sector is diverse, which is valuable. Banking sectors differ sub­ stantially across Member States, in terms of size, market concentration, foreign ownership, asset and liability structure, supervision, credit cycle, and public in­ volvement. Diversity strengthens the resilience of the banking system as it miti­ gates vulnerability to systemic interconnections and promotes effective competi­ tion. Diversity is explicitly protected by the EU treaty. (Liikanen, 2012, p. 32) Commercial banks traditionally depended upon interest margins as the main driver of profits. Profitability depended on banks’ ability to maintain a sizable gap between interest income and interest cost, while attempting to maximize operational efficiency. As banking systems were liberalized, competition in loan and deposit markets intensified. This was an observable trend from the early 1980s to the early 2000s in many European countries. Reductions in margins encouraged banks to augment their income (where possible) by di­ versifying into non-interest income, or non-traditional areas of business such as insurance and securities underwriting. Following the EU Second Banking Directive of 1989, non-in­ terest income as a proportion of total income increased from 26 percent in 1989 to 41 percent in 1998 (ECB, 2000). Non-interest income has increased slightly since 2007, and has remained at a similar level, albeit with big variations across countries.9 The crisis of 2007–9 caused a rethink in the business models adopted by big banks. Prior to the crisis, such banks focused on the co-existence of investment and commercial bank­ ing, and the creation of complex and large corporate entities that sought to realize the various benefits associated with size. Post-crisis, the costs associated with ‘Too-Big-To-Fail (TBTF) bailouts heightened the policy debate concerning the relative benefits of bank size, and the influence of safety net subsidies on the behavior of large banks (Inanoglu et al., 2016). The role of large banks and recent regulatory proposals have directed renewed attention to the issue of economies of scale in banking and there is some evidence that scale economies remain important for large European banks (Beccalli, Anoli, and Borello, 2015). In addition to economies of scale, banks’ business models have also been (p. 1012) driven by economies of scope and deregulation (Gambacorta and van Rixtel, 2013). The trend toward diversification adopted by large European banks is associated with in­ creased consolidation that results in fewer, larger, and more complex banking conglomer­ ates. Empirical evidence suggests significant benefits for banks that are potential TBTF candidates (Molyneux, Schaeck, and Zhou, 2014). A related (and substantial) strand of re­ search has focused on diversification. Some studies have examined the risk implications of diversification in non-European banking industries (DeYoung and Torna, 2013; Engle et Page 28 of 56

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Banking in Europe: Integration, Reform, and the Road to a Banking Union al., 2014; De Jonghe, Diepstraten and Schepens, 2015, Abedifar, Molyneux, and Tarazi, 2018). Such studies show that (when combined with traditional financial intermediation), non-interest activities generally contribute to higher stand-alone bank risk and systemic risk. Other recent European studies present mixed findings (Maudos, 2017; Saghi-Zedek, 2016). Post-crisis regulatory reforms in Europe have resulted in a range of restrictions on banks’ non-interest activities (particularly in higher-risk trading areas). These regulations, how­ ever, do not include explicit size restrictions. Instead they seek to reduce scope economies and eliminate implicit TBTF subsidies. Other proposed structural reforms that included explicit bank size restrictions in relation to the financial system as a whole or relative to GDP (Tarullo, 2012; Haldane, 2013) appear to have diminished as conditions in the banking industry have improved. The scope for banks to exploit economies of scale and scope will depend on any restrictions on size imposed by other regulations, such as the leverage rule in Basel III to be implemented by 2019 (see Chapter 2, this volume). The general recognition that a reliance on non-interest revenue, particularly securities trading and investment banking, creates risk for financial stability has resulted in reforms in the UK to “ring-fence” retail banking from investment banking, and in the EU to sepa­ rate high-risk activities from low-risk deposit-taking within each banking group. Postglobal financial crisis, it is noticeable that the business models of banks, particularly large institutions have changed: Broadly speaking, banks have reassessed their earlier ventures into trading activi­ ties as well as a growing dependence on wholesale sources of funding, in associa­ tion with stricter capital and liquidity regulation. Use of deposit funding has in­ creased, while businesses have tended to be repositioned toward less complex and less capital-intensive activities, including retail banking and, in some cases, wealth management. These patterns have been evident in the strategic changes implemented by many banks, and in their balance-sheet compositions and revenue mix. There has also been a re-focus on home market business or core foreign mar­ kets. (BIS, 2018, p. 14) Changes to business models are also most noticeable for the largest (globally systemically important) banks (or G-SIBS) that have significantly reduced their investment banking and trading activities, particularly the Royal Bank of Scotland in the UK and the Union Bank of Switzerland and Credit Suisse in Switzerland. Advances in technology have substantially reduced the costs associated with the collec­ tion, storage, processing and transmission of data, and transformed the means (p. 1013) whereby customers gain access to banking services and products. Front-office innovation is reflected in the growth in number and usage of automated teller machines (ATMs), electronic funds transfer at the point of sale (EFTPOS), Internet banking, e-money and new FinTech services. FinTech services are offered by both traditional and new operators Page 29 of 56

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Banking in Europe: Integration, Reform, and the Road to a Banking Union aiming to dis-intermediate traditional bank value chains (in foreign exchange, retail pay­ ments, retail/SME lending, wealth management, and so on). Back-office operations have also been transformed by the adoption of new internal systems, such as customer rela­ tionship management and business management technologies, core processing technolo­ gies and various support and integration technologies.10 Many of these innovations in­ volve large set-up costs relative to marginal costs, and the impact is not always cost sav­ ing. Even if technology reduces costs, revenues might adversely be affected (customers might be unhappy with a new technology, and demand less service). The cost-to-income ratio provides a crude measure of cost efficiency. In the 1980s and 1990s, a cost-to-in­ come ratio of around 70 percent was considered excessive, and indicative of a bank or system that was badly managed and relatively inefficient. By the mid-2000s, a ratio below 60 percent was considered respectable. By 2016, Eurozone bank cost-to-income ratios stood at a median of 58 percent with substantial country variation. This ratio exceeded 70 percent for German and Italian banks, and was around 70 percent in France. The high cost-to-income ratios in these countries is attributed in part to the higher cost of banks that focus on trading/investment banking as well as to their relatively fragmented bank­ ing markets.11 While bankers and industry analysts often focus on the cost-to-income ratio efficiency metric, academics have used more sophisticated modeling techniques to compute effi­ ciency scores for banks. These more technical measures can be obtained via parametric or non-parametric statistical methods, allowing controls for variations in the mix of in­ puts, and of outputs. Berger and Humphrey (1997) review 133 earlier efficiency studies. In general, large banks are more efficient than their smaller counterparts, and there is greater potential for realizing cost savings by emulating best practice than by increasing size (scale economies) or product diversification (scope economies). Weill (2009) reports evidence that European integration has coincided with convergence in bank efficiency across countries. Using both parametric and non-parametric modeling approaches, Casu and Girardone (2010) report that bank efficiency has generally im­ proved as a result of European integration. Closely related literature explores European bank productivity. Altunbas, Goddard, and Molyneux (1999) report that technical change reduced EU banks’ average costs during the 1990s, whereas Battese, Heshmati, and Hjal­ marsson (2000) in a study of Swedish banks find that the cost-saving effects of technical change became exhausted, as “average” banks caught up with the industry best practice. Casu, Girardone, and Molyneux (2004) report that banks in some European countries benefited from productivity growth during the 1990s. Several studies suggest (p. 1014) deregulation often had a negative impact on bank productivity (Lozano-Vivas, 1998; Can­ hoto and Dermine, 2003). This is somewhat surprising, as studies for countries outside the US and Europe typically find that liberalization boosts productivity. Casu et al. (2016) investigate the total factor productivity growth of commercial banks in nine Eurozone countries between 1992 and 2009, allowing for heterogeneous technology and the presence of “technology gaps” between countries. The analysis suggests that, while technical improvements have occurred, there is variation between countries in the Page 30 of 56

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Banking in Europe: Integration, Reform, and the Road to a Banking Union benefits to each banking industry. There are signs that all banking industries are converg­ ing toward use of the best available technology. The speed of convergence accelerated af­ ter the introduction of the single currency, but decelerated following the 2007–9 financial crisis. Other recent studies on European bank efficiency, perhaps unsurprisingly, continue to find a decline in efficiencies after the global financial crisis and around the timing of the Eurozone sovereign debt crisis. However, the observed declines are relatively modest (Matousek et al., 2015; Tsionas, Assaf, and Matousek, 2015). Other studies report a de­ cline in productivity growth over a similar period (Degl’Innocenti et al., 2017). Galema and Koetter (2016) examine the efficiency features of Eurozone banks that started to be regulated under the Single Supervisory Mechanism (SSM), which commenced with the ECB overseeing around 100+ of the Euro Area’s largest banks from November 2014 on­ wards. They compare the performance of these systemically important banks with those (smaller) banks solely regulated by national authorities. Banks supervised under the SSM were more cost and profit inefficient and this typically tended to increase once under su­ pervision by the ECB. As perhaps one might expect, substantial variations in European bank profitability persist although the double digit return-on-equity common for many banks in 2005–6 has not been repeated since the global financial crisis.12 Table 32.4 highlights profits trends in se­ lect Euro Area and other EU countries (as well as in the US). The table highlights the par­ ticularly low level of profits, suggesting that many banks are failing to cover their cost-ofcapital. One can also see the impact of the sovereign debt crisis on Spain and Italy over 2011–13, with Italian banks yet to fully recover. The table also reveals the relatively bet­ ter performance of US banks in recent years compared with all the largest European banking markets.

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Banking in Europe: Integration, Reform, and the Road to a Banking Union Table 32.4 Bank Profitability—Return on Equity (%) 2001–02

2003–04

2005–06

2007–08

2009–10

2011–12

2013–14

2015–16

Eurozone

6.3

5.1

10.7

3.6

3.6

0.2

3.2

4.4

Belgium

11.8

14.7

20.4

−11.6

4.0

1.9

6.8

9.2

5.5

5.9

3.6

4.7

6.3

France Germany

3.7

0.1

7.1

0.1

−0.7

2.3

2.4

3.1

Italy

7.8

8.3

10.5

6.7

2.7

−3.3

−3.9

−1.7

Luxem­ bourg

3.2

8.9

9.0

7.8

7.0

Nether­ lands

−9.0

3.8

5.0

4.4

7.4

16.1

14.7

8.3

−12.4

6.3

5.8

Other Eu­ rope

16.3

3.9

5.8

4.2

4.5

3.9

Sweden

19.7

17.1

7.8

12.0

12.5

12.7

Spain

14.2

14.9

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Banking in Europe: Integration, Reform, and the Road to a Banking Union Switzer­ land

17.1

−3.3

7.7

4.7

5.0

4.0

United Kingdom

15.7

4.9

4.8

2.6

2.7

2.2

12.5

3.4

2.2

8.2

9.2

9.3

United States

13.7

14.3

Source: Adapted from BIS (2018, annex table 1.27, p. 104).

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Banking in Europe: Integration, Reform, and the Road to a Banking Union

32.2.3 Competition and Risk Since the banking crisis there has been much discussion in both policy and academic cir­ cles as to which type of business model will yield the safest and most profitable banking system. According to Liikanen (2012), while the adverse effects of the crisis (p. 1015) were universal, those banks that were “less resilient” typically relied heavily on short-term wholesale funding, excessive leverage and trading activity, and were characterized by ex­ cessive lending and weak corporate governance. The impact of the crisis on competition in banking, together with state support for ailing banks, has been debated widely. Until the 1980s there was a general consensus that competition between banks was damaging for financial stability. Competition encouraged excessive risk-taking on the assets (loans) side of banks’ balance sheets, increasing the likelihood of individual bank failure. More recently it has been suggested that competition may be helpful in reducing risk. Accord­ ing to theory, the allocation of bank assets is determined by solving a portfolio problem, emphasizing the liabilities side of the balance sheet. Upon confronting increased competi­ tion on the deposits side, banks tend to increase their rates in order to attract depositors. When paying higher deposit rates, neglecting the effects of competition in the loans mar­ ket, earnings decline. In an attempt to recapture lost profits, banks tend to accept more risky investments. By contrast, when competition is restrained, banks exercise market power by paying lower deposit rates, and can thereby increase their profits. Banks that are subject to limited competition are less willing to invest in high-return–high-risk projects, reducing the likelihood of failure. The counter-argument that competition lowers risk is developed by Koskela and Stenbac­ ka (2000) and Boyd and De Nicolo (2005), who develop a theoretical model of competition on both the deposits and loans sides of the balance sheet. Project risk is determined by the interest rates charged to borrowers. The portfolio problem is transformed into a con­ tracting problem that is subject to moral hazard. Banks with market power charge lower rates on deposits and higher rates on loans. In this context, portfolio theory suggests that banks with market power have little incentive to take on risk, because they can earn mo­ nopoly profits without doing so. However, the contracting problem reverses this logic. Higher loan rates force bank borrowers to seek out more (p. 1016) risky projects, increas­ ing portfolio risk for (monopoly) banks. By contrast, banks subject to competitive pres­ sure offer lower loans rates in order to reduce moral hazard, and face reduced risk be­ cause their borrowers are less likely to pursue risky investments. In line with the compe­ tition stability view, by studying commercial, savings, and cooperative banks from ten Eu­ ropean countries from 1999 to 2005, Schaeck and Cihák (2012) find that banks operating in more competitive environments have higher capital ratios. A later analysis by the same authors (Schaeck and Cihák, 2014) also finds that competition leads to soundness as it has a positive impact on the distance to default. Other research by Martinez-Miera and Repullo (2010) suggests that the relationship between competition and stability may be non-linear.

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Banking in Europe: Integration, Reform, and the Road to a Banking Union Following the financial and sovereign debt crises, moral hazard issues concerning large banks too-big-, too-interconnected—or too-systemically-important-to-fail have been debat­ ed extensively in academic and policy circles (Strahan, 2013; Barth and Wihlborg, 2017; Chapter 4, this volume). Large banks obtain implicit (or explicit) subsidies via govern­ ment safety nets, which encourage excessive risk-taking (O’Hara and Shaw, 1990; Stern and Feldman, 2004, 2009; Brown and Dinç, 2011; Demirgüç-Kunt and Huizinga, 2013; Chapter 4, this volume). Empirical evidence on the competition-fragility and competitionstability hypotheses is mixed (Turk-Ariss, 2010; Beck, De Jonghe, and Schepens, 2013; Jiménez, López, and Saurina, 2013). Using data for EU-25 countries, Uhde and Heimeshoff (2009) show that national banking market concentration has a negative im­ pact on banking sector stability. Berger, Klapper, and Turk-Ariss (2009) examine market power and risk issues for a sample of more than 8,000 banks in twenty-three developed countries for the period 1999–2005. Banks with more market power have lower risk expo­ sure. The results provide some support for both the competition-fragility and competitionstability hypotheses: market power increases credit risk, but banks with more market power are less exposed to other types of risk. Liu, Molyneux, and Wilson (2013) construct measures of competition and economic activi­ ty using regional data to examine bank risk in ten European countries over the period 2000–8. They find a U-shaped relationship exists between regional bank competition and stability, implying that too little or too much competition is associated with bank fragility. Regional economic conditions are also found to play a significant role in determining the stability of European banks. Leroy and Lucotte (2017) examine European listed banks be­ tween 2004 and 2013 and find that competition (using the Lerner index) increases indi­ vidual bank risk but reduces systemic risk (measured in various ways, including Brown­ lees and Engle’s, 2017 SRISK measure). Overall, both the theoretical and the empirical evidence concerning the nature of the relationship between competition and risk in bank­ ing are inconclusive.

32.3 Crisis in European Banking The impact of the financial crisis on European banking began in the summer of 2007, with the failure of a structured investment vehicle (known as Rhineland) of IKB (p. 1017) Deutsche Industriebank, a small German lender. This event prompted a state-led rescue. Liquidity within the banking system evaporated, and overnight interest rates increased dramatically. An injection of liquidity into the Eurozone banking system was effective in averting any major bank failure. The outlook deteriorated dramatically in September 2008, however, following the collapse of the US investment bank Lehman Brothers (DeY­ oung, Chapter 31, this volume). These events created a crisis of confidence that brought the US and European banking systems perilously close to the brink of collapse in Septem­ ber and October 2008 (European Economy, 2009; Goddard, Molyneux, and Wilson, 2009). Between 2007 and 2010, the largest European banks reported huge credit losses. Several major UK and Swiss banks were among the largest casualties. Since October 2008 the Page 35 of 56

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Banking in Europe: Integration, Reform, and the Road to a Banking Union capitalization of many of Europe’s largest banks was bolstered through injections of pub­ lic funding, predominantly in the form of government purchase of preference shares and other quasi-equity instruments. In response to the crisis, most European governments an­ nounced a combination of loan guarantee schemes, bank rescue plans and fiscal stimulus packages (Pisani-Ferry and Sapir, 2010; Stolz and Wedow, 2010; ECB, 2011; EU State Aid Scoreboard, 2017). In terms of explicit government support packages, German banks had the largest recapitalization (€80bn), followed by the UK (€56bn), France (€40bn) and the Netherlands (€36.8bn). For guarantees, the Irish authorities provided support amounting to (€485bn), followed by Germany (€400bn), France (€320bn) and the UK (€280bn) (see ECB, 2009, table 2, p. 42). Since this wave of government-backed bank bailouts, recapitalization plans, liquidity in­ jections, and credit guarantee schemes, there has been widespread concern over the business models of European banks. Large-scale banking rescues have raised serious worries about the social and economic costs of “too-big-to-fail” or “too systemically im­ portant to fail.” Such concerns are not confined to the largest banks: for example, the UK’s Northern Rock was bailed out with public funds because it was perceived to be of systemic importance. An important question for policymakers is whether limits should be placed on bank size, growth or concentration, to minimize the moral hazard concerns raised by banks having achieved TBTF or related status. However, as noted earlier there have been no such size restrictions imposed. Besides the actions of national governments, the European Commission has issued several communications concerning aspects of the crisis: the application of state aid rules to the banking sector; the treatment of banks’ im­ paired assets; the recapitalization of financial institutions; and the provision of restructur­ ing aid to banks. Many of the regulatory or supervisory frameworks for dealing with prob­ lems in the financial system at an EU level were found to be deficient in key respects (Fonteyne et al., 2010). National approaches to crisis management and depositor protec­ tion proved inadequate, and sometimes produced adverse spillover effects on banking systems in other EU member states. There was a lack of cooperation and agreement over arrangements for sharing the burden of fiscal costs arising from the crisis. Effective regu­ lation has also been constrained by a lack of transparency concerning banks’ business models. At first many governments took national measures to deal with the shock of the global fi­ nancial crisis and it was apparent that an effective EU-wide response was lacking. (p. 1018) This led to broad policy debate on how to develop EU institutional arrangements so they are more effective when dealing with banking crises, and particularly in relation to the resolution of large cross-border banking groups. Recognition of these deficiencies led to the de Larosière Report (2009) that outlined issues surrounding the regulation and supervision of EU financial markets. An important area highlighted was the lack of a com­ mon rulebook across EU member states that led to inconsistencies in crisis management. The report proposed the establishment of a new systemic risk board to oversee financial markets as well as high-level coordination among national supervisors. The report recom­ mended the creation of a European Systemic Risk Council (ESRC), chaired by the Presi­ dent of the European Central Bank. Most of the recommendations of the report were Page 36 of 56

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Banking in Europe: Integration, Reform, and the Road to a Banking Union adopted by the EU and a new structure for European financial supervision evolved in late 2010 when the EU Council of Finance (ECOFIN) agreed upon the creation of a new Euro­ pean Systemic Risk Board (ESRB) and a European System of Financial Supervisors (ESFS), comprising three functional authorities: the European Banking Authority (EBA), the European Insurance and Occupational Pensions Authority (EIOPA) and the European Securities and Markets Authority (ESMA). The European System of Financial Supervisors facilitated greater cooperation between national supervisors and also helped develop a single rulebook for financial services. In 2012, the European Commission put forward a longer-term plan known as the Van Rompuy plan (Van Rompuy, 2012) establishing a bank­ ing union (see section 32.4). In addition, proposals for the set-up of a banking union were also driven by the serious fiscal challenges posed to various Eurozone countries as a result of the sovereign debt crisis. This started late 2009 when in various countries worries grew that problems in the banking sector would spill over into government financing, making it difficult for certain sovereigns to borrow in international markets. As noted earlier, evidence of the problems became apparent in April 2010 when Greece had to request emergency financing from the EU, the IMF and the ECB. These fiscal problems caused substantial stress in financial markets, which spread to peripheral Eurozone countries (namely, Ireland, Italy, Portugal, and Spain). These events pushed up sovereign bond yields and the EU, the IMF, and the ECB engineered a series of interventions to improve market liquidity with the aim of sup­ porting banks that would feed through into growth and employment. In an attempt to deal with the sovereign debt crisis, the ECB established the Securities Market Programme (SMP) in May 2010, this enabled the ECB to purchase bonds (particu­ larly sovereign bonds) on the secondary market (it was replaced by a similar scheme known as Outright Monetary Transactions (OMT) in September 2012). Also the ECB used longer-term refinancing operations where the ECB provided banks with central bank money longer than was the case in its normal refinancing activities. As the sovereign debt crisis developed, traditional LTROs were joined by refinancing activity of one year or longer. The most high-profile being two unconventional LTROs with a three-year maturity, which were implemented in December 2011 and February 2012. The loans amounted to some €1 trillion to the banking sector. Later the ECB introduced Targeted Longer-Term Refinancing Operations (TL­ TROs) which are modified longer-term refinancing operations, intended to improve bank lending to the Eurozone’s non-financial sector. The first TLTRO program (TLTRO I) was undertaken in September 2014 with a maturity of up to four years. Banks’ borrowings are based on the total amount of their outstanding loans to the non-financial private sector. Four more TLTROs, each with a maturity of four years, were conducted in 2016 and March 2017. The interest rate for these loans (TLTRO II) corresponds to the Main Refi­ nancing Operations (MRO) rate (namely, the standard one-week liquidity operations rate of the ECB). (p. 1019)

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Banking in Europe: Integration, Reform, and the Road to a Banking Union Finally, an asset purchase program (APP) was adopted at the beginning of 2015. This ini­ tially comprised three parts: the covered bond purchase program (CBPP 3; launched in October 2014), the asset-backed securities purchase program (ABSPP; launched in No­ vember 2014) and the public sector purchase program (PSPP; launched in March 2015). The corporate sector purchase program (CSPP) was added as a further component in June 2016. Under the APP, the ECB purchased around €60 billion worth of securities every month from March 2015 to March 2016; and €80 billion a month from April 2016 to March 2017. From January to April 2018 monthly purchasing volume totaled €30 billion. The APP is sometimes referred to as “quantitative easing.” The APP ended in December 2018. A number of studies highlight the impact of the ECB’s SMP and liquidity injections on the sovereign bond market and banking sector. For instance, De Pooter, Martin, and Pruitt (2018) find that the SMP helped lower the sovereign bond liquidity premium, and Eser and Schwaab (2016) find the interventions lowered yield spreads and volatilities of Euro­ pean sovereign bonds. Garcia-de Andoain et al. (2016) find that liquidity injections helped stabilize the overnight unsecured interbank market. Acharya, Pierret, and Steffen (2016) find that LTROs increased banks’ holding of risky sovereign debt. More recent studies have looked at the impact of the ECB’s actions on banks; for instance, Acharya et al. (2017) show that banks increased their lending to corporations following the Outright Monetary Transactions (OMT) program in mid-2012. Daetz et al. (2017) find that Euro­ zone firms did not increase investments even when their banks retained LTRO funds for a long period, although counterfactual evidence suggests that LTROs helped Eurozone cor­ porations sustain investments better than European corporations outside the Eurozone.

32.4 New Regulatory Architecture and Banking Union There is a general recognition that before the global financial crisis European banks fo­ cused too heavily on high-risk non-interest revenue generation, particularly through secu­ rities trading and investment banking activity. In response, a series of major structural (p. 1020) proposals and legislation have aimed to reduce bank risk and minimize the likeli­ hood of further taxpayer-financed bank bailouts.13 In the UK, the Independent Commis­ sion on Banking (or Vickers Commission after its Chair Sir John Vickers) was tasked with considering structural and non-structural reforms to the UK banking industry, to promote competition and financial stability. The recommendations of the Commission’s Final Re­ port, published in September 2011, suggested that retail banking activity should be “ringfenced” from wholesale and investment banking; systemically important banks with large retail banking activities should have a minimum 10 percent equity-to-assets ratio; contin­ gent capital and debt should be available to absorb future losses; and risk management should become a self-contained, less-complex business for retail banking, but remain complex for wholesale and investment banking (Vickers, 2011).

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Banking in Europe: Integration, Reform, and the Road to a Banking Union The recommendations of the Report were incorporated into the Banking Reform Act of 2014. The annual cost of these reforms to the UK economy are estimated to range be­ tween £1 billion and £3 billion, which compares favorably with an estimated annual cost of £40 billion in lost output following the financial crisis. Ring-fencing has to be in place for UK banks by January 1, 2019 (Britton et al., 2016). The recommendations made by the EU High-level Expert Group on Reforming the Struc­ ture of the EU Banking Sector chaired by Erkki Liikanen (Liikanen, 2012) suggests pro­ prietary trading and other significant trading activities should be assigned to a separate legal entity if the activities to be separated amount to a significant share of a bank’s busi­ ness. Banks now have to draw up and maintain effective and realistic recovery and reso­ lution plans, as outlined in the EU’s Recovery and Resolution Directive adopted in May 2014. The Directive stipulates that the resolution authority is able to request wider sepa­ ration than the mandatory level described above, if deemed necessary. Banks also have to build up a sufficiently large layer of bail-in debt, and such debt should be held outside the banking system. More robust risk weightings have been introduced in the determination of minimum capital standards, and there have been moves to try and ensure that risk is treated more consistently in internal models. Running in parallel with the aforementioned legislation has been the Fourth Capital Re­ quirements Directive (2013) in the EU and Basel III (BCBS, 2010a, 2010b, 2013, 2014, 2017) internationally. The former seeks to implement the latter (with a few changes) into EU law and the new capital and liquidity requirements have to be in place by 2019. Banks hold capital as a buffer against losses as well as a resource for investment. Capital is pre­ dominantly built up through retained earnings and the issuance of equity and quasi-equi­ ty instruments. If losses occur, these are covered out of existing capital. (p. 1021)

The role of capital in regulating banks has been widely studied (see, for instance,

Demirgüç-Kunt, Detragiache, and Merrouche (2013) for an assessment of the role of capi­ tal over the crisis). There have also been attempts to investigate how changes in capital impact on bank risk-taking behavior. Some find that the level of bank equity (the highest quality type of capital) has little impact on reducing bank risk-taking (Delis and Staik­ ouras, 2011; Abedifar, Molyneux, and Tarazi, 2013), whereas others find strong evidence that more capital reduces the probability of bank failure (Berger and Bouwman, 2013). Beltratti and Stulz (2012) and Demirgüç-Kunt, Detragiache, and Merrouche (2013) find that better capitalized banks improved stock performance during the financial crisis. More recently, Gropp et al. (2019) investigate the effects of higher capital requirements (by exploiting the 2011 capital exercise by the European Banking Authority) on bank lending to corporate and retail customers. The results of the empirical analysis suggest the presence of a strong link between bank capital and lending. This is particularly evi­ dent for corporates that have a high dependence on external finance. The capital rules as set out in Basel III and also the EU’s Fourth Capital Requirements Di­ rective (2013) relate to weightings aligned to the riskiness of bank assets and off-balancesheet items. As such, the regulatory classification of the riskiness of particular bank as­ Page 39 of 56

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Banking in Europe: Integration, Reform, and the Road to a Banking Union sets and off-balance-sheet activities should accurately reflect their individual and com­ bined risks. Overall risk-weightings should be sensitive to the portfolio risks faced by banks and reforms to the rules were expected to boost bank capital. Supportive empirical evidence is limited in this regard. Using a sample of large banks from twenty-one OECD countries, Mariathasan and Merrouche (2014) find that reported bank-risk levels were lowered after the introduction of new capital rules (Basel II internal ratings-based ap­ proach). In another cross-country study covering forty-one countries (including banks from Europe) Vallascas and Hagendorff (2013) also demonstrate that that risk-weights as­ signed to bank assets do not reflect overall bank portfolio risks. In fact, the Basel Com­ mittee have revised the earlier risk scheme to try and deal with these inconsistencies (BCBS, 2017). Capital regulations are put in place to try and ensure that banks have sufficient resources to cover losses overall. However, even if banks have sufficient capital they may at times be faced with extreme short-term financial pressures. A short-term liquidity crisis (such as the inability of banks to pay depositors on demand) can rapidly turn into a solvency (capital) crisis. Therefore, together with capital regulations, policymakers have sought to strengthen liquidity standards since the financial crisis (BCBS, 2010b, 2013, 2014). A study by Chiaramonte and Casu (2017) models the link between capital, liquidity, and bank distress for a large sample of EU banks, using various logistic probability models. The authors find that the likelihood of bank failure and distress decreases with increased liquidity. The EU Fourth Capital Requirement Directive (2013) also seeks ongoing reform of bank corporate governance in order to strengthen boards and management; promote the risk management function; amend compensation for bank management and staff; improve risk disclosure; and strengthen sanctioning powers. For executive pay, new EU rules stipulate that the variable part of total compensation cannot exceed 100 percent of (p. 1022) the fixed component. This is tougher than rules in the UK introduced by the Remuneration Code in 2009 (FSA, 2009). This code compels executives to defer a larger proportion of their bonuses (at least 50 percent) for three years. Work on the impact of these regula­ tions is now emerging, for instance, Kleymenova and Tuna (2017) examine the influence of the UK and EU regulations and find that the market reacted positively to the Remuner­ ation Code, but negatively to the EU bonus cap. UK banks also deferred more bonuses and reduced risk, although executive compensation became more complex. Evidence on Europe is further confirmed by Díaz, García-Ramos, and García Olalla (2017) who also find that the EU bonus cap legislation was perceived negatively by investors.

32.4.1 European Banking Union In June 2012, the European Council outlined proposals to create a European banking union as part of a program aimed toward strengthening the resilience of the European fi­ nancial system (European Council, 2012; Dermine, 2013; Véron, 2013; Véron and Wolff, 2013). By addressing the entanglement of non-performing bank debt with sovereign debt, the proposals for the banking union are designed to tackle a fundamental cause of the on­ Page 40 of 56

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Banking in Europe: Integration, Reform, and the Road to a Banking Union going European financial and sovereign debt crises. The banking union comprises three pillars. First, responsibility for bank supervision is undertaken by the ECB for Eurozone banks. Second, common mechanisms are instituted for the effective resolution of ailing banks and particularly large cross-border institutions. Third, common arrangements are to be put in place for the insurance of customer deposits. The first pillar of banking union involved the transfer of supervisory responsibilities for around 120 banks deemed to be “significant,” from national supervisors to a Single Su­ pervisory Mechanism (SSM) operated by the European Central Bank (ECB). The objective is to implement a single harmonized supervisory rulebook based on Basel III, rather than divergent national arrangements. Differences in standards applied at the national level lead to differences between countries in the availability and cost of credit, inhibiting the emergence of an integrated market in financial services. National supervision inhibits or distorts cross-border capital flows: in a crisis, banks with subsidiaries abroad are encour­ aged by their home-country supervisors to repatriate capital or liquidity; while sub­ sidiaries of foreign banks are encouraged by their host-country supervisors not to repatri­ ate funds to their parent banks abroad (Gros, 2012). The initial criteria for a bank to qualify for direct ECB supervision were one or more of the following: assets above €30 billion; assets above €5 billion and 20 percent of GDP in the EU member state in which the bank is located; one of the top three banks in the state in which the bank is located; significant cross-border activity; or recipient of bailout assis­ tance. The role of the European Banking Authority (EBA) was adapted to the new regula­ tory arrangements and, as mentioned in the previous section, new rules on capital regula­ tion (including the EU Capital Requirements Regulation and the Fourth Capital Require­ ments Directive CRD IV) have come into force (effectively implementing Basel III into Eu­ ropean legislation). Prior to the establishment of the SSM in 2014, (p. 1023) the ECB un­ dertook an asset quality review (AQR) of the banks that would fall under its jurisdiction. The AQR was a key element in establishing the ECB’s supervisory credibility, and in deal­ ing with legacy issues of undeclared non-performing assets, which may constitute a major barrier to the implementation of Pan-European resolution and deposit insurance arrange­ ments. At this early stage there were concerns about the ECB’s lack of financial re­ sources to recapitalize banks whose balance sheets were revealed to contain gaps, and the lack of legal authority to enforce either recapitalization by other means or resolution. However, it seems that these concerns were overblown and the ECB (to date) has had a strong and credible supervisory track record. Some have questioned the regulatory focus of the ECB on the largest systemically impor­ tant banks. If the ECB does not exercise supervisory responsibility over small banks, it is also (in theory) debarred from providing liquidity or emergency support. However, small bank failure has been a source of systemic risk in various countries, evidenced by the role of the Spanish savings banks, or the small German lender Hypo Real, in the financial and sovereign debt crises (Beck, 2012; Wyplosz, 2012). Finally, potential tensions may emerge between the ECB’s dual responsibilities for price stability through monetary policy on the one hand, and financial stability through supervision of the banking system on the other. Page 41 of 56

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Banking in Europe: Integration, Reform, and the Road to a Banking Union With respect to the latter Schoenmaker (2013) advocates a separation of the functions of macro-prudential (systemic) and micro-prudential (individual bank) supervision within the ECB. The second pillar, a Pan-European resolution scheme to be mainly funded by the banks, aims to provide a mechanism for the orderly shutdown of non-viable banks, so minimizing the likelihood of taxpayer-funded bank bailouts. Features of the resolution scheme are in­ corporated into the Bank Recovery and Resolution Directive (BRRD) that came into force on January 1, 2015, which is applicable to all credit institutions and most investment firms, including financial groups.14 The Directive requires firms to make “living wills”; af­ fords supervisors early intervention powers; specifies minimum harmonized resolution tools (including the power to sell businesses to third-parties, to transfer a business to a state-owned bridge institution, or “bad” assets to a publicly owned asset management firm); requires institutions to issue bail-in debt that can convert to equity; requires EU member states to set up pre-funded resolution funds; and configures national deposit guarantee schemes for resolution-funding purposes. From January 1, 2016, the bail-in re­ quirements for banks in resolution under the Bank Resolution and Recovery Directive en­ tered into force in all member states that had not already implemented them in 2015. Resolution contributions from the Single Resolution Fund can only be made after a bail-in of at least 8 percent of the bank’s total liabilities. This can require the conversion of se­ nior debt and uncovered (uninsured) deposits. Any contribution of the Fund is subject to a State Aid Decision by the Commission.15 The recent development of using bail-in debt to help refinance a bank when in fi­ nancial difficulties has had a somewhat mixed impact.16 In the run-up to the introduction (p. 1024)

of tougher bail-in laws under the BRRD, which came into force in January 2016, regulato­ ry authorities in various countries used such approaches to resolve troubled banks. In Italy in late 2015, four small regional banks, Banca Eutiria, Banca Marche, Carichieti, and Carife had to be supported to the amount of €3.6 billion euros from a fund financed by the country’s healthy lenders. That move caused political uproar because many of the banks’ junior bonds had been sold to retail investors as savings products, including one pensioner who later committed suicide. Retail investors were generally unaware of the risks posed by holding such bonds. Senior bondholders and depositors were protected in this case. A rescue package announced in November forced losses on some retail in­ vestors after the European Union rejected an alternative scheme that would have spared them, saying it violated EU state aid rules. Other bail-ins that have also been somewhat controversial include the December 2015 heavy losses imposed on nearly €2bn of senior bondholders at the Portuguese bank, Novo Banco, the bank that emerged from the re­ structuring of Banco Espírito Santo. This controversial move prompted threats of lawsuits from some major international investors. Also bond bail-ins have occurred for the major Greek banks in 2015 and depositor bail-ins in 2012, all of which have not been politically popular. It still remains to be seen whether bail-ins will be an effective resolution tool in the case of major bank failure (Honohan, 2017; Philippon and Salord, 2017).

Page 42 of 56

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Banking in Europe: Integration, Reform, and the Road to a Banking Union In Europe, existing insolvency frameworks are fragmented along national lines, and ma­ jor reform would be required for a single resolution scheme to be established along the lines of prompt corrective action (PCA) in the US.17 Banking systems in Europe, as noted in section 32.1 (see Table 32.3) are highly concentrated, and TBTF moral hazard is likely to be pervasive. Sapir and Wolff (2013) argue that broader steps in the direction of Euro­ pean financial integration are required. The fragmentation of retail banking along nation­ al lines raises barriers to the creation of an effective pan-European resolution scheme, because it increases the exposure of banks to shocks at the national level, and limits the options for cross-border merger as a means of achieving resolution. The national orienta­ tion of most European banks also translates into a bias toward lending to their own gov­ ernments, or providing funds for state-sponsored projects that are not financially or com­ mercially viable. In exchange, implicit or explicit guarantees offered to banks by national governments effectively subsidize the banks’ funding costs. All of this strengthens the dangerous ties between banks and sovereigns, to the detriment of (p. 1025) the prospects for financial stability and resolution of the debt crisis. Acharya (2012) identifies the need to curb excessive sovereign borrowing from home-country banks as a further prerequisite (and as a natural counterpart to the banking union) for addressing the crisis. Realistic (rather than zero-) risk weightings should be applied to sovereign debt on banks’ balance sheets, and sovereign credit risk should be recognized in the application of liquidity re­ quirements in bank regulation. Limits on individual bank lending to a single sovereign borrower could be imposed. The cases of countries such as Ireland and Spain during the financial and sovereign debt crises demonstrate that existing national deposit insurance and resolution funds can rapidly be depleted, creating a need for government support which, in turn, pushes sover­ eigns in the direction of insolvency. The third pillar of the banking union is the creation of a European deposit insurance scheme (EDIS) that would operate, along with the resolu­ tion fund, under a common resolution authority. This pillar, however, is hugely controver­ sial because it implies a form of debt mutualization, whereby deposit protection funded by a member with an orderly banking system would be used to protect depositors in a country with a failing banking system. The question whether an effective banking union can be achieved in a gradual manner with the implementation of the first and second pillars and the third (EDIS) still appears some way off. However, the European Commission in October 2017 announced further measures with regard to the introduction of the banking union which included: accelerat­ ing the introduction of EDIS (planned to be in place by 2024); a package of measures aimed at reducing the level of existing NPLs and preventing the build-up of NPLs in the future; a fiscal backstop to the banking union; measures to promote the issuance of sover­ eign bond-backed securities; and other proposals aimed at ensuring high quality bank/fi­ nancial firm supervision.18 It seems that the introduction of the banking union is on track and it does not look like the UK leaving the EU, by an expected 2019, will derail the process. In May (2017) the ECB outlined its financial stability assessment of “Brexit,” where they argue that “it is likely to have limited implications for the Eurozone economy and financial stability” (ECB, 2017c, p. 7). This view was further confirmed by the ECB’s Page 43 of 56

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Banking in Europe: Integration, Reform, and the Road to a Banking Union President Mario Draghi when he testified before the European Parliament’s Economic and Monetary Affairs Committee in Brussels, Belgium on September 24, 2018.19 Having said this, Brexit could have a sizable adverse impact on UK banks, given that approxi­ mately 25 percent of their revenue is believed to be in some way linked to EU clients. Ma­ jor banks with significant wholesale activities in the Eurozone are considering various passporting requirements post-Brexit, and there has already been movement of key trad­ ing parts of various institutions to Frankfurt and Paris.

(p. 1026)

32.5 Summary

This chapter focuses on the evolution of the banking industry in the European Union since the signing of the Treaty of Rome in 1957 to the present day. Particular attention is paid to the operating environment since the global financial and sovereign debt crises. The aforementioned crises have had an adverse impact on the banking sector integration process and bank profitability remains low by historical standards. The EU has intro­ duced a wide range of reforms aimed at boosting banking (and financial sector) stability including new capital and liquidity requirements (in line with those set out under Basel III) as well as new governance rules for banks. It has also set out a roadmap for the estab­ lishment of a banking union comprising three pillars: the single supervisory mechanism (SSM) including ECB oversight of the largest banks; a single resolution mechanism (SRM) to deal with troubled banks; and a single European deposit insurance scheme (EDIS). The EU is also continuing its ongoing push to create a fully integrated banking and financial services industry throughout the Eurozone. A major challenge for the industry relates to restoring profitability back to pre-crises levels. This will inevitability require greater at­ tention to improving efficiencies and, where possible, boosting income. At present many banks remain encumbered by regulatory demands that, while helping their solvency, act as a drag on performance. Many of the largest institutions are yet to fully implement the (ring-fencing) separation of their retail and investment banking activities. It remains an open question as to how this impacts on bank performance going forward. Moreover, the impact of Brexit may force large securities trading banks to contemplate relocating from London to other major financial centers (such as Frankfurt and Paris) within the Euro­ zone. Overall, it seems likely, given the regulatory and economic environment, that Euro­ pean bank performance will be subdued for some time to come.

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(eds.), The Palgrave Handbook of European Banking, Chapter 11 (London: Palgrave Macmillan, 257–92). Gambacorta, L. and van Rixtel, A. (2013). “Structural Bank Regulation Initiatives: Ap­ proaches and Implications,” Bank for International Settlements (BIS) Working Paper No. 412S. Garcia-de Andoain, C., Heider, F., Hoerova, M., and Manganelli, S. (2016). “Lending-ofLast-Resort Is as Lending-of-Last-Resort Does: Central Bank Liquidity Provision and Inter­ bank Market Functioning in the Euro Area,” Journal of Financial Intermediation, 28, 32– 47. Goddard, J., Liu, H., Molyneux, P., and Wilson, J.O.S. (2013). “Do Bank Profits Converge?” European Financial Management, 19, 345–65. Goddard, J., Molyneux, P., and Wilson, J.O.S. (2001). European Banking: Efficiency, Tech­ nology and Growth (Chichester: John Wiley and Sons). Goddard, J., Molyneux, P., and Wilson, J.O.S. (2004a). “Dynamics of Growth and Profitabili­ ty in Banking,” Journal of Money, Credit and Banking, 36, 1069–90. Goddard, J., Molyneux, P., and Wilson, J.O.S. (2004b). “The Profitability of European Banks: A Cross-Sectional and Dynamic Panel Analysis,” Manchester School, 72, 363–81. Page 49 of 56

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Banking in Europe: Integration, Reform, and the Road to a Banking Union Goddard, J., Molyneux, P., and Wilson, J.O.S. (2009). “The Financial Crisis in Europe: Evo­ lution, Policy Responses and Lessons for the Future,” Journal of Financial Regulation and Compliance, 17, 362–80. Goddard, J., Molyneux, P., and Wilson, J.O.S. (2010). “Banking in the European Union,” in A.N. Berger, P. Molyneux, and J.O.S Wilson (eds.), Oxford Handbook of Banking (Oxford: Oxford University Press), 807–43. Goddard, J., Molyneux, P., and Wilson, J.O.S. (2014). “Banking in the European Union: Deregulation, Crisis and Renewal,” in A.N. Berger, P. Molyneux, and J.O.S. Wilson (eds.), Oxford Handbook of Banking, 2nd edn (Oxford: Oxford University Press), 849–72. Goddard, J., Molyneux, P., Wilson, J.O.S., and Tavakoli, M. (2007). “European Banking: An Overview,” Journal of Banking & Finance, 31, 1911–36. Gropp, R., Mosk, T.C., Ongena, S., and Wix, C. (2019). “Bank Response to Higher Capital Requirements: Evidence from a Quasi-Natural Experiment,” Review of Financial Studies, 32, 266–99. Gros, D. (2012). “The Single European Market in Banking in Decline: ECB to the Res­ cue?” in T. Beck (ed.), Banking Union for Europe: Risks and Challenges (London: Centre for Economic Policy Research), 49–54. Haldane, A. (2013). “Have We Solved ‘Too Big To Fail’?” VOX-EU, Centre for European Policy Research Portal, 17 January. Honohan, P. (2017). “Management and Resolution of Banking Crises: Lessons from Re­ cent European Experience,” Peterson Institute for International Economics Policy Brief 17-1, January, Peterson Institute for International Economics, Washington, DC. Inanoglu, H., Jacobs, M., Liu, J., and Sickles, R.C. (2016). “Analyzing Bank Efficiency: Are ‘Too-Big-To-Fail’ Banks Efficient?” in E. Haven, P. Molyneux, J.O.S. Wilson, S. Fedotov, and M. Duygun (eds.), The Handbook of Post Crisis Financial Modeling (Frankfurt: Springer International), 110–46. Jiménez, G., López, J.A., and Saurina, J. (2013). “How Does Competition Impact Bank Risk Taking?” Journal of Financial Stability, 9, 185–95. Kleymenova, A. and Tuna, A.I. (2017). “Regulation of Compensation (June 21, 2017),” Chicago Booth Research Paper No. 16-07, available at SSRN: https://ssrn.com/ab­ stract=2755621 or http://dx.doi.org/10.2139/ssrn.2755621. Koskela, E. and Stenbacka, R. (2000). “Is There a Tradeoff between Bank Compe­ tition and Financial Fragility?” Journal of Banking & Finance, 24, 1853–73. (p. 1031)

Lane, P. (2012). “The European Sovereign Debt Crisis,” Journal of Economic Perspectives, 26, 49–68.

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Banking in Europe: Integration, Reform, and the Road to a Banking Union Leroy, A. and Lucotte, Y. (2017). “Is there a Competition–Stability Trade-off in European Banking?” Journal of International Financial Markets, Institutions and Money, 46, 199– 215. Liikanen, E. (2012). “High-level Expert Group on Reforming the Structure of the EU Banking Sector,” Brussels, October 2, available at: https://ec.europa.eu/info/system/ files/liikanen-report-02102012_en.pdf. Liu, H., Molyneux, P., and Wilson, J.O.S. (2013). “Competition and Stability in European Banking: A Regional Analysis,” Manchester School, 81, 176–201. Lozano-Vivas, A. (1998). “Efficiency and Technical Change for Spanish Banks,” Applied Fi­ nancial Economics, 8, 289–300. Mariathasan, M. and Merrouche, O. (2014). “The Manipulation of Basel Risk-Weights,” Journal of Financial Intermediation, 23, 300–21. Marquez, L.B., Correa, R., and Sapriza, H. (2013). “International Evidence on Govern­ ment Support and Risk Taking in the Banking Sector,” International Monetary Fund Work­ ing Paper No. WP/13/94. Martinez-Miera, D. and Repullo, R. (2010). “Does Competition Reduce the Risk of Bank Failure?” Review of Financial Studies, 23, 3638–64. Matousek, R., Rughoo, A., Sarantis, N., and Assaf, A.G. (2015). “Bank Performance and Convergence during the Financial Crisis: Evidence from the ‘Old’ European Union and Eurozone,” Journal of Banking & Finance, 52, 208–16. Maudos, J. (2017). “Income Structure, Profitability and Risk in the European Banking Sec­ tor: The Impact of the Crisis,” Research in International Business and Finance, 39, 85– 101. Molyneux, P., Schaeck, K., and Zhou, T.M. (2014). “Too Systemically Important to Fail in Banking—Evidence from Bank Mergers and Acquisitions,” Journal of International Money and Finance, 49, 258–82. O’Hara, M. and Shaw, W. (1990). “Deposit Insurance and Wealth Effects: The Value of Be­ ing ‘Too Big to Fail’,” Journal of Finance, 45, 1587–600. Philippon, T. and Salord, A. (2017). “Bail-ins and Bank Resolution in Europe: A Progress Report,” Geneva Reports on the World Economy Special Report 4, International Center for Monetary and Banking Studies and CEPR, Geneva, International Center for Monetary and Banking Studies. Pisani-Ferry, J. and Sapir, A. (2010). “Banking Crisis Management in the EU: An Early As­ sessment,” Economic Policy, 25(62), 341–73.

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Banking in Europe: Integration, Reform, and the Road to a Banking Union Saghi-Zedek, N. (2016). “Product Diversification and Bank Performance: Does Ownership Structure Matter?” Journal of Banking & Finance, 71, October, 154–67. Sapir, A. and Woolff, G. (2013). “The Neglected Side of Banking Union: Reshaping Europe’s Financial System,” Note Presented at the Informal ECOFIN, Vilnius, September. Schaeck, K. and Cihák, M. (2012). “Banking Competition and Capital Ratios,” European Financial Management, 18, 836–66. Schaeck, K. and Cihák, M. (2014). “Competition, Efficiency, and Stability in Banking,” Eu­ ropean Financial Management, 43, 215–41. Schoenmaker, D. (2013). “An Integrated Financial Framework for the Banking Union: Don’t Forget Macro-Prudential Supervision,” European Economy Economic Papers No. 495, April. Stern, G.H. and Feldman, R. (2004). Too Big To Fail: The Hazards of Bank Bailouts (Washington: Brookings Institution Press). (p. 1032)

Stern, G.H. and Feldman, R. (2009). “Addressing TBTF by Shrinking Financial Institu­ tions: An Initial Assessment,” The Region, June, 8–13, available at: https:// www.minneapolisfed.org/publications/the-region/addressing-tbtf-by-shrinking-in­ stitutions-an-initial-assessment. Stolz, S.H. and Wedow, M. (2010). “Extraordinary Measures in Extraordinary Times—Pub­ lic Measures in Support of the Financial Sector in the EU and the United States,” Euro­ pean Central Bank Occasional Paper Series No. 117, July. Strahan, P.E. (2013). “Too Big to Fail: Causes, Consequences, and Policy Responses,” An­ nual Review of Financial Economics, 5, 43–61. Tarullo, D.K. (2012). “Financial Stability Regulation,” Speech at the Distinguished Jurist Lecture, University of Pennsylvania Law School, October 10, Philadelphia, Pennsylvania. Tsionas, E.G., Assaf, A.G. and Matousek, R. (2015). “Dynamic Technical and Allocative Ef­ ficiencies in European Banking,” Journal of Banking & Finance, 52, 130–9. Turk-Ariss, R. (2010). “On the Implications of Market Power in Banking: Evidence from Developing Countries,” Journal of Banking & Finance, 34, 765–75. Uhde, A. and Heimeshoff, U. (2009). “Consolidation in Banking and Financial Stability in Europe: Empirical Evidence,” Journal of Banking & Finance, 33, 1299–311. US Government Accountability Office (2011). Modified Prompt Corrective Action Frame­ work Would Improve Effectiveness (Washington, DC: Government Accountability Office). Vallascas, F. and Hagendorff, J. (2013). “The Risk Sensitivity of Capital Requirements: Evi­ dence from an International Sample of Large Banks,” Review of Finance, 17, 1947–88. Page 52 of 56

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Banking in Europe: Integration, Reform, and the Road to a Banking Union Van Rompuy, H. (2012). “Towards a Genuine Economic and Monetary Union,” 5 Decem­ ber, European Commission, Brussels. Véron, N. (2013). “A Realistic Bridge Toward European Banking Union,” Bruegel Policy Contribution No. 9. Véron, N. and Woolff, G.B. (2013). “From Supervision to Resolution: Next Steps on the Road to European Banking Union,” Bruegel Policy Contribution No. 4. Vickers, J. (2011). Independent Commission on Banking, Final Report (London: The Sta­ tionery Office). Weill, L. (2009). “Convergence in Banking Efficiency across European Countries,” Journal of International Financial Markets, Institutions & Money, 19, 818–33. World Bank (2017). “Understanding Bank Recovery and Resolution in the EU: A Guide­ book to the BRRD,” Financial Sector Advisory Center FinSAC, The World Bank, Finance and Markets, April, Washington, DC. Wyplosz, C. (2012). “Banking Union as a Crisis-Management Tool,” in T. Beck (ed.), Bank­ ing Union for Europe: Risks and Challenges (London: Centre for Economic Policy Re­ search), 17–22.

Notes: (1) The founding six members (Belgium, France, Germany, Italy, Luxembourg, the Nether­ lands) followed by Denmark, Ireland and the UK (1973), Greece (1981), and Spain and Portugal (1986). (2) Since 1986 when there were twelve members, see footnote 1; Austria, Finland, and Sweden joined in 1995; ten countries joined in 2004 (the Czech Republic, Cyprus, Esto­ nia, Latvia, Lithuania, Hungary, Malta, Poland, Slovakia, and Slovenia); Romania and Bul­ garia (2007); and Croatia (2013). The UK voted to leave the EU in June 2016. (3) Germany is the leading EU economy, accounting for over a fifth (21.1%) of EU GDP in 2016, followed by the UK (16.0%), France (15.0%), Italy (11.3%), Spain (7.5%), and the Netherlands (4.7%). Source: http://ec.europa.eu/eurostat/web/products-eurostat-news/-/ DDN-20170410-1. (4) Using a synthetic counterfactual approach, Campos, Coricelli, and Moretti (2014, 2016) show that the benefits from being a member of the EU substantially outweigh the costs. (5) Features of the overall White Paper on Completing the Internal Market were incorpo­ rated in the Single European Act, which entered into force on July 1, 1987 and set a dead­ line of December 31, 1992 for completion of the internal market. This was probably the most important early legislation impacting integration and deregulation across many sec­ tors as it made it easier to introduce EU legislation (and therefore member state legisla­ Page 53 of 56

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Banking in Europe: Integration, Reform, and the Road to a Banking Union tion) that took account of the free provision of services, free movement of capital and ap­ proximation of national legislation. (6) Marquez, Correa, and Sapriza (2013), in a large cross-country study, find that more government support is linked to greater bank risk-taking, particularly between 2009 and 2010. (7) In the UK, for example, the top ten banks employed 288,100 staff in 2012, of which 60 percent were female. Around 37 percent of female employees, but only 4 percent of male employees, were part-time (British Bankers Association, 2012). (8) Emter, Schmitz, and Tirpák (2018) examine the reduction in cross-border banking in the European Union (EU) since the global financial crisis and note that cross-border claims of banks in the Euro Area and the rest of the EU fell by 25 percent over the period. (9) Eurozone fee and commission income has remained relatively flat since 2008 up to 2016, but trading income has increased from 2014. See ECB (2017b, p. 40). (10) Frame, Wall, and White, Chapter 9 in this volume, provide a detailed overview of tech­ nological changes in the banking industry. (11) See chart 2.31, ECB (2017b, p. 42). (12) Prior evidence suggests that there is significant persistence in bank profitability throughout the 1990s, but that this declines (as integration increases) following the intro­ duction of the single currency and the Financial Services Action Plan (Goddard, Molyneux, and Wilson, 2004a, 2004b; Goddard et al., 2013). (13) Risk-based tax schemes (or so-called bank levies) have also been introduced in a num­ ber of EU member states since the financial crisis. The United Kingdom introduced a per­ manent bank tax in January 2011, comprising initially of a tax of 0.04 percent on risky bank liabilities. Besides the UK, there has been a proliferation of bank levies in many oth­ er EU countries including Austria, Belgium, Cyprus, France, Germany, Hungary, Latvia, Netherlands, Portugal, Romania, Slovakia, Slovenia, and Sweden. Chronopoulos, Sobiech, and Wilson (2017) provide a summary of the risk-based schemes introduced in various countries. See also Celerier, Kick, and Ongena (2018) who present evidence that suggests that changes to taxation arrangements which increase the cost of leverage to banks, lead to an increase in equity relative to debt and a reallocation of assets toward loans (without any resultant increase in risk). (14) See World Bank (2017) for a detailed evaluation of the BRRD. (15) State aid: How the EU rules apply to banks with a capital shortfall—Factsheet, Brus­ sels, June 25, 2017. See http://europa.eu/rapid/press-release_MEMO-17-1792_en.htm. (16) Cutura (2018) finds that bank bonds subject to BRRD bail-in carry a bail-in premium in the form of a higher yield spread. This bail-in premium is more pronounced for nonGSIB banks and banks located in peripheral European countries. Page 54 of 56

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Banking in Europe: Integration, Reform, and the Road to a Banking Union (17) PCA has provided extensive experience of bank resolution; but a report by the US Government Accountability Office suggests that PCA did not always operate effectively during the financial crisis, and recommends that additional early warning triggers (relat­ ed to asset quality and asset concentration) be adopted (US Government Accountability Office, 2011). (18) See http://europa.eu/rapid/press-release_IP-17-3721_en.htm?locale=en. (19) See https://www.reuters.com/article/us-britain-eu-ecb/ecbs-draghi-sees-muted-impactto-euro-zone-from-brexit-idUSKCN1M41ND.

John Goddard

John Goddard is the Head of Aberystwyth Business School at Aberystwyth University, Wales. He is also Emeritus Professor of Financial Economics at Bangor University, and served as Deputy Head of Bangor Business School between 2007 and 2017. His previous academic appointments were at the University of Leeds, Abertay University and Swansea University. He has several years’ practitioner experience in the UK life insurance industry. His research interests are in industrial organization, financial markets and institutions, and the economics of professional sports. He is author or co-author of sixty-nine refereed journal articles. His co-authored book publications include The Economics of Football (2nd edition, Cambridge University Press, 2011), Banking: A Very Short Introduction (Oxford University Press, 2016) and the textbook Industrial Organization: Competition, Strategy, Policy (5th edition, Pearson, 2017). Philip Molyneux

Philip Molyneux is Dean of the College of Business Administration at the University of Sharjah (in the UAE). His main area of research is on the structure and efficiency of banking markets and he has published widely in this area. Recent publications ap­ pear in the Journal of Money, Credit and Banking, Journal of Financial Intermedia­ tion, Journal of Banking & Finance and the Review of Finance. He has co-written/ edited over thirty-five books and is also the series editor of the Palgrave Macmillan Studies in Banking and Financial Institutions—with over 135 books in the series to date. In the past, Philip has acted as a consultant to the New York Federal Reserve Bank, World Bank, European Commission, UK Treasury, Citibank Private Bank, Bar­ clays Wealth, McKinsey, Credit Suisse and various other international banks and con­ sulting firms. John O. S. Wilson

John O. S. Wilson is Professor of Banking and Finance and Director of the Centre for Responsible Banking & Finance based at the University of St Andrews. He is also a Member of the Scientific Advisory Board of Chartered Association of Business Schools Academic Journal Guide. Previously, he was Treasurer and General Secretary of the British Accounting and Finance Association during the period 2009–11, and the founding Chair of the British Accounting and Finance Association Financial Mar­ Page 55 of 56

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Banking in Europe: Integration, Reform, and the Road to a Banking Union kets and Institutions Special Interest Group over the period 2007–18. He has guest edited special issues for Journal of Corporate Finance, Journal of Banking & Finance, Journal of Economic Behaviour & Organization, European Journal of Finance, Public Money & Management, British Accounting Review and Managerial Finance. In the period June 2011 to April 2012, John served as a full member of a Commission on Credit Unions established by the Irish Government. The Commission delivered inter­ im and final reports to the Minister for Finance in September 2011 and April 2012 respectively. In 2018, John delivered evidence on the impact of Brexit on UK small and medium-sized enterprises to the House of Lords EU Internal Markets Committee.

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Banking in Japan: A Post-global Financial Crisis Perspective

Banking in Japan: A Post-global Financial Crisis Per­ spective   Hirofumi Uchida and Gregory F. Udell The Oxford Handbook of Banking (3rd edn) Edited by Allen N. Berger, Philip Molyneux, and John O. S. Wilson Print Publication Date: Oct 2019 Subject: Economics and Finance, Financial Economics Online Publication Date: Nov 2019 DOI: 10.1093/oxfordhb/9780198824633.013.33

Abstract and Keywords This chapter focuses on the structure, performance, and some of the defining characteris­ tics of the Japanese banking industry. An analysis of the banking industry in Japan may be of particular interest because of its important role in one of world’s largest economies, its historical orientation to banks in its financial system, its idiosyncratic features related to the nature of the Japanese corporate environment such as its “main bank system,” and its significant transition, which is sometimes idiosyncratic to this country, such as the bank­ ing crisis of the 1990s. After providing an overview of the Japanese banking system, we focus on some specific topics on banking in Japan, including the Japanese main bank sys­ tem, lending technologies in Japan, the Japanese banking crisis, and banking in post-cri­ sis Japan. Keywords: Japan, bank-oriented financial system, main bank system, banking crisis, lost-decades

33.1 Introduction THIS chapter focuses on the structure, performance, and some of the defining character­ istics of the Japanese banking industry. There are a number of reasons why an analysis of the banking industry in Japan may be of particular interest. First, it is an essential part of one of world’s largest economies. Second, like some other developed economies such as Germany, Japan has historically been a banking-oriented financial system. Third, the banking industry has some very interesting idiosyncratic features related to the nature of the Japanese corporate environment such as its “main bank system.” Fourth, like other countries, the Japanese banking system has been in a period of significant transition, some of which is idiosyncratic to Japan, such as the banking crisis of the 1990s. In section 36.2 we provide an overview of the Japanese banking system. Then in section 36.3 we turn to some specific topics on banking in Japan, including the Japanese main

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Banking in Japan: A Post-global Financial Crisis Perspective bank system, lending technologies in Japan, the Japanese banking crisis, and banking in post-crisis Japan. Section 36.4 concludes.1

33.2 Overview of the Japanese Banking System (p. 1034)

In this section we provide an overview of the banking industry in Japan including discus­ sions of its market structure, efficiency, permissible activities, and regulation.

33.2.1 The Importance of Banking and Intermediated Finance in Japan The importance of banking and intermediated finance in Japan can be seen in Table 33.1. This breakdown of Japanese financial assets shows that of the 8,150 trillion yen of finan­ cial assets, 47 percent are held by Japanese financial institutions. Depository financial in­ stitutions are, by far, the largest component, holding 23 percent of the country’s financial assets, virtually all of which can be loosely classified as “banks”—the main focus of this chapter. The largest segment of the banking industry is domestically licensed banks (58 percent of banking assets). The remainder consists of foreign banks (2 percent), “financial” (banking) institutions for agriculture, forestry and fisheries (15 percent), and “financial” (banking) institutions for small businesses (25 percent). We can also see the importance of the banking system to the Japanese corporate, govern­ ment, and household sectors. Table 33.2 shows the composition of financial assets and claims by financial instruments for each of these sectors. In the corporate sector, loans by private financial institutions and shareholders’ equity (i.e., “shares”) were the largest cat­ egories. At the end of March 2017, they comprise respectively 18.6 percent and 50.0 per­ cent of firms’ total financing. The corresponding figures were 23.2 percent and 25.1 per­ cent at the end of March 2012, indicating a reduced reliance on bank loans and an in­ creased reliance on equity, although this may reflect higher stock prices given that equity is shown at market value. Other forms of relatively less important debt include commer­ cial paper (0.1 percent) and corporate bonds (i.e., “industrial securities”) (2.8 percent). By way of comparison, in the US, domestic bank loans comprise 8.5 percent of corporate liabilities with commercial paper providing 0.8 percent and corporate bonds providing 19.7 percent (Q4 2017 US Flow of Funds Accounts). As is often the case in developed economies, the government sector is the largest debtor sector in Japan. Not surprisingly this sector is heavily dependent on bonds and bills for its financing (e.g., “financing bills,” “central government securities and FILP bonds,” and “local government securities”: 82.8 percent). Many of these bonds and bills are held by the banking sectors with only a relatively small amount of this owned directly by the pub­ lic (i.e., “households”).

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Banking in Japan: A Post-global Financial Crisis Perspective On the consumer side, of the 1,808 trillion yen of financial assets held by households, 51.6 percent is invested in demand (“transferable”) and time and savings deposits. (p. 1039) The next biggest category of consumer assets is insurance and pension assets (28.7 percent) followed by equity investments (“equity”) (10.1 percent) and investment trusts including mutual funds (“investment trust beneficiary certificates”) (5.4 percent). The biggest component of consumer debt is housing loans from either private or public fi­ nancial institutions (55.4 percent). Overall, these data indicate that Japan is still predomi­ nantly a bank-intermediated financial system compared to market-oriented systems such as the UK and the US.

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Banking in Japan: A Post-global Financial Crisis Perspective (p. 1035)

(p. 1036)

Table 33.1 Financial Assets in Japan by Holder

Financial in­ stitutions

38,95 5,550

(47% )

Central bank

5,112, 329

(6%)

Depository corporations

19,13 8,092

(23%)

Banks

18,94 2,240

(23%)

Domestically licensed banks

10,97 8,071

(58% amon g “Bank s”)

Foreign banks in Japan

431,4 22

(2% amon g “Bank s”)

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Banking in Japan: A Post-global Financial Crisis Perspective Financial institutions for agriculture, forestry, and fisheries

2,872, 858

(15% amon g “Bank s”)

Financial institutions for small businesses

4,659, 889

(25% amon g “Bank s”)

Collectively managed trusts Securities investment trusts

195,8 52 1,882, 381

(0%)

(2%)

Of which MMF and MRF Insurance and pension funds In­ suran ce

120,9 45 6,370, 071

(8%)

4,812, 656

(6%)

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Banking in Japan: A Post-global Financial Crisis Perspective Life insurance

3,747, 743

Non-life insur­ ance

461,2 97

Mutual aid in­ surance

603,6 16

Pension funds

Other financial intermedi­ aries

5,129, 397

1,557, 415

(2%)

808,8 90

(1%)

(6%)

Non-banks

Finance compa­ nies

623,4 44

Structured-financing special purpose compa­ nies and trusts

185,4 46

Public financial institu­ tions

2,521, 371

(3%)

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Banking in Japan: A Post-global Financial Crisis Perspective Fiscal Loan Fund

1,301, 411

Gov­ ern­ ment finan­ cial insti­ tu­ tions

1,219, 960

Financial dealers and bro­ kers

1,799, 136

Financial auxiliaries (financial institutions other than intermediaries)

719,6 57

(1%)

Of which: Financial hold­ ing companies Public captive financial institutions

Non-financial corpora­ tions

12,03 2,515

(2%)

586,4 40 603,6 23

(1%)

(15% )

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Banking in Japan: A Post-global Financial Crisis Perspective General government

5,615 ,428

(7%)

Households

18,07 9,776

(22% )

Private non-profit institutions serving households

554,5 87

(1%)

Over­ seas

6,251 ,329

(8%)

Total

81,48 9,185

(100 %)

Source: Flow of Funds Account (the Bank of Japan) (100 million yen, March 31, 2017).

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Banking in Japan: A Post-global Financial Crisis Perspective (p. 1037)

(p. 1038)

Table 33.2 Assets and Liabilities of the Japanese Corporate, Government, and Household Sectors

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Banking in Japan: A Post-global Financial Crisis Perspective

Currency and de­ posits

Currency

Private non-financial cor­ porations

General Government

Households

Assets

Assets

Assets

Liabilities

Liabilities

Liabilities

2,5 53, 308

(22. 3%)

935 , 815

(16. 7%)

9,3 24, 761

(51. 6%)

80,7 05

(0.7 %)

7

(0.0 %)

818, 866

(4.5 %)

217, 507

(3.9 %)

Govern­ ment de­ posits Transfer­ able de­ posits

1,61 3,10 8

(14. 1%)

311, 841

(5.6 %)

3,91 9,45 7

(21. 7%)

Time and savings de­ posits

584, 484

(5.1 %)

146, 332

(2.6 %)

4,52 6,61 1

(25. 0%)

Certificates of deposits

174, 458

(1.5 %)

126, 565

(2.3 %)

279

(0.0 %)

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Banking in Japan: A Post-global Financial Crisis Perspective Foreign cur­ rency de­ posits

100, 553

(0.9 %)

Deposits with the Fiscal Loan Fund

Loans

Call loans and bills

574 , 986

(5.0 %)

1,32 1

(0.0 %)

Loans by private fi­ nancial in­ stitutions Hou sing loan s

4,0 40, 361

3,08 9,41 6

(24. 4%)

(18. 6%)

133, 563

(2.4 %)

274 , 490

(4.9 %)

243 , 683

(4.3 %)

64

(0.0 %)

1,5 72, 965

(12. 4%)

638, 982

(5.0 %)

59,5 48

(0.3 %)

4,0 59

(0.0 %)

2,9 51, 627

(93. 1%)

2,51 5,14 0

(79. 4%)

1,75 5,09 5

(55. 4%)

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Banking in Japan: A Post-global Financial Crisis Perspective Con sum er cre dit Loa ns to com pa­ nies and gov­ ern­ men ts Loans by public fi­ nancial in­ stitutions

328, 246

(10. 4%)

3,08 9,41 6

(18. 6%)

638, 982

(5.0 %)

431, 799

(13. 6%)

338, 580

(2.0 %)

903, 257

(7.1 %)

385, 861

(12. 2%)

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Banking in Japan: A Post-global Financial Crisis Perspective Of whi ch: Hou sing loan s Loans by the non-fi­ nancial sec­ tor

556, 006

(4.9 %)

Installment credit (not included in consumer credit) Repurchase agreements and securi­ ties lending transactions

17,6 59

(0.2 %)

424, 970

(2.6 %)

187, 395

(1.1 %)

243, 374

245

(4.3 %)

(0.0 %)

27,9 90

2,73 6

(0.2 %)

4,05 9

(0.0 %)

225, 038

(7.1 %)

49,6 18

(1.6 %)

1,00 8

(0.0 %)

(0.0 %)

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Banking in Japan: A Post-global Financial Crisis Perspective Debt securities

277 , 419

(2.4 %)

668 , 741

(4.0 %)

Treasury discount bills

836 , 098

(14. 9%)

10, 518 , 824

(82. 8%)

29

(0.0 %)

1,15 2,13 2

(9.1 %)

245 , 446

(1.4 %)

Central gov­ ernment se­ curities and FILP bonds

85,3 56

(0.7 %)

518, 565

(9.2 %)

8,63 2,54 1

(68. 0%)

125, 263

(0.7 %)

Local gov­ ernment se­ curities

8,00 3

(0.1 %)

122, 353

(2.2 %)

726, 802

(5.7 %)

7,06 1

(0.0 %)

Public cor­ poration se­ curities

30,7 39

(0.3 %)

109, 142

(1.9 %)

377

(0.0 %)

6,05 8

(0.0 %)

Bank debentures

4,24 0

(0.0 %)

5,22 7

(0.1 %)

275

(0.0 %)

Industrial securities

19,7 43

(0.2 %)

76,6 04

(1.4 %)

70,1 75

(0.4 %)

2,19 2

467, 782

(0.0 %)

(2.8 %)

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Banking in Japan: A Post-global Financial Crisis Perspective External se­ curities is­ sued by res­ idents

177, 015

(1.1 %)

35

(0.0 %)

21,7 52

(0.1 %)

6

(0.0 %)

6,97 2

Commercial paper

20,7 37

(0.2 %)

Trust bene­ ficiary rights

46,4 30

(0.4 %)

4,08 7

(0.1 %)

Structuredfinancing instruments

62,1 71

(0.5 %)

50

(0.0 %)

Equity and invest­ ment fund shares

3,6 02, 984

(31. 4%)

8,4 18, 151

(50. 7%)

1,1 83, 607

(21. 1%)

144 , 056

3,47 0,60 7

(30. 3%)

8,29 9,56 4

(50. 0%)

1,18 1,99 8

(21. 0%)

144, 056

Equity

(0.1 %)

36,6 14

(0.2 %)

(1.1 %)

2,8 14, 355

(15. 6%)

(1.1 %)

1,82 9,18 2

(10. 1%)

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Banking in Japan: A Post-global Financial Crisis Perspective Investment trust benefi­ ciary certifi­ cates

132, 377

(1.2 %)

118, 587

(0.7 %)

Insurance, pen­ sion and stan­ dardized guaran­ tees

22, 481

(0.2 %)

287 , 473

(1.7 %)

Financial deriva­ tives and employ­ ee stock options

28, 117

(0.2 %)

48, 943

(0.3 %)

56

(0.0 %)

1,7 73

(0.0 %)

Forwardtype instru­ ments

25,1 87

(0.2 %)

42,7 70

(0.3 %)

56

(0.0 %)

1,77 3

(0.0 %)

Option-type instruments

2,93 0

(0.0 %)

3,86 1

(0.0 %)

5,79 8

(0.0 %)

2,31 2

(0.0 %)

2,31 2

(0.0 %)

Employee stock op­ tions

1,60 9

(0.0 %)

985, 173

(5.4 %)

5,1 83, 100

(28. 7%)

8,1 10

(0.0 %)

8,1 40

(0.3 %)

2,57 1

(0.0 %)

5,56 9

(0.0 %)

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Banking in Japan: A Post-global Financial Crisis Perspective Deposits money

366 , 430

(3.2 %)

412 , 793

(2.5 %)

42, 687

(0.8 %)

46, 294

(0.4 %)

163 , 161

(0.9 %)

Trade credits and foreign trade credits

2,2 28, 206

(19. 4%)

1,9 76, 925

(11. 9%)

6,3 61

(0.1 %)

179 , 295

(1.4 %)

32, 509

(0.2 %)

64, 296

(2.0 %)

Accounts receiv­ able/payable

143 , 824

(1.3 %)

304 , 124

(1.8 %)

183 , 289

(3.3 %)

92, 274

(0.7 %)

66, 487

(0.4 %)

50, 255

(1.6 %)

Outward direct in­ vestment

1,1 60, 913

(10. 1%)

Outward invest­ ment in securities

337 , 612

(2.9 %)

1,7 61, 995

(31. 4%)

219 , 514

(1.2 %)

Other external claims and debts

10, 439

(0.1 %)

1,4 57

(0.0 %)

118 , 959

(2.1 %)

22, 040

(0.2 %)

Others

154 , 653

(1.3 %)

428 , 815

(2.6 %)

28, 388

(0.5 %)

122 , 464

(1.0 %)

18, 274

(0.1 %)

95, 251

(3.0 %)

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Banking in Japan: A Post-global Financial Crisis Perspective Total

11, 461 , 372

(10 0.0 %)

(Difference be­ tween financial as­ sets and liabilities)

16, 587 , 783

(10 0.0 %)

−5, 126, 411

(deb tor)

5,6 15, 428

(10 0.0 %)

12, 699 , 985

(10 0.0 %)

−7, 084, 557

(deb tor)

18, 079 , 776

(10 0.0 %)

3,1 69, 569

(10 0.0 %)

14,9 10,2 07

(cre di­ tor)

Source: Flow of Funds Account (the Bank of Japan) (100 million yen, March 31, 2017).

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Banking in Japan: A Post-global Financial Crisis Perspective

Figure 33.1 Composition of Financial Assets in Japan by Holder. Source: Flow of Funds Account (the Bank of Japan) (March 31, 2017).

It has been suggested that high growth in the post-war period may have been facilitated by the banking-oriented nature of Japan’s financial system, and some have further argued that this type of financial system with its emphasis on financial intermediation may be a good model for developing economies (Aoki and Patrick, 1994). However, it should also be noted that Japan suffered a banking crisis that began in the 1990s, the cause of which has been linked to the banking system. While Japan can still be categorized as having a bank­ ing-oriented financial system, the dependence on banking appears to be diminishing. Specifically, the proportion of financial assets held in banks has been on a general down­ ward trend throughout the 1990s, the 2000s, and the 2010s (see Figure 33.1).2

33.2.2 Segmentation in the Japanese Banking Market Since World War II the Japanese financial industry had been segmented by the nature of the services provided by each type of financial institution. The origin of this regulatory segmentation dates back to the crisis-mode wartime system. Its purpose was to limit com­ petition in order to promote banking profitability, thereby enhancing the safety and soundness of the financial system. Although financial liberalization in the 1980s and 1990s blurred the divide between different types of financial institutions, there still re­ main some boundaries (see Hoshi and Kashyap, 2001, chapter 4). Today commercial banks and commercial banking are defined under the 1981 Banking Law. Ordinary banks (futsuu ginko) are the most common type under the law, but there are other financial institutions and public banks that engage in commercial banking. The law also permits banks to engage in activities other than lending, deposit-taking or pay­ Page 20 of 79

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Banking in Japan: A Post-global Financial Crisis Perspective ments/settlement services, including investing in bonds and stocks (with some restric­ tions). As we will see in section 33.3.1, bank equity ownership gives banks an important role in corporate governance not only as a creditor but also as a stockholder.3 In the case of certain activities such as factoring and leasing, banks must engage in them indirectly through affiliates. With this background in mind we now turn to a description of the vari­ ous types of bank in Japan.4 (p. 1040)

33.2.2.1 City Banks

City banks—often referred to as mega banks—are a type of ordinary bank. Although there are now only five city banks in Japan (Mitsui-Sumitomo (SMBC), Mitsubishi-Tokyo-UFJ (MUFG), Mizuho, Resona, and Saitama Resona), they are the largest single category (see Table 33.3).5 City banks grew quite rapidly in absolute and relative importance during the 1980s (see Figure 33.2). Four of these (excluding Saitama Resona) are (p. 1041) universal banks offering nationwide branch banking and three (excluding Resona and Saitama Res­ ona) have extensive foreign bank networks.

33.2.2.2 Regional Banks and Second Regional Banks Comprising the second largest category—the regional banks—are sixty-four regionally oriented medium-sized banks (all substantially smaller than the city banks) (Table 33.3). The second (-tier) regional banks also operate regionally but tend to be smaller in size. Historically these were established as mutual (Sogo) banks whose purpose was to provide (p. 1044) financing to small to medium-sized enterprises (SMEs). While they are no longer restricted to this sector, they still tend to focus on SMEs. As a group, the second regional banks are considerably smaller than city banks and regional banks but they still play an important role in providing SME financing. Economists have often grouped regional and second regional banks together because both categories tend to focus on local and retail banking.

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Banking in Japan: A Post-global Financial Crisis Perspective

Figure 33.2 Loans Outstanding of Private Banks. Source: Financial Institutions Accounts (the Bank of Japan).

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Banking in Japan: A Post-global Financial Crisis Perspective (p. 1042)

pri­ vat e ban ks

(p. 1043)

Table 33.3 Descriptive Statistics for Different Bank Types in Japan # of ba nks

As­ set s

Lo ans

De­ pos its

Lo ans /as­ set s

Lo ans / De­ pos its

su­ per vi­ so­ ry au­ tho rity

City banksx

5

5,3 86, 766

1,9 05, 295

3,4 33, 657

0.3 5

0.5 5

FS A (Fi­ nan cial Ser vic es Age ncy )

Regional banks

64

3,1 04, 493

1,9 25, 353

2,5 43, 180

0.6 2

0.7 6

FS A

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Banking in Japan: A Post-global Financial Crisis Perspective Second re­ gional banks

41

747 , 335

507 , 988

Trust banks

16

1,0 04, 000

0.6 8

0.7 7

0.4 6

*

Foreign banks

53

463 , 480

73, 135

82, 870

0.1 6

0.8 8

FS A

Japan Post Bank

1

2,0 95, 688

40, 641

1,7 94, 347

0.0 2

0.0 2

FS A

Other banks un­ der the Banking Act#

12

329 , 621

148 , 940

247 , 134

0.4 5

0.6 0

FS A

Shinkin banks

264

1,5 12, 273

691 , 675

1,3 79, 128

0.4 6

0.5 0

FS A

*

462 , 268

657 , 873 *

494 , 925

*

0.9 3

FS A

*

FS A

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Banking in Japan: A Post-global Financial Crisis Perspective Credit co­ operatives

151

223 , 179

106 , 382

199 , 392

0.4 8

0.5 3

FS A

Agricultur­ al coopera­ tives

679

1,1 77, 958

216 , 836

982 , 529

0.1 8

0.2 2

Min istr y of Agr icul tur e, For es­ try and Fis her y

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Banking in Japan: A Post-global Financial Crisis Perspective Gov ern me nt fi­ nan cial in­ sti­ tu­ tion s

Japan Housing Finance Agency

1

263 , 202

96, 730

0

0.3 7

NA

Min istr y of Lan d, In­ fras tru ctu re and Tra nsp ort

Develop­ ment Bank of Japan

1

164 , 226

132 , 102

0

0.8 0

NA

Min istr y of Fi­ nan ce

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Banking in Japan: A Post-global Financial Crisis Perspective Shoko Chukin Bank

1

127 , 789

93, 568

51, 090

0.7 3

1.8 3

Min istr y of Eco no­ my, Tra de, and In­ dus try

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Banking in Japan: A Post-global Financial Crisis Perspective Jap an­ Fi­ nan ce Cor po­ ra­ tion

Mi­ cro Bus ine ss and In­ di­ vid­ ual Uni t (for me rly Na­ tion al Life Fi­ nan ce Cor po­ ra­ tion )

1

69, 966

69, 219

0

0.9 9

NA

Min istr y of He al­ th, La­ bor and Wel far e and Min istr y of Fi­ nan ce

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Banking in Japan: A Post-global Financial Crisis Perspective Agr icul tur e, For es­ try, Fis her ies and Foo d Bus ine ss Uni t (for me rly Agr icul tur e For es­ try

1

27, 334

26, 480

0

0.9 7

NA

Min istr y of Agr icul tur e, For es­ try and Fis her ies

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Banking in Japan: A Post-global Financial Crisis Perspective and Fis her ies Fi­ nan ce Cor po­ ra­ tion ) Sm all and Me di­ um En­ ter­ pris e (S ME ) Uni t

1

53, 667

55, 376

0

1.0 3

NA

Min istr y of Eco no­ my, Tra de, and In­ dus try

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Banking in Japan: A Post-global Financial Crisis Perspective (for me rly Jap an Fi­ nan ce Cor po­ ra­ tion for Sm all and Me di­ um En­ ter­ pris es)

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Banking in Japan: A Post-global Financial Crisis Perspective Jap an Ban k for In­ ter­ na­ tion al Co­ op­ era­ tion +

1

185 , 717

143 , 091

0

0.7 7

NA

Min istr y of Fi­ nan ce

Notes: Deposits do not include CDs (certificates of deposits) and financial bonds issued by some banks (similar to time-de­ posits). (x) Mizuho Bank, Bank of Tokyo-Mitsubishi UFJ, Sumitomo Mitsui Banking Corporation, Resona Bank, Saitama Res­ ona Bank. (*) These figures are for four trust banks that are full members of the Japanese Bankers Association.

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Banking in Japan: A Post-global Financial Crisis Perspective (#) Aozora Bank, AEON Bank, Shinhan Bank Japan, Jibun Bank, Japan Net Bank, Shinginko Tokyo, Shinsei Bank, SBI Sumishin Net Bank, Seven Bank, Sony Bank, Daiwa Next Bank, and Rakuten Bank. The Resolution and Collec­ tion Bank is excluded because it is not an ordinary commercial bank. Sources and dates: [# of banks for private banks]: FSA, the Japanese Bankers Association, National Shinkin Banks Financial Statements, National Central Society of Credit Cooperatives, and Norinchukin Research Institute, as of March 31, 2017. [Balance sheet figures]: The Bank of Japan, the Japanese Bankers Association, National Shinkin Banks Financial Statements, National Central Society of Credit Cooperatives, Norinchukin Research Institute, and respective banks, as of March 31, 2017. [Unit (for assets, loans, and deposits)]: 100 million yen.

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Banking in Japan: A Post-global Financial Crisis Perspective 33.2.2.3 Trust Banks Under the 1943 Act on Provision of Trust Business by Financial Institutions, special types of banks, called trust banks, are allowed to offer trust services. They are, nevertheless, commercial banks under the Banking Law with respect to their provision of normal bank­ ing services. These banks offer money trusts (kinsen shintaku) which are essentially a form of medium- to long-term time deposit. From an asset perspective, these money trusts enable these banks to provide long-term corporate funding by making long-term commercial loans and investing in bonds and equities. This role was especially important given that the domestic post-war Japanese corporate bond market had been undeveloped.

33.2.2.4 Long-term Credit Banks Historically, long-term credit banks also played an important role in providing long-term corporate funding in the post-war Japanese financial system. They no longer exist in their original form, however. They were initially designed to complement ordinary banks which were (supposed to be) restricted to short-term lending. Long-term credit banks could is­ sue bonds that were historically more attractive to investors than time deposits because of, among other things, deposit rate ceilings. These banks disappeared as a distinct group due to their financial distress or their consolidation (e.g., merger) during the Japanese banking crisis. Their function as providers of long-term corporate finance has been partly replaced by the emergence of a domestic Japanese corporate bond market and increased access to the Eurobond and other international bond markets.

33.2.2.5 Foreign Banks There are a large number of foreign banks that have branch offices or agencies in Japan. These branches require a banking license, and are regulated in the same manner as do­ mestic banks under the Banking Law. Overall, focusing primarily on providing foreign ex­ change-related services, they play only a minor role in Japanese financial intermediation, as indicated in Table 33.3, and Figure 33.2.

33.2.2.6 Shinkin Banks and Credit Cooperatives Shinkin banks (Shin-you Kinko) and credit cooperatives (Shin-you Kumiai) are both coop­ eratives that specialize in providing commercial banking services to member SMEs and individuals. They are not legally “banks” because they operate under a special set of laws, but they engage in the same activities as other banks, although they are restricted (p. 1045) to lending to their member firms and restricted geographically. Financial deregu­ lation in the 1980s expanded their product scope to include, for example, lending to nonmembers and offering mutual funds.

33.2.2.7 Other Financial Institutions Providing Commercial Banking Ser­ vices As shown in Table 33.3, there are also a number of other financial institutions that pro­ vide commercial banking services. Other banks under the Banking Law include two for­ mer long-term credit banks (see section 33.2.2.4); Internet banks established by non-fi­ nancial companies; a resolution bank to manage, collect, and dispose of the assets of Page 34 of 79

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Banking in Japan: A Post-global Financial Crisis Perspective failed financial institutions; and, recently established banks which do not fit into the clas­ sifications above. There are also additional cooperative banks beyond Shinkin banks and credit coopera­ tives: labor banks, agricultural cooperatives, fishery cooperatives, and forestry coopera­ tives. Among these, the agricultural cooperatives are quite numerous (commonly called collectively as JA Bank (Japan Agriculture Bank). Like Shinkin banks and credit coopera­ tives, these banks are becoming similar to banks that operate under the Banking Law, due to deregulation.

33.2.2.8 Public Banks As in some other countries, postal savings have played a historically important role in Japan. Postal savings had long been provided by the government (via the Ministry of Posts and Telecommunications). Funds collected through postal savings flowed to the Ministry of Finance which, in turn, allocated the funds to government financial institutions and other official accounts through the Fiscal Investment Loan Program (FILP) (see, e.g., Cargill and Yoshino, 2000). In the January 2001 reform, the Postal Services Agency assumed the operation of the three postal businesses (postal savings as well as postal insurance and postal mail ser­ vices), and in April 2001 stopped sending its funds to the Ministry of Finance and started to allocate the funds at its own discretion. In 2003, the three businesses were further transferred to Japan Post, a state-owned company. Finally, in October 2007 the operation of the postal savings business was succeeded by a newly established private bank, the Japan Post Bank. All the equity of the Japan Post Bank was owned by a government hold­ ing company (the Japan Post Holdings). Initially, the equity was to be sold in the market in a stepwise manner ending in 2017, but this deadline was changed to “as soon as possi­ ble.” Although the Japan Post Bank was first listed on the Tokyo Stock Exchange in No­ vember 2015, whether it becomes a fully private bank is still a contentious political issue.6 Although postal savings in the past had tax and institutional advantages, today they are the same as deposits provided by other private banks—making the Japan Post Bank (p. 1046) effectively the single largest depository institution in Japan (see Table 33.3). Due to historical inertia, most of the assets of the Japan Post Bank are now invested in very low-risk instruments, making it effectively similar to a narrow (100 percent reserve) bank, although there is some interest in expanding its asset composition into such cate­ gories as housing and corporate loans.7 There are also a number of other government financial institutions. Some are not techni­ cally banks because they do not raise funds through deposits (Table 33.3). These institu­ tions had been users of the FILP funds raised through postal savings (and related sources). Now they raise funds themselves by issuing special government guaranteed bonds. They were also consolidated and some are in the process of privatization. The Japan Housing Finance Agency (formerly the Government Housing Loan Corporation) had Page 35 of 79

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Banking in Japan: A Post-global Financial Crisis Perspective historically provided housing loans but now it only securitizes housing loans originated by private banks. The Development Bank of Japan is a public bank that has been providing long-term funds to corporations. It played an important role in the post-war development of Japan. There are also some institutions that focus on SME lending: the Shoko Chukin Bank and the Japan Finance Corporation (JFC). The latter was established in 2008 as a successor to the National Life Finance Corporation and the Japan Finance Corporation for Small and Medium Enterprises (formerly the Japan Finance Corporation for Small Business).8 The JFC also absorbed the Agriculture Forestry and Fisheries Finance Corpo­ ration and temporarily absorbed the Japan Bank for International Cooperation (JBIC). However, the JBIC, which provides support for the Japanese government’s foreign eco­ nomic policy initiatives and economic cooperation programs, was again made an indepen­ dent institution on April 1, 2012.

33.2.3 Market Structure and Competition of the Japanese Banking Industry On the deposit side of the banking market the segmentation described above is not an is­ sue because there is little, if any, product differentiation—even between bank deposits and postal savings. However, the lending market is more complicated. On the one hand, financial deregulation has likely promoted the integration of the markets of different bank types. On the other hand, different types of bank are likely to have different comparative advantages with respect to different borrower types. Moreover, geographical segmenta­ tion may still be important, particularly for certain types of lending, such as relationship loans that likely have a spatial dimension. Thus, two types of segmentation (p. 1047) are likely to exist: spatial segmentation and bank-type segmentation. Defining the scope of lending markets in Japan is an important empirical question. Few empirical studies have investigated Japanese market segmentation. A rare exception is Kano and Tsutsui (2003), who find that the lending market for Shinkin banks is seg­ mented by prefecture (probably due to geographical restrictions on their operating ar­ eas), whereas prefectural segmentation is only weakly confirmed for regional banks. However, they do not investigate segmentation by bank type, which remains unexplored. Segmentation by prefecture was also found by Ishikawa and Tsutsui (2013).9 Whether or not markets are segmented by type or by region, banks can compete via branching. Historical restrictions on branch banking were relaxed in a stepwise manner from the 1980s through the 1990s, and now banks are virtually unconstrained in opening branch offices. Also, banks are now able to provide banking services through their agents, such as other banks, insurance companies, securities companies, and non-finan­ cial companies. Table 33.4 shows the number of branch offices for the four major types of banks. City banks have many branches in their nationwide operations (except for Resona and Saita­ ma Resona, both of which have a regional orientation). Typically, there are one or two re­ gional banks and one or two second regional banks in a prefecture (there are forty-seven Page 36 of 79

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Banking in Japan: A Post-global Financial Crisis Perspective prefectures in Japan). These banks typically have branch offices in and around their own prefecture and in large cities such as Tokyo and Osaka. How competitive is the Japanese banking market? Again there is a scarcity of research. Pooling city and regional banks, Molyneux, Thornton, and Lloyd-Williams (1996) find that Japanese banks were uncompetitive in 1986 and 1988. Another study, using a sample of city and regional banks from 1974 to 2000, estimates the degree of competition by bank type using a marginal price (Lerner index) approach (Uchida and Tsutsui, 2005). They find that competition had improved throughout the sample period, especially in the 1970s and in the first half of the 1980s when financial deregulation began. They also find that city banks had been facing more competitive pressure than regional banks.10

33.2.4 The Efficiency of Japanese Banks Most of the studies on the efficiency of Japanese banks focus on ordinary banks (plus long-term credit banks and trust banks).11 On balance, they find evidence of economies of scale, at least for the average bank. Some studies found evidence of scale economies until the early 1990s regardless of bank size (Fukuyama, 1993; McKillop, Glass, and Morikawa, 1996), although one study found evidence of diseconomies (Tadesse, 2006). Fukuyama (1993) finds that regional banks are scale inefficient, second regional banks are more effi­ cient than regional banks, and city banks are close to efficient, exhibiting constant re­ turns to scale. However, subsequent studies do not uniformly find evidence of scale economies in later periods. Altunbas et al. (2000) find during the 1993–6 period scale economies for the smallest banks in their sample only (i.e., banks with assets of 1–2 trillion yen of assets or less), but find scale diseconomies for large banks. Drake and Hall (2003) find similar re­ sults in 1996, but the optimal bank size in their study is larger than found by Altunbas et al. (2000). Whether the disappearance of universal scale economies after the 1990s is due to an underlying environmental change or due to methodological improvements is an open question.

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Banking in Japan: A Post-global Financial Crisis Perspective (p. 1049)

(p. 1050)

(p. 1051)

Table 33.4 Four Main Types of Bank in Japan

# of branches

# of em­ ploy­ ees

Total

Do­ mestic

For­ eign

5 City banks total

2,835

2,683

152

97,60 1

Mizuh o Bank

558

516

42

Bank of Toky­ oMit­ subishi UFJ

824

752

72

# of branches

# of em­ ploy­ ees

Total

Do­ mestic

For­ eign

41 Se­ cond re­ gional banks total

3,049

3,048

39

44,79 0

24,957

North Pacific Bank

171

171

–

3,455

31,694

Kiraya­ ka Bank

117

117

–

1,007

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Banking in Japan: A Post-global Financial Crisis Perspective Sumit­ omo Mitsui Bank­ ing Corpo­ ration

975

937

38

27,904

Kita­ Nip­ pon Bank

80

80

–

900

Res­ ona Bank

347

347

–

9,788

Sendai Bank

73

73

1

687

Res­ ona Bank

131

131

–

3,258

Fukus hima Bank

54

54

2

535

Daito Bank

62

62

3

579

Towa Bank

91

91

4

1,560

64 Re­ gional banks total

7,488

7,471

17

130,9 44

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Banking in Japan: A Post-global Financial Crisis Perspective Saita­ ma Res­ ona Bank

131

131

–

3,258

Tochigi Bank

92

92

5

1,663

Hokkai do Bank

142

142

–

2,291

Keiyo Bank

119

119

6

2,119

Aomori Bank

101

101

–

1,320

Hi­ gashiN ippon Bank

85

85

7

1,428

Michi­ noku Bank

96

96

–

1,296

Tokyo Star Bank

33

33

8

1,680

Akita Bank

96

96

–

1,400

Kana­ gawa Bank

34

34

9

382

Hoku­ to Bank

83

83

–

935

Taiko Bank

70

70

10

854

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Banking in Japan: A Post-global Financial Crisis Perspective Shonai Bank

87

87

–

928

Nagan o Bank

54

54

11

689

Yama­ gata Bank

81

81

–

1,335

First Bank of Toya­ ma

66

66

12

728

Bank of Iwate

108

108

–

1,472

Fukuh o Bank

38

38

13

504

To­ hoku Bank

57

57

–

618

Shizuo ka Chuo Bank

46

46

14

465

77 Bank

142

142

–

2,774

Aichi Bank

105

105

15

1,651

Toho Bank

115

115

–

2,159

Bank of Nagoy a

113

112

16

1,948

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Banking in Japan: A Post-global Financial Crisis Perspective Gunma Bank

151

150

1

3,177

Chuky o Bank

86

86

17

1,213

Ashik­ aga Bank

152

152

–

2,876

Daisan Bank

98

98

18

1,400

Joyo Bank

179

179

–

3,668

Kansai Urban Bank­ ing Corpo­ ration

155

155

19

2,632

Tsuku­ ba

147

147

–

1,656

Taisho Bank

27

27

20

338

Musas hino Bank

96

96

–

2,285

Minato Bank

106

106

21

2,294

Chiba Bank

184

181

3

4,357

Shi­ mane Bank

34

34

22

400

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Banking in Japan: A Post-global Financial Crisis Perspective Chiba Kogyo Bank

73

73

–

1,337

Toma­ to Bank

60

60

23

866

Tokyo Tomin Bank

78

78

–

1,540

Momiji Bank

114

114

24

1,422

Bank of Yoko­ hama

208

207

1

4,694

Saikyo Bank

64

64

25

781

Daishi Bank

121

121

–

2,341

Tokush ima Bank

81

81

26

952

Hokuet su Bank

84

84

–

1,486

Ka­ gawa Bank

87

87

27

1,031

Ya­ man­ ashi Chuo Bank

91

91

–

1,685

Ehime Bank

103

103

28

1,364

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Banking in Japan: A Post-global Financial Crisis Perspective Hachi­ juni Bank

152

151

1

3,178

Bank of Kochi

71

71

29

903

Hokuri ku Bank

186

186

–

2,779

Fukuo­ ka Chuo Bank

41

41

30

518

Toya­ ma Bank

39

39

–

337

Saga Kyoei Bank

34

34

31

376

Hokko ku Bank

104

103

1

1,787

Bank of Na­ gasaki

23

23

32

259

Fukui Bank

96

96

–

1,385

Ku­ mamo­ to Family Bank

70

70

33

1,025

Shizuo ka Bank

203

200

3

2,884

Howa Bank

42

42

34

493

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Banking in Japan: A Post-global Financial Crisis Perspective Suru­ ga Bank

122

122

–

1,624

Miyaza ki Taiyo Bank

52

52

35

653

Shimiz u Bank

79

79

–

1,000

Mi­ namiNi ppon Bank

64

64

36

668

Ogaki Kyorit­ su Bank

149

149

–

3,073

Oki­ nawa Kaiho Bank

49

49

37

719

Juroku Bank

160

160

–

3,291

Yachiy o Bank

85

85

38

1,649

Mie Bank

75

75

–

1,286

Hyaku­ go Bank

135

135

–

2,480

6 Trust banks total

273

264

43

22,08 2

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Banking in Japan: A Post-global Financial Crisis Perspective Shiga Bank

119

118

1

2,147

Mit­ subishi UFJ Trust and Bank­ ing

62

58

40

7,471

Bank of Ky­ oto

172

172

–

3,428

Mizuh o Trust & Bank­ ing

57

57

41

3,769

Kinki Osaka Bank

118

118

–

2,208

Sumit­ omo Trust & Bank­ ing

153

148

42

10,385

Sen­ shu Ikeda Bank

141

141

–

2,686

Nomu­ ra Trust and Bank­ ing

1

1

43

457

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Banking in Japan: A Post-global Financial Crisis Perspective Nanto Bank

136

136

–

2,615

Kiyo Bank

111

111

–

2,451

Other banks

308

299

89

24,28 9

Tajima Bank

72

72

–

713

Shin­ sei Bank

273

264

44

22,082

Tottori Bank

66

66

–

719

Aozora Bank

35

35

45

2,207

Sanin Godo Bank

134

134

–

1,995

Chugo ku Bank

161

160

1

3,179

Hi­ roshi­ ma Bank

167

167

–

3,381

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Banking in Japan: A Post-global Financial Crisis Perspective Yam­ aguchi Bank

135

132

3

1,820

Awa Bank

99

99

–

1,312

Hyaku­ jushi Bank

124

124

–

2,327

Iyo Bank

152

150

2

2,927

Shikok u Bank

105

105

–

1,374

Bank of Fukuo­ ka

170

170

–

3,835

Chikuh o Bank

44

44

–

657

Total

13,70 0

13,52 1

179

299,46 2

(Cf) Japan Post Bank

19,87 5

19,87 5

–

12,965

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Banking in Japan: A Post-global Financial Crisis Perspective Bank of Sa­ ga

103

103

–

1,500

Eigh­ teenth Bank

100

100

–

1,385

Shin­ wa Bank

88

88

–

1,379

Higo Bank

122

122

–

2,236

Oita Bank

95

95

–

1,692

Miyaza ki Bank

96

96

–

1,465

Kagos hima Bank

124

124

–

2,192

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Banking in Japan: A Post-global Financial Crisis Perspective Bank of the Ryuky us

75

75

–

1,258

Bank of Oki­ nawa

65

65

–

1,124

NishiN ippon City Bank

186

186

–

3,723

Ki­ takyus hu Bank

36

36

–

482

Note: Only the full members of the Japanese Bankers Association are included. Source: Japanese Bankers Association and Japan Post Bank homepage. (as of March 31, 2017).

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Banking in Japan: A Post-global Financial Crisis Perspective Drake and Hall (2003) also find that, in comparing bank types, ordinary banks are scale inefficient, whereas long-term credit banks and trust banks are scale efficient. However, the efficiency results for long-term credit banks and trust banks may suffer from a lack of appropriate controls for the difference between these banks and ordinary banks. Studies based on data envelopment analysis investigate pure technical inefficiency, or ad­ equate/excessive use of inputs. Fukuyama (1993) finds pure technical inefficiency for or­ dinary banks with the magnitude being the greatest for regional banks. Drake and Hall (2003) find that the magnitude of pure technical inefficiency is greater than that of scale inefficiency—that is, banks can reduce cost more by adopting a technology requiring few­ er inputs than by increasing the scale of their operation. Drake and Hall (2003) also show that, in terms of pure technical inefficiency, regional banks, and next second regional banks are inefficient, while city banks are almost efficient, and trust and long-term credit banks are efficient. They also report that the larger the bank size, the smaller the pure technical inefficiency becomes.12 Studies of scope economies are few and their results are not consistent.13 Tachibanaki, Mitsui, and Kitagawa (1991) find cost complementarity between lending and securities in­ vestment for city, regional, long-term credit, and trust banks. However, McKillop, Glass, and Morikawa (1996) find no global economy of scope for city banks among lending, liq­ uid asset holdings, and securities investments. Rather, they find cost anti-complementari­ ty between lending and holding liquid assets and between lending and securities invest­ ment, and cost complementarity between holding liquid assets and securities investment. In a study of regional banks, Harimaya (2008) finds cost anti-complementarity between lending and securities investment, and between lending and trust businesses, but cost complementarity between securities investment and trust businesses. He also finds that, although scale economies are observed on average, product-specific scale diseconomies are found for banks’ trust business, casting doubt on the prospect of banks increasing (p. 1052) their profitability by focusing on fee businesses. Interestingly, a recent study sug­ gested that results might vary depending on modeling methodologies (Drake, Hall, and Simper, 2009). Thus, on balance, it is still unclear whether there are scope economies in banking.14,15

33.2.5 Commercial versus Universal Banking in Japan Historically Japan’s regulation of universal banking has mostly mirrored regulation in the US. Like the Glass–Steagall Act in the US, Article 65 of the 1948 Securities and Exchange Law in Japan separated investment banking from commercial banking. As in the US, there was a sequential dismantling of this separation, which began in the 1980s when city, long-term, trust, and regional banks were allowed to underwrite and deal in public bonds. It peaked in the 1990s when as a part of a “big bang” financial system liberaliza­ tion (like the UK and the US), corporate underwriting by banks through affiliates and fi­ nancial holding companies were allowed (see Horiuchi, 2000; Royama, 2000). Investment banking and trust activities, however, must still be conducted in affiliate organizations Page 51 of 79

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Banking in Japan: A Post-global Financial Crisis Perspective that are separate from the banking entity. As of March 31, 2017, there were twenty bank financial holding companies including those of the five city banks and the Japan Post Bank. There have been some studies that have examined issues related to universal banking in Japan, including the conflict of interest issue and relationship building across commercial and investment banking services. The results are mixed. Hamao and Hoshi (2000) show that the new-issue corporate bond yield spread does not depend on whether the under­ writer is a bank affiliate. However, Takaoka and McKenzie (2004) find that underwriting commissions are smaller when the lead underwriter is a bank-owned securities company. They also find that, after the entry of bank-affiliates, underwriting commissions and yield spreads decreased. Takaoka and McKenzie (2004) further find that commissions and spreads do not vary depending on the strength of the bank–issuer relationship, but Yasu­ da (2007), using a more elaborate methodology, finds that the bank–issuer relationship does have a beneficial effect.16 (p. 1053)

33.2.6 Regulation of the Japanese Banking System

Before the banking crisis in Japan, the Ministry of Finance (MoF) played a dominant role in the prudential supervision of most of the banking system. In 1998, bank regulatory re­ sponsibility was shifted to the new Financial Supervisory Agency, which was reorganized as the Financial Services Agency (FSA) in 2000. As can be seen in Table 33.3, the FSA su­ pervises and charters most of the banking system including, most importantly, the ordi­ nary banks and financial holding companies. Some of the other private banking institu­ tions are supervised by various ministries of the government as are all of the government financial institutions.17 As the central bank, the Bank of Japan (BoJ) also has the ability to monitor its customer banks (so-called “on-site examinations”) in order to discharge its responsibilities in deter­ mining and executing monetary policy and in providing liquidity to the banking system, including its role as lender of last resort. The deposit insurance system in Japan was es­ tablished in 1971 and is provided by the Deposit Insurance Corporation.

33.3 Selected Topics in Japanese Banking 33.3.1 The Main Bank System and Relationship Banking The main bank system in Japan can be more precisely defined as a “system of corporate financing and governance involving an informal set of practices, institutional arrange­ ments, and behaviours among industrial and commercial firms, banks of various types, other financial institutions, and the regulatory authorities. At its core there is the rela­ tionship between the main bank and the firm” (Aoki, Patrick, and Sheard, 1994, p. 3). Originally set up in war-time Japan, based on zaibatsus to help coordinate wartime pro­ duction, these industrial groups allegedly became a driver of economic growth during the Page 52 of 79

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Banking in Japan: A Post-global Financial Crisis Perspective post-war period when they became known as keiretsu (see Teranishi, 1994; Hoshi and Kashyap, 2001). This relationship has many dimensions including reciprocal shareholdings, the supply of management resources and directors, and the provision of a broad array of financial ser­ vices. Also important is the relationship between a firm’s main bank, the firm’s other fi­ nanciers (see Sheard, 1994b), and the relationships among the regulatory authorities and all of these actors. The financial institutions and the firms tied together under this system are referred to as the “financial keiretsu” (horizontal keiretsu). This can be distinguished (p. 1054) from the concept of a “corporate keiretsu” (vertical keiretsu) that mainly focuses on ties through vertical relationships among suppliers and sellers (see Aoki and Patrick, 1994). Before the early empirical studies on relationship banking in the US (e.g., Petersen and Rajan, 1994; Berger and Udell, 1995) and later in Europe (e.g., Angelini, DiSalvo, and Ferri, 1998), the practitioners and academics in Japan had focused primarily on the role of Japan’s main bank system. As we shall see in section 33.3.1.1, these earlier main bankfocused studies share much of their theoretical foundation with the newer literature on relationship lending. However, two distinctions need to be made between the newer literature on relationship lending and the study of the role of the main bank in the financial keiretsu. First, the main bank literature has a corporate governance component which is lacking in the new­ er relationship lending literature. Second, the main bank literature focuses, for the most part, on large companies while most of the newer relationship lending literature focuses on SMEs. These distinctions are important because corporate governance issues are much less relevant in the SME sector where there is usually no separation of ownership and management. It is important to note that there have been some studies on SME lend­ ing in Japan, conducted in the spirit of the newer literature on relationship lending that focus on the relationship between SMEs and their main banks.

33.3.1.1 Traditional Main Bank Studies Numerous academic studies since the 1980s have examined the role of main banks in fi­ nancial keiretsus. The early focus of these studies was on risk-sharing among keiretsu members (e.g., Nakatani, 1984; Osano and Tsutsui, 1985). The literature then gradually shifted to the role of banks as providers of corporate governance (see Aoki, 1994). Some studies emphasize a special corporate governance role of the main bank in periods of firm distress (Sheard, 1994a; Osano, 1998). Other studies emphasize a contingent governance role for the main bank: the main bank plays a minimal role in normal times but in finan­ cial distress the bank assumes managerial control (e.g., Berglöf and Perotti, 1994). To a certain extent, the Japanese main bank system in terms of corporate governance can be viewed as similar to Germany’s historical Hausbank system, each standing in contrast to markets-oriented economies such as the UK and the US where the market for corporate control and shareholder activism play a more important role (Prowse, 1995).

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Banking in Japan: A Post-global Financial Crisis Perspective Empirically, the issue of the very definition of “the main bank” is challenging. A common approach is to follow the definition used by data providers, such as (1) keiretsu affiliation in Keiretsu no Kenkyu (Studies on Keiretsu) data, (2) a first-listed bank in Quarterly Cor­ porate Report (Japan Company Handbook), and (3) an affiliation in Dodwell Marketing Consultants’ Industrial Groupings in Japan. Alternatively, the main bank is defined as a bank that (4) has a director on the borrower’s board, (5) is the largest lender, (6) is the largest shareholder, or (7) is both (5) and (6) (plus other characteristics). Empirical studies here can also be broadly classified based on their focus on the role of the main bank. Some emphasize the role of the main bank in mitigating liquidity con­ straints (e.g., Hoshi, Kashyap, and Scharfstein, 1990a, 1990b, 1991; Ogawa and Suzuki, 2000).18 Others investigate managerial intervention by main banks. Kaplan and Minton (1994), Kang and Shivdasani (1995, 1997), and Morck and Nakamura (1999) find that during the late 1980s banks assigned new board members in a timely and effective man­ ner. Shin and Kolari (2004) found that main banks played a unique role in information production specific to the 1995–7 period during the banking crisis.19 However, to some extent the tone of the research on main banks may reflect the timing of the studies themselves and the changing view of the Japanese economy from the more positive pre-crisis perspective to the more critical post-crisis perspective. Other later studies find that firms with a main bank exhibit weaker performance (e.g., Weinstein and Yafeh, 1998; Hanazaki and Horiuchi, 2000; Wu and Xu, 2005), suggesting that main banks extract excessive rents from their borrowers. Kang and Shivdasani (1999) and Kang and Stulz (2000) find similar results for bank- (though not necessarily main bank-) dependent firms. Some authors even argue that the main bank system and the importance of keiret­ sus is a “myth” and that many of the empirical results in this literature cannot be repro­ duced (Miwa and Ramseyer, 2002, 2005). One interpretation of these seemingly conflicting results is that the benefits from the main bank system (e.g., liquidity provision) may come at the cost of extracted rents. Inter­ estingly, Weinstein and Yafeh (1998) find (in effect) evidence of a tradeoff where a main bank relationship may mitigate financing constraints even though it reduces firm perfor­ mance. Moreover, the possibility of such a tradeoff between the benefits and costs of a main bank relationship had already been noted in a much earlier study (Nakatani, 1984). It is important to add here that recently there has been a fundamental change in corpo­ rate governance in Japan—a change that has been associated with a dismantling of keiret­ su ties (Aoki, Jackson, and Miyajima, 2007). This suggests that for large businesses the main bank relationship may be significantly less important in the future. However, empiri­ cal evidence suggests that the main bank relationship is still important for large business­ es, at least until 2008, with respect to the lack of changes in banks identified as the firm’s main bank and with respect to the provision of financial services (Hirota, 2009). Also, it seems unlikely that this trend has altered the importance of the main bank relationship for SMEs that continue to depend on banks for external finance.20

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Banking in Japan: A Post-global Financial Crisis Perspective 33.3.1.2 SME Relationship Lending Relatively recently there has been growing interest in research that examines relation­ ship lending in the context of Japanese SMEs. Increased data availability has spawned (p. 1056) new empirical work on SME financing constraints including research on the im­ pact of bank–borrower relationships and the benefits of soft information production. This coincides with increased practitioner and policy interest in SME financing and the FSA’s adoption of measures that are intended to promote relationship banking between SMEs and smaller banks (the Action Program concerning Enhancement of Relationship Banking Functions (2003 and 2004), and its successor program Ensuring Further Promotion of Re­ gionally-based Relationship Banking (2005 and 2006)). Findings in the academic literature on SME lending practices in Japan are interesting from an international perspective. Kano et al. (2011) find that the lower loan interest rate and enhanced credit availability that are associated with long-term banking relationships occur only when hard information is unavailable for the borrower and the bank is small and faces stiff competition. However, the lending relationship in this sample is quite long (32.2 years on average) compared with that in other countries. Uchida, Udell, and Watan­ abe (2008) find that the mode of relationship building in Japan is somewhat different from that in the US as reported in Berger et al. (2005). Findings in Uchida, Udell, and Yamori (2012) also suggest that the role of the loan officer in Japan may be different than in the US.21

33.3.2 Lending Technologies in Japan Recently, the literature on business lending, especially small business lending, classifies types of lending as different lending technologies with relationship lending (discussed above) being one of the technologies (Berger and Udell, 2002, 2006). There are some in­ teresting aspects of Japanese business lending from the lending technology viewpoint.22 In this subsection, we will discuss three of these: the role of collateral, business credit scoring, and government credit guarantee programs.

33.3.2.1 The Role of Collateral in Business Lending in Japan Collateral is one of the most powerful contracting tools used by bankers to mitigate infor­ mation-based problems associated with business lending and is a vital component of many SME lending technologies. Lending against real estate, for example, is quite com­ mon globally in SME lending. Japan is no exception (see Ono et al., 2015). In fact, the role of collateral historically appears to have been of particular importance in Japan where banks practiced the so-called “collateral principle” under which they routinely under­ wrote business loans based almost entirely on real estate—real estate owned by the busi­ ness and/or the entrepreneur. Interestingly, however, analyses from the post crisis period (mid-2000s) suggests that the collateral principle is no longer a dominant SME loan un­ derwriting technology (see Uchida, Udell, and Yamori, 2008; Uchida, 2011).

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Banking in Japan: A Post-global Financial Crisis Perspective Whether or not the use of collateral is associated with borrower risk has been ex­ tensively studied in the literature, particularly in the US (see John, Lynch, and Puri, 2003). Evidence from one study on Japan suggests that there is a positive association, and that collateral’s use mitigates ex post moral hazard (Ono, Sakai, and Uesugi, 2012), but anoth­ er study shows that ex ante borrower risk does not change the likelihood of pledging col­ lateral (Ono and Uesugi, 2009). Another interesting finding in Japan (perhaps related to the collateral principle) is that stronger banking relations appear to be associated with an increased likelihood of pledging collateral (e.g., Ono and Uesugi, 2009; Kano et al., 2011). (p. 1057)

Relatively recently the requisite legal and commercial infrastructure to allow lending against movable assets (i.e., account receivables and inventory) was introduced in Japan (see Ono et al., 2015, section 4.1). As a result, commercial banks in Japan have begun of­ fering SME lending technology known as asset-based lending (ABL), a type of collateral lending against receivables and inventory associated with intense monitoring. ABL had been confined almost entirely to common law countries such as Australia, Canada, New Zealand, the UK, and the US and is generally associated with a riskier class of borrowers (Carey, Post, and Sharpe, 1998; Udell, 2004). Some research suggests that ABL is still in the development stage in Japan (Kinjo, 2013).

33.3.2.2 Small Business Credit Scoring in Japan Japanese banks started to adopt in the early 2000s another lending technology originally introduced in the US in the mid-1990s—small business credit scoring (SBCS), and its vol­ ume rapidly increased to more than 2 trillion yen by 2005 (BoJ, 2007). Its introduction was also facilitated by a government policy initiative mentioned earlier to promote rela­ tionship banking by smaller banks (the Action Program Concerning Enhancement of Rela­ tionship Banking Functions 2003 and 2004). SBCS was promoted under this program as a form of lending that does not depend on collateral. However, due to the huge loan losses in SBCS loans, particularly those extended by Shinginko Tokyo (a bank established by the Tokyo Metropolitan Government to focus on SME lending), banks decreased the volume of their SBCS lending in the late 2000s (Hasu­ mi and Hirata, 2013). Even earlier, the BoJ (2007) already identified the inadequacy of the informational infrastructure in Japan (e.g., the inability to link firm data with the owners’ personal credit history) as a potential source of high SBCS loan losses. In addition, the BoJ identified problems with the scoring model as it was applied to relatively large bor­ rowers where the fit was generically poor. Hasumi and Hirata (2013) conclude that ad­ verse selection problems, exacerbated by financial statement window-dressing (from which SBCS inputs were drawn), were the main causes of the huge losses.23

33.3.2.3 Government Guarantee Programs in Japanese Business Lending Governments in both developed and developing economies have directly or indirectly pro­ vided substantial amounts of funding to SMEs to address a “funding gap” (p. 1058) (e.g., Cressy, 2000, 2002). Evidence suggests that this funding gap is exacerbated by macro shocks that affect the banking system (e.g., Jiménez et al., 2012; Popov and Udell, 2012).

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Banking in Japan: A Post-global Financial Crisis Perspective In addition to direct lending by government financial institutions (see section 33.2.2.8), Japan has long implemented massive government loan guarantee programs for small business. Multiple credit guarantee corporations (CGCs) around the country, which are public institutions established based on the Credit Guarantee Corporation Law, provide guarantees on loans to SMEs, and the Japan Finance Corporation’s Small and Medium Enterprise Unit provides insurance on the guaranteed liabilities associated with the loans. The outstanding amount of liabilities guaranteed by the credit guarantee corpora­ tions was 23.9 trillion yen at the end of March 2017.24 Historically, the most important feature of these guarantee programs was the assumption of all risk (by CGCs) stemming from a 100 percent guarantee. To mitigate the screening and monitoring problems that arose from the 100 percent guarantee, a “ResponsibilitySharing System” was implemented in 2007 that reduced in principle the guarantee cover­ age to 80 percent. However, there have been some significant exceptions in the form of “special” 100 percent guarantee programs, including guarantee programs to respond to the Global Financial Crisis (the “Emergency (Safety-Net) Credit Guarantee Program,” from 2008), and to the Great Tohoku Earthquake (the “Great East Japan Earthquake Re­ covery Emergency Guarantee,” from 2011). Collectively, the credit guarantee programs in Japan provide a unique opportunity to study this type of government intervention and the potential moral hazard and adverse selection problems they might invite. Some evidence on the “Special Credit Guarantee Program for Financial Stability” implemented in 1998–2001 suggests that the benefits were significant and that many firms—specifically low-risk firms—actually became more efficient (Uesugi, Sakai, and Yamashiro, 2010). Other evidence on the same program sug­ gests that it might have had bigger spillover effects on the supply of funds to non-users (Wilcox and Yasuda, 2008). Yet another study focusing on the “Emergency (Safety-Net) Credit Guarantee Program” calls for a more nuanced view. Ono, Uesugi, and Yasuda (2013) find that, while this program improved credit availability for borrowing firms, it al­ so encouraged a portfolio substitution by the borrower’s main banks away from non-guar­ anteed loans to guaranteed loans. They also find deteriorating ex post performance of firms obtaining guaranteed loans from their main bank as compared with those obtaining non-guaranteed loans.

33.3.3 The Japanese Banking Crisis The banking crisis in Japan became a public policy issue in the middle of the 1990s, esca­ lated dramatically shortly thereafter, and then continued perhaps as late as the (p. 1059) mid-2000s.25 We offer a brief overview of the crisis and its causes and its effects on bank behavior.

33.3.3.1 Brief Review of the Crisis The visible beginning of the crisis is associated with the failures of two credit coopera­ tives in 1994. The enormity of the banking crisis was revealed in stages.26 Ultimately there were 171 bank failures in Japan from 1994 through 2003 involving one city bank, Page 57 of 79

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Banking in Japan: A Post-global Financial Crisis Perspective two long-term credit banks, one regional bank, twelve second regional banks, twentythree Shinkin banks, and 132 credit cooperatives (Nikkin, 2005). The regulatory response can best be described as one of catching up with rapidly unfolding events. In particular, the regulatory policies and infrastructure in place at the beginning of the crisis were sim­ ply not capable of handling a crisis of this magnitude. New policies and infrastructure were created to address the problem—but with a significant lag. A limited number of bank failures prior to 1994 were resolved in a conventional manner using arranged mergers. However, the crisis moved to a more visibly serious stage in late 1994 with the failures of Tokyo Kyowa and Anzen, the two urban credit cooperatives. They were too large to be resolved by an arranged merger, and the deposit insurance fund was insufficient to cover the unprecedented losses. Concern about contagion effects persuaded regulators to avoid a payoff resolution in which depositors would take a hair­ cut. The ultimate “hand-made” (Nakaso, 2001, p. 7) nature of the resolution of these two failures involved the establishment of a new successor bank capitalized by funds from the deposit insurance agency, the BoJ, and private financial institutions including those that had no relationship with the two cooperatives. In the following year a number of other banks failed, including a much larger urban coop­ erative. In addition, a group of real estate finance companies, the jusen, failed. Initially founded by commercial banks to augment their residential mortgage lending, the jusen had shifted their focus to financing real estate developers. Because of the collective size of these institutions, the resolution could not be handled without the use of taxpayer funding. Additional emergency measures were also undertaken at this time including the creation of the Resolution and Collection Bank, and the temporary implementation of a 100 percent deposit insurance guarantee.27 Following several other bank failures the financial crisis escalated in 1997 as it became apparent that problem loans were threatening the viability of Japan’s largest banks. Nip­ pon Credit Bank, one of the three long-term credit banks, was bailed out, two security firms failed, and major bank failures began occurring on a regular basis in the fall, including that of Hokkaido Takushoku Bank (a city bank) and some second regional (p. 1060)

banks. Belatedly, in 1997 the government implemented emergency and permanent mea­ sures to cope with the crisis. These measures resulted in capital injections into twentyone large banks in 1998. Nevertheless, problems in the banking system continued to mount in 1998 including the failure of two of the long-term credit banks—the Nippon Credit Bank (bailed out earlier) and the Long Term Credit Bank of Japan, each being resolved by temporary nationaliza­ tion. Early in 1998, legislation was passed that provided for a further injection of $230 billion of public funds, part of which was allocated to the Deposit Insurance Corporation and the remainder was allocated to direct capital injections. Later in 1998, the Diet (Par­ liament) passed two pieces of legislation that significantly expanded the regulatory infra­ structure to handle the disposition of failed banks and to inject capital into viable banks. Also, available funds were doubled from the original $230 billion. Additionally, in June Page 58 of 79

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Banking in Japan: A Post-global Financial Crisis Perspective 1998 the responsibility for the prudential supervision of banks was shifted from the Min­ istry of Finance to the Financial Supervisory Agency, which later reorganized as the Fi­ nancial Services Agency in 2000. On October 2002, the Financial Services Agency officially announced the Program for Fi­ nancial Revival: Revival of the Japanese Economy through Resolving Non-Performing Loans Problems of Major Banks. The agency declared its intent to reduce the non-per­ forming loans (NPLs) ratio of major banks by around 50 percent. Following these actions and others including the sporadic capital injections as described above, the crisis sub­ sided and indeed the NPL ratio decreased by more than half.28 No major bank failure has occurred since the failure and nationalization of Ashikaga Bank (a regional bank) in 2003.29 In hindsight, the resolution of the crisis saw the government and bank regulators deploy a variety of tools that had been used (or would be used) elsewhere in the world. These in­ cluded establishing a bridge bank for segregating non-performing loans, and temporarily nationalizing large banks. Ultimately these measures were associated with the injection of massive amounts of government funding to back up the 100 percent deposit insurance coverage.30

33.3.3.2 Causes of the Crisis Cargill (2000) argues that there were five underlying causes of the crisis: a rigid financial regime, the failure of the BoJ’s monetary policy, a slow and indecisive regulatory (p. 1061) response to emerging problems, a lack of public and political support to deal with trou­ bled financial institutions with public funds, and the intransigence of financial institutions in accepting criticism of management policies. Hoshi (2001) and Hoshi and Kashyap (2001) make a related argument that the slow and incomplete deregulation of the finan­ cial system in the 1980s was also a key causal factor, because it precipitated the flight of good borrowers from the bank loan market to the capital markets, forcing banks to lend to borrowers with whom they were unfamiliar. Ueda (2000) also points out that excessive lending to unfamiliar borrowers in the real estate and related industries, as a conse­ quence of the financial deregulation, might have contributed to the increase in non-per­ forming loans.31 Ueda (2000) also speculates that rising land prices decreased the perceived risk in real estate lending, prompting more lending ex ante. He also finds evidence that the big drop in land prices ex post was an important determinant of deteriorating non-performing loans.32 The “collateral principle” discussed above might also have exacerbated this pathology. Ogawa et al. (1996) and Ogawa and Suzuki (2000) find that large firms with more real estate were less financially constrained than those with less real estate. Anecdotal evidence indicates that euphoric lending practices driven by the formation of the asset price bubble ultimately led to problem loans in the banking system. This is part­ ly consistent with the lazy bank hypothesis (Manove, Padilla, and Pagano, 2001). Irra­ tional herding behavior may also have occurred (Uchida and Nakagawa, 2007; Nakagawa Page 59 of 79

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Banking in Japan: A Post-global Financial Crisis Perspective and Uchida, 2011).33,34 Kashyap (2002), however, argues that the loan problems that were ultimately revealed in the later stages of the crisis were simply too large to be en­ tirely attributable to euphoric or reckless lending during the formation of the bubble. Fur­ ther, Ono et al. (2018) find that the increase in the amount of loans was far smaller than the increase in land prices, which is at least quantitatively inconsistent with the euphoric or herding scenarios. These arguments notwithstanding, the evidence seems clear that the initial cause of problems in the banking sector was a pricing bubble in real estate that burst around 1990 (Hoshi and Kashyap, 2010).

33.3.3.3 The Effects of the Crisis Did the banking crisis lead to a credit crunch? The BoJ concluded so, noting in the min­ utes of their Monetary Policy Meeting (January 16, 1998) that the “prospects for a more restrictive lending attitude of financial institutions and its possible effects were discussed in detail.” Also, a quarterly survey on business expectations conducted by the BoJ, the (p. 1062) TANKAN survey, showed a significant shift in the perception of credit tightening by corporate Japan beginning in late 1997 (see Figure 33.4 below).35 A number of research papers have shown that bank capital deterioration and the decline in the health of the banking industry reduced bank lending (Ito and Sasaki, 2002), firm capital expenditures, and firm performance (Gibson, 1997; Fukuda, Kasuya, and Nakaji­ ma, 2005b; Hosono and Masuda, 2005; Miyajima and Yafeh, 2007), and increased the like­ lihood of the bankruptcy of borrowers (Fukuda, Kasuya, and Akashi, 2009).36 Woo (2003) and Watanabe (2007) find that the negative impact of the capital crunch was the greatest in fiscal year 1997, when the MoF became stricter on bank asset valuation.37

33.3.4 Banking in Post-Crisis Japan 33.3.4.1 Japanese Banks and the Global Financial Crisis Soon after the persistent adverse effect from the banking crisis subsided in Japan, the turmoil in the US subprime residential mortgage market beginning in early 2007 trig­ gered an unprecedented worldwide financial crisis. The effect of the Global Financial Cri­ sis spread to the Japanese economy after the failure of Lehman Brothers in September 2008. For the most part, however, the effect was minimal and Japan was not significantly affected by the Global Financial Crisis in ways that were comparable to Europe and the US (see IMF, 2012, p. 7). As shown in Figure 33.3, which shows the decomposition of profits and losses for ordinary banks, the adverse effect was only short-lived. There were several reasons for this. First, residential mortgages underwritten in Japan are all prime mortgages. Second, securitization is relatively undeveloped in Japan. When we compare the amount of residential mortgages (housing loans) underwritten and the amount of residential mortgage-backed securities (RMBS) issued from fiscal years 2004 to 2016, even at its peak in fiscal 2006, the volume of RMBS issued is just one-fourth of the volume of residential mortgages underwritten.38 Third, Japan did not experience a re­ al estate bubble during this period, and Japanese banks did not purchase significant amounts of US subprime mortgage-backed securities.39 Finally, the crisis (p. 1063) was not Page 60 of 79

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Banking in Japan: A Post-global Financial Crisis Perspective propagated through capital-impaired foreign banks as in Europe (e.g., Popov and Udell, 2012) because Japanese banking is dominated by domestic banks.40 Interestingly, there are a number of parallels between the Japanese crisis in the 1990s and the financial crisis in the US, including the root cause—the bursting of a real estate bubble. Other similarities include the failure of investment banks and other non-banking financial institutions and the “hand made”/ad hoc nature of the regulatory response.41 For a more complete comparison of the Japanese banking crisis and the current financial cri­ sis in the US, see Udell (2009), Hoshi and Kashyap (2010) and Allen, Chakraborty, and Watanabe (2011).42,43

Figure 33.3 Profits and Losses for Ordinary Banks. Source: Japanese Bankers Association.

33.3.4.2 Lost-decades and banking problems As in many developed countries, the Japanese economy has suffered from long-standing deflation that continued through and after the Global Financial Crisis, and in Japan, the period from the 1990s is often called “the lost-decades.” Possible causal factors include two that could be attributable to the banking sector: the credit crunch and evergreening loans. The former predicts that capital regulation contributes to a decrease in lending by under-capitalized banks. The latter, however, predicts an increase in lending, because banks might renew/roll over problem loans to make them appear performing, which could prop up economically unviable firms (“zombies”) who should otherwise be liquidated. As explained at the end of the previous subsection (section 33.3.3.3), there is strong evi­ dence indicating a credit crunch and its adverse effects on the real economy. However, the effects do not seem to be prolonged. While the diffusion index of the lending attitude of Japanese financial institutions (Figure 33.4) sharply declined during the banking crisis (consistent with a nationwide crunch), it is generally good in other periods with the ex­ Page 61 of 79

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Banking in Japan: A Post-global Financial Crisis Perspective ception of the decline due to the Global Financial Crisis around 2009.44,45 This positive (p. 1064) lending attitude is at least partly due to massive monetary easing by the BoJ.46 Also, the exit rate of firms due to bankruptcy is low after the Global Financial Crisis, and even after the Great Tohoku Earthquake (March 2011), financial shocks from distressed banks did not increase this rate (Uchida et al., 2015). (p. 1065) 47

Figure 33.4 Diffusion Index for Lending Attitude of Financial Institutions. Source: TANKAN Judgement Survey (the BoJ).

Hayashi and Prescott (2002) provide evidence showing that the stagnation of the Japan­ ese economy in the 1990s was not due to a breakdown of the financial system, but rather due to low productivity growth (measured as total factor productivity (TFP)) in the real economy. Motonishi and Yoshikawa (1999) also report that tighter lending attitudes in banks did not constrain corporate investments by large firms, although small firms were constrained by tighter lending behavior. Regarding evergreening, Peek and Rosengren (2005) provide evidence consistent with evergreening in the form of increased lending by banks with low capital ratios to dis­ tressed firms in keiretsu.48 Further, Caballero, Hoshi, and Kashyap (2008) find evidence suggesting that the presence of zombie firms in an industry reduces investment and em­ ployment growth of non-zombie firms in the same industry, and increases the (p. 1066) dis­ parity in the productivity between zombies and non-zombies. However, later studies using an improved identification of zombie firms report a decrease in the number of zombie firms (Fukuda and Nakamura, 2011). Also, no evidence of zombie firms has been found for smaller firms (Fukuda, Kasuya, and Nakajima, 2005a; Sakai, Uesugi, and Watanabe, 2010).

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Banking in Japan: A Post-global Financial Crisis Perspective On balance, although the problems due to the banking sector might have had severe tem­ poral adverse effects, it is difficult to conclude that they were the primary causes of the prolonged stagnation of the Japanese economy. Rather, a mechanism that works in the op­ posite direction appears more important. Under the zero interest rate environment driven by massive quantitative easing, especially after the introduction of the negative interest rate policy by the BoJ (January 2016), banks in Japan are suffering from decreasing inter­ est revenues (see “Fund management profit/loss” in Figure 33.3).49

33.4 Conclusion This chapter examined the structure, the performance, and some of the defining charac­ teristics of the Japanese banking industry. In addition to this overview, we have reviewed the literature on four interesting topics: the Japanese main bank system, lending tech­ nologies in Japan, the Japanese banking crisis in the 1990s, and banking in post-crisis Japan. We conclude by pointing out the scarcity of research on Japanese banking. Even on the selected topics discussed above there remain many open questions. For example, how and to what extent are banking markets in Japan segmented? Are there economies of scale or scope in banks in Japan, and to what extent? What were, and what are, the pros and cons of the main bank system? Did the banking crisis cause the prolonged stagnation in the Japanese economy, or vice versa? What is the future of the Japanese banking indus­ try and the keiretsu-driven ties between firms and their main banks? The banking-oriented financial system has been a critical component of Japan’s economy —an economy that has grown to one of the largest in the world. Despite the idiosyncratic nature of Japanese banking, its seems quite likely that there is much we can learn from the Japanese experience that will inform us more generally about the role of banks in the global financial system architecture. More research on the banking industry in Japan is clearly called for.

(p. 1067)

Acknowledgments

The authors would like to thank Allen Berger, Phil Molyneux, John Wilson, Kozo Hari­ maya, Hikaru Fukanuma, Hiroshi Fujiki, Takeo Hoshi, Tae Okada, Arito Ono, Kenji Fujii, Wako Watanabe, and Yoshiaki Ogura for their helpful comments.

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Banking in Japan: A Post-global Financial Crisis Perspective Morck, R. and Nakamura, M. (1999). “Banks and Corporate Control in Japan,” Journal of Finance, 54, 319–39. Motonishi, T. and Yoshikawa, H. (1999). “Causes of the Long Stagnation of Japan during the 1990s: Financial or Real?” Journal of the Japanese International Economies, 13, 181– 200. Nakagawa, R. and Uchida, H. (2011). “Herd Behaviour by Japanese Banks after Financial Deregulation,” Economica, 78, 618–36. Nakaso, H. (2001). “The Financial Crisis in Japan During the 1990s: How the Bank of Japan Responded and the Lessons Learnt,” BIS Papers No. 6. Nakatani, I. (1984). “The Economic Role of Financial Corporate Grouping,” in M. Aoki (ed.), The Economic Analysis of the Japanese Firm (Amsterdam: Elsevier), 227–58. National Federation of Credit Guarantee Corporations (2017). Credit Guarantee System in Japan 2017. Nikkin (2005). Nikkin Data Annual (in Japanese). Ogawa, K. and Imai, K. (2014). “Why Do Commercial Banks Hold Government Bonds? The Case of Japan,” Journal of the Japanese and International Economies, 34, 201–16. Ogawa, K. and Suzuki, K. (2000). “Demand for Bank Loans and Investment Under Bor­ rowing Constraints: A Panel Study of Japanese Firm Data,” Journal of the Japanese and In­ ternational Economies, 14, 1–21. Ogawa, K., Kitasaka, S.-I., Yamaoka, H., and Iwata, Y. (1996). “Borrowing Constraints and the Role of Land Asset in Japanese Corporate Investment Decision,” Journal of the Japan­ ese and International Economies, 10, 122–49. Ono, A. and Uesugi, I. (2009). “Role of Collateral and Personal Guarantees in Relationship Lending: Evidence from Japan’s SME Loan Market,” Journal of Money, Credit, and Bank­ ing, 41, 935–60. Ono, A., Hasumi, R., and Hirata, H. (2014). “Differentiated Use of Small Business Credit Scoring by Relationship Lenders and Transactional Lenders: Evidence from Firm–Bank Matched Data in Japan,” Journal of Banking & Finance, 42, 371–80. Ono, A., Sakai, K., and Uesugi, I. (2012). “The Effects of Collateral on Firm Performance,” Journal of the Japanese and International Economies, 26, 84–109. Ono, A., Uchida, H., Kozuka, S., and Hazama, M. (2015). “A New Look at Bank– Firm Relationships and the Use of Collateral in Japan: Evidence from Teikoku Databank Data,” in T. Watanabe, I. Uesugi, and A. Ono (eds.), The Economics of Interfirm Networks (Tokyo: Springer Japan), 191–214. (p. 1073)

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Banking in Japan: A Post-global Financial Crisis Perspective Ono, A., Uchida, H., Udell, G. F., and Uesugi, I. (2018). “Lending Pro-Cyclicality and Macro-Prudential Policy: Evidence from Japanese LTV Ratios,” Mizuho Research Institute, Kobe University, Indiana University, and Hitotsubashi University. Ono, A., Uesugi, I., and Yasuda, Y. (2013). “Are Lending Relationships Beneficial or Harm­ ful for Public Credit Guarantees? Evidence from Japan’s Emergency Credit Guarantee Program,” Journal of Financial Stability, 9, 151–67. Osano, H. (1998). “Default and Renegotiation in Financial Distress in the Multiple Bank Model: An Analysis of the Main Bank System,” Japanese Economic Review, 49, 138–57. Osano, H. and Tsutsui, Y. (1985). “Implicit Contracts in the Japanese Bank Loan Market,” Journal of Financial and Quantitative Analysis, 20, 211–30. Peek, J. and Rosengren, E. S. (2005). “Unnatural Selection: Perverse Incentives and the Misallocation of Credit in Japan,” American Economic Review, 95, 1144–66. Petersen, M. A. and Rajan, R. G. (1994). “The Benefits of Lending Relationships: Evidence from Small Business Data,” Journal of Finance, 49, 3–37. Popov, A. and Udell, G. F. (2012). “Cross-Border Banking, Credit Access, and the Financial Crisis,” Journal of International Economics, 87, 147–61. Prowse, S. (1995). “Corporate Governance in an International Perspective: A Survey of Corporate Control Mechanisms Among Large Firms in the USA, UK, Japan and Germany,” Financial Markets, Institutions and Instruments, 4, 1–63. Royama, S. (2000). “The Big Bang in Japanese Securities Markets,” in T. Hoshi and H. T. Patrick (eds.), Crisis and Change in the Japanese Financial System (Amsterdam: Kluwer Academic), 253–76. Sakai, K., Uesugi, I., and Watanabe, T. (2010). “Firm Age and the Evolution of Borrowing Costs: Evidence from Japanese Small Firms,” Journal of Banking and Finance, 34, 1970– 81. Sawada, M. (2013). “Measuring the Effect of Postal Saving Privatization on the Japanese Banking Industry: Evidence from the 2005 General Election,” Pacific-Basin Finance Jour­ nal, 21, 967–83. Sheard, P. (1994a). “Main Banks and the Governance of Financial Distress,” in M. Aoki and H. T. Patrick (eds.), The Japanese Main Bank System, 188–230. New York: Oxford Uni­ versity Press. Sheard, P. (1994b). “Reciprocal Delegated Monitoring in the Japanese Main Bank Sys­ tem,” Journal of the Japanese and International Economies, 8, 1–21. Shin, G. H. and Kolari, J. W. (2004). “Do Some Lenders have Information Advantages? Evi­ dence from Japanese Credit Market Data,” Journal of Banking and Finance, 28, 2331–51. Page 72 of 79

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Banking in Japan: A Post-global Financial Crisis Perspective Spiegel, M. M. and Yamori, N. (2003). “The Impact of Japan’s Financial Stabilization Laws on Bank Equity Values,” Journal of the Japanese and International Economies, 17, 263–82. Sun, Y. and Uchida, K. (2016). “The Role of Bank-Affiliated Venture Capital for Parent Banks in Japan: New Evidence,” Asia-Pacific Journal of Financial Studies, 45, 864–85. Suzuki, K. and Yamada, K. (2012). “Do the Use of Proceeds Disclosure and Bank Charac­ teristics Affect Bank Underwriters’ Certification Roles?” Journal of Business Finance & Accounting, 39, 1102–30. Tachibanaki, T., Mitsui, K., and Kitagawa, H. (1991). “Economies of Scope and Sharehold­ ing of Banks in Japan,” Journal of the Japanese and International Economies, 5, 261–81. Tadesse, S. (2006). “Consolidation, Scale Economies and Technological Change in Japanese Banking,” Journal of International Financial Markets, Institutions and Money, 16, 425–45. (p. 1074)

Takaoka, S. and McKenzie, C. R. (2004). “The Impact of Bank Entry in the Japanese Cor­ porate Bond Underwriting Market,” Journal of Banking and Finance, 30, 59–83. Teranishi, J. (1994). “Loan Syndication in War-time Japanese and the Origins of the Main Bank System,” in M. Aoki and H. T. Patrick (eds.), The Japanese Main Bank System (New York: Oxford University Press), 51–88. Uchida, H. (2011). “What Do Banks Evaluate When They Screen Borrowers? Soft Infor­ mation, Hard Information and Collateral,” Journal of Financial Services Research, 40, 29– 48. Uchida, H. and Nakagawa, R. (2007). “Herd Behavior in the Japanese Loan Market: Evi­ dence from Bank Panel Data,” Journal of Financial Intermediation, 16, 555–83. Uchida, H. and Tsutsui, Y. (2005). “Has Competition in the Japanese Banking Sector Im­ proved?” Journal of Banking and Finance, 29, 419–39. Uchida, H., Miyakawa, D., Hosono, K., Ono, A., Uchino, T., and Uesugi, I. (2015). “Finan­ cial Shocks, Bankruptcy, and Natural Selection,” Japan and the World Economy, 36, 123– 35. Uchida, H., Udell, G. F., and Watanabe, W. (2008). “Bank Size and Lending Relationships in Japan,” Journal of the Japanese and International Economies, 22, 242–67. Uchida, H., Udell, G. F., and Yamori, N. (2008). “How Do Japanese Banks Discipline Smalland Medium-Sized Borrowers? An Investigation of the Deployment of Lending Technolo­ gies,” International Finance Review, 9, 57–80. Uchida, H., Udell, G. F. and Yamori, N. (2012). “Loan Officers and Relationship Lending,” Journal of Financial Intermediation, 21, 97–122.

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Banking in Japan: A Post-global Financial Crisis Perspective Uchino, T. (2014). “Bank Deposit Interest Rate Pass-through and Geographical Segmenta­ tion in Japanese Banking Markets,” Japan and the World Economy, 30, 37–51. Udell, G. F. (2004). Asset-Based Finance (New York: Commercial Finance Association). Udell, G. F. (2009). “Wall Street, Main Street, and a Credit Crunch: Thoughts on the Cur­ rent Financial Crisis,” Business Horizons, 52, 117–25. Ueda, K. (2000). “Causes of Japan’s Banking Problems in the 1990s,” in T. Hoshi and H. T. Patrick (eds.), Crisis and Change in the Japanese Financial System (Amsterdam: Kluwer Academic), 59–84. Uesugi, I., Sakai, K., and Yamashiro, G. M. (2010). “The Effectiveness of Public Credit Guarantees in the Japanese Loan Market,” Journal of the Japanese and International Economies, 24, 457–80. Watanabe, W. (2007). “Prudential Regulation and the ‘Credit Crunch’: Evidence from Japan,” Journal of Money, Credit and Banking, 39, 639–65. Watanabe, W. (2010). “Does a Large Loss of Bank Capital Cause Evergreening? Evidence from Japan,” Journal of the Japanese and International Economies, 24, 116–36. Watanabe, W. and Sekino, M. (2016). “Does the Policy Lending of the Government Finan­ cial Institution Mitigate the Credit Crunch? Evidence from the Loan Level Data in Japan,” Asian Finance Association (AsianFA) 2016 Conference, available at SSRN: https:// ssrn.com/abstract=2722304. Weinstein, D. E. and Yafeh, Y. (1998). “On the Costs of a Bank-Centered Financial System: Evidence from the Changing Main Bank Relations in Japan,” Journal of Finance, LIII, 635– 72. Wilcox, J. A. and Yasuda, Y. (2008). “Do Government Loan Guarantees Lower, or Raise, Banks’ Non-Guaranteed Lending?” Evidence from Japanese Banks, World Bank Workshop. Woo, D. (2003). “In Search of ‘Capital Crunch’: Supply Factors Behind the Credit Slow­ down in Japan,” Journal of Money, Credit, and Banking, 35, 1019–38. Wu, W. and Xu, L. L. (2005). “The Value Information of Financing Decisions and Corporate Governance During and After the Japanese Deregulation,” Journal of Business, 78, 243–80. (p. 1075)

Wu, X. and Yao, J. (2012). “Understanding the Rise and Decline of the Japanese Main Bank System: The Changing Effects of Bank Rent Extraction,” Journal of Banking and Fi­ nance, 36, 36–50. Yamori, N. and Harimaya, K. (2010). “Efficiency in the Japanese Trust Banking Industry: A Stochastic Distance Function Approach,” Banks and Bank Systems, 5, 86–95.

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Banking in Japan: A Post-global Financial Crisis Perspective Yamori, N. and Murakami, A. (1999). “Does Bank Relationship have an Economic Value? The Effect of Main Bank Failure on Client Firms,” Economics Letters, 65, 115–20. Yamori, N., Harimaya, K., and Tomimura, K. (2017). “Corporate Governance Structure and Efficiencies of Cooperative Banks,” International Journal of Finance & Economics, 22, 368–78. Yasuda, A. (2007). “Bank Relationships and Underwriter Competition: Evidence from Japan,” Journal of Financial Economics, 86, 369–404.

Notes: (1) For a more comprehensive analysis of corporate finance and the Japanese banking in­ dustry see Hoshi and Patrick (2000) and Hoshi and Kashyap (2001). For an analysis of the Japanese economy see Flath (2000). And for a comprehensive evaluation of economic policies related to the recent recession with respect to Japan, see Ito, Patrick, and Wein­ stein (2005). (2) Note that the spike in 2008 is due to the inclusion of Japan Post Bank in “Banks.” (3) In May 2017, the Banking Law was revised to relax ordinary banks’ equity holding in order to promote FinTech. (4) Liu and Wilson (2010, 2012) respectively compare banks’ profitability and risk, and ex­ amine their determinants across bank types (city banks, regional banks, second-regional banks, Shinkin banks, and credit cooperatives). (5) Saitama Resona Bank is often classified differently because of its regional orientation in Saitama prefecture. Both Saitama Resona Bank and Resona Bank are affiliated with the same holding company (Resona Holdings). (6) See Sawada (2013) for the effect of the privatization in 2007 on other private banks. (7) The government allowed the Japan Post Bank to provide non-collateralized loans to its account holders in June 2017. (8) For the role of these government financial institutions in supporting SMEs, see Fukanuma, Nemoto, and Watanabe (2006). Watanabe and Sekino (2016) find that the Japan Finance Corporation for Small and Medium Enterprises (currently a unit of the JFC) contributed to mitigating the credit crunch due to the Banking Crisis at the end of the 1990s. (9) Uchino (2014) examines the impact of market rates on deposit rates and finds evi­ dence suggestive of regional segmentation in deposit markets. (10) Gunji and Miura (2017) report an increase in the competitiveness of regional banks for the period from 1989 to 2009 using a different methodology. Kondo and Harimaya

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Banking in Japan: A Post-global Financial Crisis Perspective (2014) find that prefectures with larger population and GDP attract more entry by region­ al banks headquartered outside the relevant prefectures. (11) Fukuyama (1996) examines the efficiency of Shinkin banks, and Fukuyama, Guerra, and Weber (1999) investigate the efficiency of credit cooperatives. (12) Glass et al. (2014) investigate the efficiency of Shinkin banks and credit cooperatives. (13) As Berger, Hunter, and Timme (1993) point out, the measurement of the economies of scope is methodologically challenging. (14) Subsequent work on bank efficiency includes: Yamori and Harimaya (2010) on the ef­ ficiency of trust banks after deregulation; Montgomery, Harimaya, and Takahashi (2014) on the effect of bank mergers; Harimaya and Kondo (2016) on the effect of branch expan­ sion; and Yamori, Harimaya, and Tomimura (2017) on the effect of outside directors. (15) Assaf, Barros, and Matousek (2011) analyze the productivity and efficiency of Shinkin banks from 2000 to 2006 using the bootstrap and Bayesian approaches. (16) Other studies on commercial and investment banking services include Kang and Liu (2007), Kutsuna, Smith, and Smith (2007), and Suzuki and Yamada (2012). Sue and Uchi­ da (2016) compare equity holdings by banks and by bank-affiliated venture capital firms. (17) For a more extensive discussion of the FSA and bank regulation including financial stability, see IMF (2012). (18) Although the methodology in the Hoshi, Kashyap, and Scharfstein papers has been criticized (Kaplan and Zingales, 1997; Hayashi, 2000), similar findings have been report­ ed in a subsequent study using an improved methodology (Hori, Saito, and Ando, 2006). (19) See Gao (2008), Inoue, Kato, and Bremer (2008), and Kang et al. (2011) for more re­ cent empirical studies on the role of main banks. (20) Kobayashi and Osano (2011) and Wu and Yao (2012) provide a more current theoreti­ cal assessment of the main bank system. (21) Hattori, Shintani, and Uchida (2015) compare production of soft information by loan officers and branch managers. (22) See Uchida (2011) for the different use of various lending technologies by banks in Japan. (23) Ono, Hasumi, and Hirata (2014) investigate the ex post performance of SBCS borrow­ ers with special attention to relationship vs. non-relationship lenders. (24) For more information about the credit guarantee system in Japan, see National Feder­ ation of Credit Guarantee Corporations (2017).

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Banking in Japan: A Post-global Financial Crisis Perspective (25) Our reading of the literature suggests that there is no agreement on exactly when the crisis began and when it ended. As described below, the first bank failures, though small, began occurring in the early 1990s but then escalated dramatically later in the decade. Bank capital and non-performing loans, however, did not appear to stabilize until the mid-2000s. (26) The following discussion of the stages of the banking crisis is based on Nakaso (2001). (27) Even before this temporary measure, deposits had been implicitly 100% guaranteed under the convoy system (Hoshi, 2002). See Hoshi (2002) for a discussion of the “convoy” system in use until the early stages of the crisis in which the MoF protected and kept alive all financial institutions, including the most inefficient. (28) For smaller banks, the FSA took a less drastic and indirect approach to revitalize their customers (SMEs and regional economies). Specifically, the FSA adopted the two ac­ tion programs indicated in section 36.3.1.2 to promote relationship banking. Although the causality is unclear, it turned out that the NPL ratio of regional banks ultimately de­ creased to less than 4 percent by 2007 (from FSA’s webpage, Status of Non-Performing Loans). (29) Resona Bank was also nationalized in 2003. (30) Studies on policy responses to the crisis include Hoshi and Patrick (2000), Hoshi and Kashyap (2001), Spiegel and Yamori (2003), and Montgomery and Shimizutani (2009). (31) He also finds evidence of inefficient (lax) bank management and the safety net-driven moral hazard problem as factors driving poor loan performance. (32) Consistent with this evidence, Gan (2007) finds that banks with greater real estate exposure reduce more loans after the burst of the real estate bubble. (33) “Reckless lending,” more broadly defined, could include the practice of evergreening (the lending behavior of banks designed to keep zombie firms alive) as we will discuss in section 36.3.3.3. (34) Horiuchi and Shimizu (2001) find that practice in Japan, known as amakudari—hiring retired government officials as board members—may also have been a factor leading to non-performing loans although another study using a more elaborate methodology did not find this association (Konishi and Yasuda, 2004). (35) See Hoshi and Kashyap (2010) for a more detailed discussion of both the January 1998 meeting and the TANKAN survey. (36) Also, there are studies on the impact of bank failures on borrower performances, for example, Yamori and Murakami (1999), Brewer et al. (2003), Hori (2005), Fukuda and Koibuchi (2006), and Minamihashi (2011). Giannetti and Simonov (2013) examine the ef­ Page 77 of 79

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Banking in Japan: A Post-global Financial Crisis Perspective fect of bank bailout on the banks’ supply of credit and the performance of their borrow­ ers. (37) Some studies also found that the introduction of Basel capital standards may have re­ duced bank lending (Hall, 1993; Konishi and Yasuda, 2004). (38) Data on the amount of residential mortgages (housing loans) underwritten and the amount of RMBS issued are respectively available from Japan Housing Finance Agency and Japan Securities Dealers Association. (39) The Bank of Japan’s Financial System Report (Bank of Japan, 2008, p. 2) notes that “(w)hile Japanese banks’ losses stemming from the US subprime mortgage problem in­ creased as the problem became more serious, such losses seem to have been contained within their current profit levels and capital strength, since Japanese banks’ related expo­ sures were mainly in the form of investments in structured credit products.” (40) Japanese banks did not suffer material damage from the European sovereign debt cri­ sis (2009–) due to small exposure. (41) Imai (2009) find evidence suggesting that the political pressure mattered on the dec­ laration of insolvency of regional financial institutions. (42) See Harada et al. (2015) for Japan’s financial regulatory responses after the Global Financial Crisis. (43) The Global Financial Crisis has also spawned much policy discussion on how to offset fiscal deficits caused by bank bailouts. Banerji et al. (2017) exploit a natural experiment, the 2000 “Tokyo bank tax,” to assess the unintended consequences of taxing banks as a solution. They find that the unexpected imposition of the Tokyo bank tax increased net in­ terest margins, net interest, and fee margins, and reduced the credit supply of affected banks. (44) A study that is related and suggestive in this regard is Ishikawa and Tsutsui (2013), which uses prefectural panel data to try to identify whether the credit contraction in the 1990s was supply- or demand-driven. (45) As noted earlier, the government provided support during the Global Financial Crisis with special credit guarantee programs (section 36.3.2.3.) and increased loan supply by public banks (Shoko Chukin Bank and the JFC, see section 36.2.2.8). After the Global Fi­ nancial Crisis, the Government also enacted temporary law, the 2009 Debt Moratorium Law, to obligate banks to make the “utmost effort” to reschedule loans for SMEs and eased the regulatory standard for non-performing loans (Imai, 2019). (46) The easing was further strengthened when newly appointed Governor Kuroda at the Bank of Japan introduced quantitative and qualitative easing in April 2013. This aggres­ sive monetary policy is one of the three components, or “arrows” of the so-called

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Banking in Japan: A Post-global Financial Crisis Perspective “Abenomics” (a policy package named after the prime minister), together with flexible fis­ cal policy and a growth strategy (see Ito et al., 2018). (47) Hosono et al. (2016) find that the financial shocks from damaged banks decreased firm investment after the Great Hanshin Earthquake (January 1995). (48) Watanabe (2010) finds evidence suggesting that a large loss of bank capital in 2007 due to the regulators’ toughened stance led to the banks’ evergreening. (49) Using data from fiscal years 1998 to 2010, Ogawa and Imai (2014) find evidence to indicate a portfolio shift for banks in Japan from loans to Japanese government bonds due to the decreasing interest margin for loans.

Hirofumi Uchida

Hirofumi Uchida is Professor of Banking and Finance at the Graduate School of Busi­ ness Administration at Kobe University. His research interests focus on financial in­ stitutions and financial system architecture. He was a Visiting Scholar at the Kelley School of Business at Indiana University as a 2003 Fulbright Scholar, a Visiting Scholar at the Shorenstein Asia Pacific Research Center at Stanford University as a 2016 Abe Fellow, and is an associate editor of the Journal of Money, Credit and Bank­ ing. Gregory F. Udell

Gregory F. Udell is the Chase Chair of Banking and Finance at the Kelley School of Business, Indiana University. He is, or has been, a Visiting Economist, Scholar and/or Consultant to the Board of Governors of the Federal Reserve System, the Bank of Japan, the Bank of Italy, the European Central Bank, the Federal Reserve Banks of Chicago and San Francisco, the International Finance Corporation, the OECD, the Peoples Bank of China, the Riksbank and the World Bank. Before joining the Kelley School of Business in 1998, he was Professor of Finance and Director of the William R. Berkley Center for Entrepreneurial Studies at the Stern School of Business at New York University. Prior to his academic career he was a commercial loan officer in Chicago. He has nearly 100 publications mostly focused on financial contracting, credit availability, and financial intermediation. These have appeared in leading ac­ counting, economics, and finance journals. He is the author of a textbook on assetbased lending, Asset-Based Finance (2004), a co-author (with L. Ritter and W. Silber) of Principles of Money, Banking and Financial Markets, 12th edition (2009), and is, or has been, an associate editor/editorial board member of seven academic journals in­ cluding the Journal of Money, Credit and Banking, Journal of Banking and Finance, Journal of Financial Services Research and Small Business Economics.

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Banking in Africa

Banking in Africa   Thorsten Beck, Robert Cull, and Patricio Valenzuela The Oxford Handbook of Banking (3rd edn) Edited by Allen N. Berger, Philip Molyneux, and John O. S. Wilson Print Publication Date: Oct 2019 Subject: Economics and Finance, Financial Economics Online Publication Date: Nov 2019 DOI: 10.1093/oxfordhb/9780198824633.013.34

Abstract and Keywords This chapter takes stock of the current state of banking systems across Sub-Saharan Africa and discusses recent developments, including innovations that might help Africa leapfrog more traditional banking models. Using an array of different data, the chapter documents that African banking systems are shallow but stable. African banks are well capitalized and over-liquid, but lend less to the private sector than banks in non-African developing countries. African enterprises and households are less likely to use financial services than their peers in other developing countries, although there has been signifi­ cant progress over the past decade. The chapter also describes a number of financial in­ novations across the continent that can help overcome different barriers to financial in­ clusion and have helped to expand the bankable and the banked population. The chapter ends with discussing current challenges for policymakers and academics, including the lack of (data on) long-term finance and the supervisory challenges stemming from in­ creasing cross-border banking in the region. Keywords: banking, financial inclusion, financial innovation, financial stability, Sub-Saharan Africa

34.1 Introduction BANKING in Africa has undergone dramatic changes over the past three decades.1 While the continent was dominated by government-owned banks until the 1980s and subject to restrictive regulation—including interest rate ceilings and credit quotas—financial liberal­ ization, institutional and regulatory upgrades, and globalization have changed the face of financial systems across the region. Today, most countries have deeper and more stable financial systems, although challenges of concentration and limited competition, high costs, and limited inclusion persist. This chapter takes stock of the current state of banking systems across Sub-Saharan Africa2 and discusses recent developments including innovations that could help Africa leapfrog more traditional banking models. We use an array of different data sources to document different dimensions of the development of African banking systems, highlight­ Page 1 of 42

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Banking in Africa ing variation within the region and changes over time. We compare Africa’s banking sys­ tems to those of comparable low- and lower-middle income countries outside the region, and gauge whether there is an “Africa-specific” element to banking development. We also discuss progress in policies and institutions underpinning (p. 1077) financial deepening and the results of specific innovations, including innovative branch expansion programs, mobile banking, and new financial products designed to reach out to previously unbanked population segments. We also focus on challenges in long-term finance and the recent patterns and regulatory implications of cross-border banking in the region. Overall, we will show a picture of achievements and challenges, with progress along some fronts but with other challenges persisting and new ones arising. When talking about financial systems in Africa, one has to take into account the enor­ mous variation within the region. On the one hand, South Africa and Mauritius have rela­ tively developed banking systems and capital markets. On the other hand, smaller and poorer countries, such as South Sudan or Sierra Leone, have shallow banking systems of­ fering only the most rudimentary financial services, with few if any non-bank financial in­ stitutions or capital markets. In spite of the variation within the region, however, there are four specific characteristics that make banking in Africa more difficult than in other regions of the developing world, and most of those apply to many, if not all, African economies (see Honohan and Beck, 2007; Beck et al., 2011). First, the small size of many economies does not allow financial service providers to reap the benefits of scale economies. The limited demand for savings, insurance, credit, or even simple payment transactions means that large parts of the population of African economies are not commercially viable customers. The dispersion of population in many African countries means that financial service provision outside urban centers is not costeffective. Second, large parts of the economy and a large share of all economic agents op­ erate in the informal sector and do not have the necessary formal documentation that fa­ cilitates financial transactions, such as enterprise registration, land titles, or even formal addresses. This increases the costs and risks for financial institutions and excludes large segments of the population from formal financial services. Third, volatility increases costs and undermines risk management. At the individual level, volatility is related to informali­ ty and the consequent fluctuations in the income streams of many microenterprises and households. This means these agents are less attractive for financial institutions. At the aggregate level, volatility refers to the dependence of many African economies on com­ modity exports, which makes economies vulnerable to the large price swings characteris­ tic of commodities, as well as to political and social unrest, from which Africa has suf­ fered over the past fifty to sixty years of independence. Finally, governance problems con­ tinue to plague many private and government institutions throughout the continent and undermine not only the market-based provision of financial services, but also reform at­ tempts and government interventions aimed at fixing market failures. These characteristics make banking in Africa more challenging and increase the need for innovative solutions. Technology can potentially reduce transaction costs and risks, thus enabling the processing of smaller transactions, and turning more households and enter­ Page 2 of 42

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Banking in Africa prises into commercially viable clients. Innovative products and delivery channels can ad­ dress the constraints discussed above. Critically, these interventions and policy reforms have to work both on the supply and demand side. In what follows we will discuss several examples of such innovative approaches to financial inclusion. The recent crisis in the developed world has shed doubt on the positive impact that large, complex banks can have on economic development (Allen et al., 2014b; Ar­ cand, Berkes, and Panizza, 2015), in contrast to extensive literature illustrating a positive finance–growth relationship (Levine, 2005). Consumer credit booms in the US and several European countries, fueled by a combination of the liquidity glut linked to the global macroeconomic imbalances, regulatory neglect and the feeling that “this time is differ­ ent,” ended in the global financial crisis. If there is a lesson to be learnt for Africa’s bank­ ing systems from the crisis, it seems that the growth benefits of financial deepening can only be reaped in a stable macroeconomic environment and with the appropriate safe­ guards framework, both in terms of external regulation and supervision and internal bank governance. Notwithstanding the recent negative experience in countries with the deep­ est financial sectors, banking systems in Africa can and must play a critical role in the economic development process of the region. (p. 1078)

The remainder of this chapter is structured as follows. Section 34.2 documents financial development across different dimensions, in international comparison, but also illustrat­ ing variation within the region and over time. Section 34.3 discusses recent evidence on policies and interventions that can help deepen and broaden financial systems in Africa. Section 34.4 focuses on challenges of long-term finance in the region and presents recent patterns in cross-border banking in the region and its regulatory implications. Section 34.5 concludes and looks forward.

34.2 Stock-Taking: Where Does Africa Stand? Earlier stock-taking exercises of banking and finance in Africa suffered from a lack of da­ ta for a broad cross-section of countries in the region (Honohan and Beck, 2007). Most cross-country studies on financial development included only a few larger African finan­ cial markets and their focus was on other developing and emerging regions of the world. This situation has changed over the past decade, with data available for a large part of the region and several segments of the financial system. Relatively recent global data col­ lection efforts on the depth, outreach, stability, and efficiency of financial systems have been much more successful in collecting data on African financial systems.3 Aggregate data have been complemented with a number of enterprise surveys, and surveys for some countries now have a panel dimension (i.e., firms being surveyed at several points in time).4 Similarly, household surveys focused on financial services, such (p. 1079) as the Finscope and Finaccess surveys in several African countries, have provided important in­ sights into individual and household access to, and use of, formal and informal financial services, while the Global Findex dataset includes most countries in Sub-Saharan Africa.

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Banking in Africa In the following, we will therefore use an array of databases and other sources to docu­ ment the development and structure of banking systems across the region.

34.2.1 Aggregate Financial Development in Africa in International Comparison Africa’s banking systems are small, costly, and focused on the short-term end of the yield curve as we will illustrate in the following. However, we will also document the progress Africa’s banking systems have made over the past fifteen years. To compare banking systems in Africa to a proper benchmark, we limit our sample to lowand lower-middle-income countries in Sub-Saharan Africa and compare the median for this group to the median country across a sample of low- and lower-middle-income coun­ tries outside Africa. We thus explicitly drop several upper-middle-income African coun­ tries in our statistical comparison, although we will include them in the discussion on in­ tra-regional variation below.5

Figure 34.1 Aggregate Financial Development in In­ ternational Comparison, 2015. Source: Global Financial Development Indicators (June 2017 version), World Bank.

Figure 34.1 shows that the median African country has a markedly shallower financial system than the median non-African country. We present three standard indicators of fi­ nancial development: liquid liabilities to GDP, Bank Deposits to GDP and Private Credit to GDP, using data for 2015.6 While the median non-African developing country has liquid li­ abilities of 41 percent of GDP, the median African country has only 31 percent. Similarly, the median deposit to GDP ratio outside Africa is 40 percent, compared to 22 percent in Africa, while the median Private Credit to GDP ratio is 37 percent outside Africa, but only 17 percent inside Africa. Comparing the difference between deposit and credit ratios also indicates that African banks are less effective in intermediating society’s savings, a topic we will return to below.

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Banking in Africa

(p. 1081) Figure 34.2 Private Credit to GDP across Low- and Lower-middle-income African Countries, 2015.

Source: Global Financial Development Indicators (June 2017 version), World Bank.

It is important to note that the median ratios mask wide variation across Africa. Figure 34.2 shows that even excluding the most financially developed African economies, such as Mauritius and South Africa, there is a wide range in Private Credit to GDP across the lowand lower-middle-income countries of the region, from 1.6 percent in South Sudan to 61 percent in Cape Verde. The median country is Zambia with a Private Credit to GDP ratio of 17 percent. This compares with 146 percent in South Africa and 102 percent in Mauri­ tius. (p. 1080)

Figure 34.3 Private Credit to GDP (%). Source: Global Financial Development Indicators (June 2017 version), World Bank.

While Africa’s financial systems are shallow in international comparison, there have been marked improvements over the past decade. All three standard indicators of financial de­ Page 5 of 42

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Banking in Africa velopment have substantially improved over the period 2000 to 2015.7 Figure 34.3 shows that the median value for Private Credit to GDP increased from 9 percent to 18 percent, with similar increases in the other two indicators of financial development. And this im­ provement has been broad based. If one considers the 25th, 50th, and 75th percentiles of private credit to GDP over the same period, it is evident that countries at different points of the distribution have all witnessed improvements. Despite the improvements in the do­ mestic financial African markets, financial development gaps persist as developing coun­ tries outside Africa have also exhibited significant progress. In fact, Figure 34.3 shows that the gap between Africa and the developing world outside Africa has widened in terms of private credit, though it has remained the same for deposits to GDP and has even decreased for liquid liabilities to GDP (not shown).

Figure 34.4 Access to and use of Financial Services in International Comparison, 2010–17. Source: Global Financial Development Indicators (June 2017 version), World Bank.

Africa’s banking systems are not only shallower than banking systems in non-African de­ veloping countries, they are also less inclusive (Figure 34.4). Here we present four indica­ tors of access to, and use of, financial services. First, we present two aggregate indica­ tors: bank accounts per 100 adults and bank branches per 100,000 adults. Both indica­ tors are substantially lower in the median African country than in the median non-African developing country. Specifically, there are only fifteen bank accounts for every 100 adults (p. 1082) in the median African country, while there are fifty-one outside Africa. There are four branches per 100,000 adults in Africa, while there are ten outside Africa. Second, the more limited outreach of Africa’s banking systems is also reflected in indicators of use of formal finance by enterprises and households. While in the median African country on­ ly 16 percent of firms indicate that they have a line of credit or loan from a formal finan­ cial institution, this share is 35 percent outside Africa.8 Similarly, 33 percent of adults in the median African country (excluding high-income countries) indicate that they have an account with a formal financial institution, while this share is 65 percent outside Africa.

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Banking in Africa By 2015, Africa’s banks were, on average, less efficient, but more profitable and operated in less competitive environments. Net interest margins in the median African country stood at 5.7 percent, while they stood at 4.5 percent outside Africa. Similarly, the interest rate spread between lending and deposit rates was 7.6 percent in Africa and 7.2 percent outside. While there are many reasons that spreads and margins are higher in Africa, one important reason is higher operating costs. Specifically, overhead costs in the median African financial system stood at 5 percent of total assets, while they were 1.7 percent outside Africa. On the other hand, African banks are also more profitable than banks out­ side Africa. The return on assets (ROA) stood at 2.1 percent in the median (p. 1083) African country, while it was 1.2 percent outside Africa. We will revisit this issue below with bank-level data. The higher interest rate spreads go hand in hand with greater concentration and lower competitiveness in African banking markets. While the share of the five largest banks was 87 percent in the median African country in 2015, it was 73 percent outside Africa. High­ er interest rate spreads are related to greater concentration across a sample of African countries. While there are several countries in Africa where aggregate data point to five banks making up the whole banking system (Benin, Burkina Faso, Burundi, Cameroon, Cape Verde, Madagascar, Malawi, Mali, Mauritania, and Togo), there are only a few such countries among the much larger group of non-African developing countries. Greater con­ centration, however, does not seem to come with lower competition: The median Lerner index, which is the markup between marginal revenue and costs, was 29 percent in the median African country in 2015, while it was 36 percent outside Africa. It is important to note that the correlation between concentration and the Lerner index of market power is relatively low within Africa, at only 0.35, in comparison with the 0.81 outside Africa. This suggests that market structure is only one, and maybe not the most important, determi­ nant of the lack of competition within Africa, consistent with cross-country evidence (Claessens and Laeven, 2004). Africa’s banking systems have focused mostly on the short-end of the yield curve, as illus­ trated by the maturity structure on both the asset and liability sides of African banks’ bal­ ance sheets. Using data for the 2005–9 period, Beck et al. (2011) show that more than 80 percent of deposits are sight deposits or deposits with a maturity of less than one year and less than 2 percent of deposits have a maturity of more than ten years. There is a similar, though not as extreme, bias toward the short-end on the lending side. During the 2005–9 period, almost 60 percent of loans were for less than one year, and less than 2 percent of loans were for more than ten years. However, it is noteworthy that the maturi­ ty structure of bank loans has extended in the last decade. Figure 34.5 shows that the proportion of short-term loans has decreased, in some cases substantially, in all African countries with available data. One striking case is Guinea-Bissau that in the last decade reduced the proportion of short-term loans from 96 percent to 31 percent.

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Banking in Africa

Figure 34.5 Short-term Loans as Percentage of Total Loans. Source: African Financial Sector Database 2016, African Development Bank Group.

The maturity distribution mentioned above is consistent with the dearth of non-bank longterm financial instruments, including the limited development of contractual savings in­ stitutions, such as insurance companies, pension funds, and mutual funds. Fewer than half of the countries in the region have stock exchanges and few of them are liquid. An­ other indication of the short-term nature of African banking is the dearth of mortgage fi­ nance. While mortgage depth to GDP in the median African country was below 1 percent, it was above 2 percent outside Africa (Badev et al., 2013). These aggregate numbers match with anecdotal evidence that mortgage systems in many smaller African countries comprise just a few hundred mortgages, concentrated among wealthy individuals. While shallow, Africa’s banking systems have also proven stable and resilient over the past years. The shallowness of Africa’s banking systems appears to have helped them weather the global financial crisis of 2008 better than some other regions of the world, (p. 1084) with the impact of the crisis on Africa mostly working through real sector chan­ nels, such as lower demand for export goods, or through lower foreign direct investment. Given the limited integration with global financial markets and exposure to “toxic” assets, financial institutions across the region largely evaded the direct impact of the global fi­ nancial crisis. Greater stability is also illustrated in the aggregate balance-sheet indicators of African banks. In 2015, the capital to risk-weighted asset ratio was 18 percent in the median African country, compared to 17 percent outside Africa. On the systemic level, Africa has suffered few banking crises since the bout of systemic fragility in the 1980s and 1990s (Laeven and Valencia, 2013). Notwithstanding these positive headline indicators, pockets of (hidden) fragility continue to exist, often related to political crisis and/or governance deficiencies.

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Banking in Africa The shallowness of African financial markets is not surprising given the region’s low lev­ els of economic development and the four characteristics mentioned above—small size, informality, volatility, and institutional governance problems. However, many of the nonAfrican low- and lower-middle-income countries suffer from similar problems. Is there an Africa-specific element to financial underdevelopment? We address this issue next, before documenting in more detail specific dimensions of African banking, (p. 1085) including the structure and efficiency of banking systems, and enterprise and household access to fi­ nancial services.

34.2.2 Benchmarking Africa’s Banking Systems As suggested by Figures 34.1 and 34.3, despite extensive economic and financial sector reforms over the last few decades, many Sub-Saharan African countries still face financial development gaps relative to other developing countries. In short, the level of financial development and credit penetration in Africa is still low compared to other parts of the developing world, but it is also low relative to what would be predicted based on underly­ ing factors that are associated with financial development.

(p. 1087) Figure 34.6 Private Credit/GDP (%) in African Countries 2011–15, Actual vs. Predicted Val­ ues.

Note: Predicted values of banking sector develop­ ment, measured by credit to the private sector ex­ tended by deposit money banks/GDP, come from OLS regressions that control for a set of country-level variables including total population, population den­ sity, natural resources rents/GDP, GDP per capita, economic growth, consumer price inflation, manufac­ turing value added/GDP, primary school enrollment, and six different dimensions of governance (Voice and Accountability, Political Stability and Absence of Violence, Government Effectiveness, Regulatory Quality, Rule of Law and Control of Corruption). Note that negative predicted values are replaced by zero. Source: Authors’ calculations.

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Banking in Africa Cross-country regressions to benchmark African financial development and inclusion based on its correlates in other low- and middle-income countries reveal a substantial gap between predicted and actual levels of African financial development and inclusion. Fig­ ure 34.6 shows that predicted 2011–15 levels of private credit/GDP tended to be higher for most African countries than their actual levels. While in a few countries the (p. 1086) actual levels of financial development exceed predicted levels, most African countries still face underdeveloped credit markets. Specifically, the figure shows that a third of the countries have levels of private credit to GDP that exceed their predicted levels. However, Mauritius (MUS) and South Africa (ZAF) are not particularly representative of the African experience, and Liberia (LBR), Central African Republic (CAF), Chad (TCD) and South Su­ dan (SDN) are in the lower left-hand corner of the figure where both actual and predicted values are very low. Regarding financial inclusion, demand-side evidence from the 2017 Global Financial In­ clusion Database (Global Findex) suggests that financial institutions are not providing as much credit to all segments of the African population as they do in non-African develop­ ing countries. The average share of respondents that reported having borrowed from a fi­ nancial institution or used a credit card in the past year was 9 percent in Africa, com­ pared with 16 percent in the rest of the developing world. This is also confirmed in crosscountry regressions using 2017 Findex data based on the correlates of credit usage in other developing countries. Specifically, we find that the predicted share of Findex re­ spondents that had a loan from a financial institution in the past year exceeds the actual share in almost all cases. Only Botswana, Ethiopia, Kenya, South Africa, and Tanzania ex­ hibit higher actual than predicted levels. The case of Kenya is quite remarkable and, as we highlight later, seems to be influenced by the emergence of Equity Bank, a pioneering institution that devised a banking service strategy targeting low-income clients and tradi­ tionally underserved territories. Though the tools used are crude, the benchmarking regressions indicate that private credit provision in Africa, though improving somewhat, lags behind what fundamentals would predict, and that the allocation of what credit there is does not extend deeply into the population. To a much lesser extent, there is evidence of development gaps on the savings side. The smaller number of countries with gaps on the savings side suggests that Africa has been more effective in the provision of basic, rather than more sophisticated, banking services. In addition, both country- and firm-level tests indicate that the correlates of banking de­ velopment in Africa differ from the rest of the world. For example, Allen et al. (2014a) show that measures of the quality of macroeconomic management (inflation and the cur­ rent account balance) are not correlated with African financial development as they are in other developing countries. Measures of institutional development (such as adherence to rule of law) are positively linked to African financial development, though substantially less strongly than in other parts of the developing world. Allen et al. (2014a, 2016) also show that the most striking difference is that population density is more strongly linked to financial development in Africa than elsewhere. Population density is also more closely Page 10 of 42

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Banking in Africa linked to bank branch penetration in Africa than in other developing economies, and both are more strongly linked to firm-level access to external finance in Africa than elsewhere. Presumably, bank branch penetration figures remain low in Africa because of difficulties in achieving minimum viable scale in sparsely populated, low-income areas, though below we discuss financial institutions, strategies, and technological innovations that are rising to meet that challenge.

34.2.3 Drilling Deeper—Bank- and Branch-Level Evidence While the aggregate data already give us some indication of the shallowness of African banking systems, bank- and branch-level data provide more detailed insights. Comparing a sample of 307 banks from low- and lower-middle-income countries in Africa and 720 banks from non-African developing countries shows significantly higher liquidity ratios for African banks. Specifically, the ratio of liquid assets to short-term funding and de­ posits is 42.9 percent for African banks, as compared with 29.3 percent for non-African banks. Similarly, African banks are better capitalized, with an equity-asset ratio of 14.3 percent, compared with 13.3 percent for non-African banks. These comparisons give a picture of African banks that are well capitalized, over-liquid and provide only limited lending to the real economy, as highlighted previously by Honohan and Beck (2007) and Beck et al. (2011). As discussed above, African banks are less efficient than banks in other developing re­ gions of the world and financial services are therefore more expensive. A lot of discussion in this context has focused on interest rate spreads and margins, that is, the difference between lending and deposit interest rates. But what drives high interest rate spreads in Africa? There are three different ways to analyze spreads and margins. The first one is a decomposition of spreads into their different components. The second is to analyze the relevant underlying bank-, industry-, and country-level traits. Finally, the third way of un­ derstanding interest rate spreads in Africa is by exploring their levels across different ge­ ographic areas within a country.

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Banking in Africa Table 34.1 Decomposition of Interest Rate Spreads in Uganda in 2008 All Banks

Domestic

Foreign

Average Lending Rate

16.72

18.44

15.24

Average Deposit Rate

1.97

2.31

1.9

Spread

14.75

16.13

13.34

Overhead Costs

4.66

2.74

6.22

Loan-loss Provisions

0.72

0.38

1.01

Reserve Requirements

0.22

0.26

0.21

Taxes

2.51

3.34

1.64

Profit Margin

6.65

9.42

4.26

Source: Cull and Trandafir (2010). Table 34.1 presents a decomposition of interest rate spreads for Uganda and shows that high operating costs are one important factor, while loan loss provisions reflecting loan losses and reserve requirements are rather minor components of the interest rate spread. The highest component of interest rate spreads, however, is the high profit margin, con­ sistent with limited competition, but also a high-risk premium. Comparing domestic and foreign-owned banks, we see that domestic banks have higher spreads, due to higher lending rates, which most likely reflects a riskier loan portfolio. The spread (p. 1088) de­ compositions indicate that domestic banks generate high profit margins from a group of borrowers that repay their loans at a higher rate than clients of foreign banks. The rela­ tively high overhead costs and low profit margins for the foreign banks could be consis­ tent with the idea that they deal with a set of “blue-chip” clients whose projects are cost­ lier to evaluate and maintain. In addition, higher wages might add to their costs, though higher costs could also result from foreign banks’ propensity to invest more, including in IT and technology to develop new products.9

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Banking in Africa Table 34.2 Explaining Overhead Costs in Africa Overhead costs African banks

605

Rest of World banks

451

Difference

154

Of which: Contractual framework

12

 Non-interest income

93

 Banks size

18

 Equity-asset ratio

5

  Other bank characteristics

−3

Inflation

11

Africa residual

18

Source: Authors’ calculations using data from Bankscope. Table 34.2 uses regression analysis to relate bank-level variation in overhead costs to bank- and country-level characteristics and compares banks in Africa with banks in nonAfrican developing countries. Since overhead costs is one of the major components of in­ terest rate spreads, we regress overhead costs in 2011 for a cross-country sample of banks on (1) the share of non-interest income, (2) the equity–asset ratio, (3) the liquidity ratio, (4) loan growth over the previous year, (5) the log of total assets, (6) the inflation rate and (7) the Kaufmann, Kraay, and Mastruzzi indicator of Rule of Law. The results in Table 34.2 indicate the extent to which these different factors contribute to the substan­ tially higher overhead costs of banks in Africa (6.05 percent) than in banks outside Africa (4.51 percent). Relatively high reliance by African banks on non-interest income and their smaller size can explain 93 and 18 basis points, respectively, of the difference in overhead costs. Higher inflation in African countries and less efficient contractual frameworks can explain 11 and 12 basis points, respectively. Even after accounting for these bank and country characteristics, there is still an unexplained Africa residual of 18 basis points. Allen et al. (2018) use branch-level data to better understand Equity Bank’s interest rate spreads across different geographic areas in Kenya. Their findings are consistent with a more aggressive pricing schedule by Equity Bank in areas largely ignored by its competi­ Page 13 of 42

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Banking in Africa tors, as is reflected in higher lending-deposit interest rate spreads in arid and (p. 1089) se­ mi-arid counties. Since holding a bank account and/or a loan with Equity Bank was the only option for many customers in less-developed areas to keep their money safe and/or finance their business projects, the bank was able to combine the pursuit of financial in­ clusion with low interest paid on deposits and relatively high interest charged on loans in less-banked regions. As discussed earlier, the ownership structure of Africa’s banking systems has undergone notable changes over the past decades. Today foreign-owned banks play an increasingly important role in Sub-Saharan Africa, while government-owned banks are less prominent (Cull, Martínez Pería, and Verrier, 2018). Although foreign-owned banks have been present in Africa since the colonial era, their participation increased following the privati­ zation wave in the 1980s and 1990s, and the reforms that liberalized the financial sectors in the 1990s and early 2000s. In particular, the median share of assets held by foreignowned banks rose from 34 percent in 1995 to 73 percent in the latest year for which data are available for each country from 2010 to 2013. Long dominated by European banks, banks from emerging markets and—critically—from inside Africa have gained importance over the past decade. After the end of Apartheid, several South African banks, most no­ tably Standard Bank and ABSA, started expanding throughout the continent. More re­ cently, two West African banks—Ecobank and Bank of Africa—have begun expanding throughout Sub-Saharan Africa. Similarly, Moroccan banks have started to expand south­ wards. Finally, and as a consequence of the recent bank consolidation wave in Nigeria and Kenya (Beck et al., 2014), banks from those economies also started expanding throughout the rest of the continent. We will return to the topic of cross-border banking and regulatory implications in section 34.4.2.

34.2.4 Enterprise Access to Finance in International Comparison

Figure 34.7 Use of Formal Account and Loan Ser­ vices across Firm Size Groups in International Com­ parison, 2013–17. Source: Authors’ calculations based on World Bank’s Enterprise Surveys.

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Banking in Africa The World Bank’s Enterprise Surveys allow us to dig deeper into the international com­ parison of enterprise access to finance and distinguish between firms of different sizes. Using data from the period 2013–17, Figure 34.7 shows, as expected, that larger firms are more likely to have an account and/or a loan from a formal financial institution in both African and other developing countries. The figure also shows that the disadvantage African firms have relative to firms in other developing economies is particularly striking in terms of access to credit. Across all three size groups, enterprises within Africa are less likely to have a loan than enterprises outside Africa. On the payment/savings side, the vast majority of firms use formal accounts in both African and non-African developing countries, and the differences between firm size groups are very similar. Enterprise survey data also provide the self-reported reasons why enterprises do not have loans with formal financial institutions. Specifically, enterprises are asked for the reason why they did not apply for a loan with a formal financial institution over the past year. The share of enterprises that quote the lack of demand is substantially lower in Africa (43 percent) than in other developing countries (62 percent), suggesting that lack (p. 1090) of demand is a less important factor in the African context. High interest rates were also mentioned as a reason for not applying for loans (14 percent in Africa vs. 10 percent in other developing countries), which could indicate that the return on investment projects is too low. On the other hand, and as noted by many observers of African finance, the high cost of credit might impede the use of bank finance. Interest rate spreads and thus lend­ ing rates are notably higher in Africa than in non-African developing countries. Those high costs of credit can be explained not only by the lack of competition described above, but also by monetary and socio-political instability resulting in a high-risk premium. The importance of monetary and socio-political stability can be appreciated when considering that the share of non-applicants due to high interest rates is especially high in unstable countries such as the Democratic Republic of the Congo (DRC) and Zimbabwe. Even more striking than the differences based on the perceptions of high interest rates is the differ­ ence in the share of respondents, indicating that application procedures are the reason for not applying: 16 percent of non-applicant enterprises in Africa as opposed to 7 per­ cent in other developing countries. Collateral requirements also seem to be a greater im­ pediment in Africa than in other regions of the developing world (9 percent vs. 4 per­ cent), as is the need for bribes (4 percent vs. 2 percent). These data point to a large array of barriers both on the macroeconomic but also the bank-specific levels for enterprises in Africa to access formal sources of external finance. The financing of small and medium-sized enterprises thus continues to pose a significant challenge, and not only for African financial systems. However, it is important to distinguish between segments within this group of enterprises that have different fi­ nancing needs and profiles. A large share of the enterprises in Africa is comprised of in­ formal microenterprises whose establishment often stems from the lack of alternative economic opportunities. Not being able to produce formal financial accounts or formal guarantees, it is hard to see this segment of the enterprise population becoming bankable over the medium to long term, at least not for credit services.10 They seem a natural tar­ get group for microcredit institutions and rely more heavily than other enterprises on in­ (p. 1091)

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Banking in Africa formal finance providers. A second segment is medium-sized enterprises, often well-es­ tablished and export-oriented companies. In most cases they have access to bank finance, but struggle to get access to equity finance, including through financial markets. Finally, there are small formal enterprises, some of which might have high growth potential. These firms—often also referred to as the missing middle—are usually too big to be ser­ viced by microfinance institutions, but not formal or established enough for banks. It is especially this last segment that seems to be affected by shallow financial markets. This is also illustrated in Figure 34.7, where there is a larger difference in the use of formal loans between small and medium-sized enterprises in Africa (13 percent vs. 23 percent) than outside Africa (27 percent vs. 35 percent).

34.2.5 Household Access to Finance in International Comparison

Figure 34.8 Account Penetration across Regions, 2011, 2014, and 2017. Source: Global Findex.

Figure 34.8 shows a significant increase in the share of households with a bank account in the median country in Sub-Saharan Africa, between 2011 and 2017, increasing from 17 percent in 2011 to 22 percent in 2014 to 41 percent in 2017. This graph shows the medi­ an value across the six regions of the developing world (as classified by the World Bank) as well as high-income countries. There has been a general increase in financial inclusion across most regions, as measured by this variable, though there is substantial variation in the extent to which inclusion has increased. The one dimension on which Sub-Saharan Africa stands out is the share of the population with a mobile phone-based account (only data for 2014 and 2017 are available), where the median is significantly higher than in other regions, a topic which we will return to below. In spite of the progress in financial inclusion across the region, there is still a wide varia­ tion in account penetration across Sub-Saharan Africa, which ranges from over 80 per­ cent in Mauritius, Kenya, and Namibia to below 10 percent in South Sudan. While this variation partly reflects the variation in income levels, this is certainly not the only factor as Kenya, for example, is the African country with the second highest account penetration in the region, ahead of South Africa with 69 percent. (p. 1092)

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Banking in Africa Table 34.3 Account Penetration over Time and across Countries Country

Account Pen­ etration 2011

Account Pen­ etration 2014

Account Pen­ etration 2017

Angola

39.2

29.32

n.a.

Benin

10.46

16.62

38.49

Botswana

30.26

51.96

51.03

Burkina Faso

13.35

14.36

43.16

Burundi

7.24

7.11

n.a.

Cameroon

14.81

12.18

34.59

Chad

8.96

12.43

21.76

Congo

10.05

17.07

26.09

Congo, Dem. Republic

3.7

17.48

25.83

Gabon

18.95

33.01

58.6

Ghana

29.43

40.51

57.72

Guinea

3.69

6.96

23.49

Kenya

42.34

74.66

81.57

Madagascar

5.52

8.55

17.87

Malawi

16.54

18.09

33.71

Mali

8.21

20.08

35.42

Mauritania

17.46

22.87

20.87

Mauritius

80.12

82.21

89.84

Niger

1.52

6.71

15.52

Page 17 of 42

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Banking in Africa Nigeria

29.67

44.44

39.67

Rwanda

32.76

42.12

50.02

Senegal

5.82

15.42

42.34

Sierra Leone

15.34

15.58

19.81

South Africa

53.65

70.32

69.22

Sudan

6.9

15.27

n.a.

Tanzania

17.26

39.78

46.75

Togo

10.19

18.25

45.29

Uganda

20.46

44.45

59.2

Zambia

21.36

35.64

45.86

Zimbabwe

39.65

32.39

55.29

Source: Global Findex (2017). Table 34.3 shows account penetration across the three Findex waves for the countries for which data are available for all three years (2011, 2014, and 2017). As can be seen, sev­ eral countries in Sub-Saharan Africa saw dramatic increases in account penetration (led by Kenya with a 39 percentage point increase over the six years and Gabon, Senegal, To­ go, and Uganda with increases well above 30 percentage points). In short, while most countries saw an improvement in financial inclusion, as measured by account penetra­ tion, progress has been very uneven. The large increase in account penetration in several African countries can be linked to the rise of mobile money accounts, with 73 percent of the population in Kenya having a mobile money account in 2017 and over 40 percent in Namibia, Gabon, Zimbabwe, and Uganda. On the other extreme are countries with repressed financial systems, such as Ethiopia (less than 1 percent), countries in West Africa (Mauritania, Nigeria, Congo, Niger) or countries with very high levels of account penetration (and thus no need for mo­ bile money accounts), such as Mauritius.

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Banking in Africa

(p. 1094) Figure 34.9 Gaps in Account Penetration in Sub-Saharan Africa.

The Global Findex survey not only allows an aggregate picture of the share of households using formal financial services, but also a more detailed look into which population seg­ ments have access to formal financial services. Figure 34.9 shows account penetration across male versus female, the richest 60 percent versus the poorest 40 percent and peo­ ple in and outside the labor force. The gender gap dropped between 2011 and 2014 though it again increased between 2014 and 2017, with males being 40 percent more likely to have a formal financial account than females. It is important to note, however, that these are unconditional comparisons. Using more detailed financial sector surveys for a number of Eastern and Southern African countries, Aterido, Beck, and Iacovone (2013) show that when key observable characteristics of individuals are taken into ac­ count, the gender gap disappears. The lower use of formal financial services by women (p. 1093) may therefore be explained by gender gaps on other dimensions related to the use of financial services, such as their lower level of income and education, and by their household and employment status. On the other hand, the gap between the poorest 40 percent and richest 60 percent closed between 2011 and 2017; while in 2011 the former were only 36 percent as likely as the latter to have a formal financial account, they were 65 percent as likely in 2017. Similarly, those outside the labor force were 28 percent as likely to have a formal financial account as those in the labor force in 2011. By 2017, they were 60 percent as likely. Figure 34.10 shows the same gaps for mobile money account penetration. Men are (p. 1095) (p. 1096) only 25 percent more likely than women to have a mobile money account, the poorest 40 percent half as likely as the richest 60 percent, and people outside the labor force 55 per­ cent as likely as people in the labor force. This suggests that especially the gender gap can be closed through technology.

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Banking in Africa

(p. 1095) Figure 34.10 Gaps in Mobile Money Ac­ count Penetration in Sub-Saharan Africa.

The Global Findex data also allow us to explore the reasons why households do not have accounts with formal financial institutions. In the median African country, 73 percent of respondents without an account with a formal financial institution cite lack of money as a reason, 27 percent cite high costs, and 28 percent report lack of the necessary documen­ tation as an impediment; 25 percent point to geographic barriers, while 15 percent cite lack of trust in financial institutions. Finally, 6 percent report religious reasons for not having a formal bank account,11 while 10 percent point to someone else in the family hav­ ing an account.

34.3 Overcoming Barriers to Financial Inclu­ sion: Branch Expansion, Field Experiments, and Technology Africa has made substantial progress over the past decade, not only in financial depth and inclusion, but also in underlying macroeconomic stability, with few countries presenting double-digit inflation rates. Similarly, there has been some underlying institutional progress, including in creditor rights, contract enforcement and credit information shar­ ing. Specifically, the average cost of property registration dropped from 13 percent to 7.8 percent of property value between 2004 and 2017, while creditor rights increased from an average of 4.2 to an average of 5.2 (on a ten-point scale) over the same period. While in 2004, fewer than half of the countries had a public or private credit registry, in 2017 more than 80 percent of countries in the region had one. The average cost of contract en­

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Banking in Africa forcement decreased from 56 percent of the average claim in 2004 to 47 percent in 2017.12 While macroeconomic management and institutional development have thus shown a cer­ tain degree of improvement, the benchmarking exercise discussed in section 34.2.2 suggests that these are necessary and not sufficient conditions for financial deepening in Sub-Saharan Africa and that other barriers, including geographic disadvantages, hold back the further deepening of African banking systems. Financial innovation, that is, new delivery channels, new players, and new products, can help overcome these barriers, es­ pecially geographic barriers. Africa has seen substantial innovation on this front (p. 1097) over the past decade, as reported by Beck et al. (2011). Much of it comes from different financial institutions, banks, NGOs, and MFIs, both domestic and foreign-owned, often with support from donors. In many countries, regulators have reacted flexibly, opening space for innovation within existing regulatory frameworks or adjusting them where nec­ essary. In this section, we report on different forms of financial innovation, summarizing re­ search findings on the recent branch expansion by some banks into more sparsely popu­ lated areas and the potential for banks to use agent networks to further extend their reach. Agents are typically owners of small retail businesses who are trained by a formal financial institution (most often a bank or a microfinance institution) to collect deposits and process payments, including payments on small-scale loans (Lyman, Ivatury, and Staschen, 2006; Siedek, 2008; Flaming, McKay, and Pickens, 2011). We also summarize results from recent field experiments in Africa that are beginning to shed light on the types of financial services that could benefit underserved market segments and overcome impediments to their uptake. Finally, we explore the role that technological innovation could play in bridging some of the geographic and informational divides that currently characterize the African financial landscape.

34.3.1 Bank Branching Kenya represents a good example of an African country that has experienced a significant bank branch expansion in recent years. According to the World Bank’s Global Financial Development Dataset, the total number of bank branches in Kenya increased from 2.98 per 100,000 adults in 2004 to 5.85 in 2015, while the number of ATMs increased from 2.49 per 100,000 adults to 10.16 in the same period. While many Kenyan banks, including some state- and foreign-owned ones, expanded their branch footprints during this period, the expansion strategy of one private domestic bank in particular, Equity Bank, stood out for its potential impact on outreach to under-served market segments. This institution has played a key role in fostering financial inclusion in Kenya and in neighboring countries in East Africa while remaining profitable in the process. In the period 2006–16 its client base grew from 1 million to 11 million people, making Equity Bank the largest bank in Africa in terms of customers. As part of its expansion strategy, Equity Bank emphasized that local languages be spoken in its branches, an important consideration since 30–40 percent of the people in central Kenya do not speak English or Swahili. At the same time, Page 21 of 42

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Banking in Africa according to the Financial Times’ 2014 ranking of the world’s Top 1,000 banks, Equity Bank generated the highest rate of return in Africa with a return on assets of 6.8 percent and a return on capital of 54.9 percent. Allen et al. (2018) use the case of Equity Bank to explore the relationship between bank branch expansion, financial inclusion and bank profitability. Using instrumental variables and difference-in-differences techniques, the paper finds that the presence of Equity Bank branches has a positive and significant impact on households’ use of (p. 1098) bank ac­ counts and bank credit.13 Across estimation techniques, Equity’s presence was associated with a 4 to 9 percentage point increase in the probability of having a bank account. Simi­ lar regressions confirm that Equity’s presence was associated with an increase in borrow­ ing, although loan use increased less dramatically, from 2.9 percent of respondents in 2006 to 4.4 percent in 2009. Additionally, the study finds that the impact of Equity Bank’s expansion into underserved territories was particularly strong for Kenyans who are less educated, do not own their own home, and live in less-developed areas. In all, Equity Bank’s experience in Kenya and those of a handful of banks in other devel­ oping countries suggest that it might be possible to generate sustainable profits with a business model focused on the provision of financial services to population segments that are typically ignored by commercial banks.14 At the same time, the number of studies is small (and most are not from African countries) making it hard to identify the factors that lead to the successful adaptation of those strategies. As noted above, another potential method for promoting financial inclusion in sparsely populated areas is agent banking.15 For example, a review of the Latin American experi­ ence suggests that agents have been effective in reaching the unbanked (Alliance for Fi­ nancial Inclusion, 2012). In Kenya, Equity Bank has also moved forcefully into agent banking, expanding its number of agents from under 1,000 in early 2011 to over 6,000 by the end of 2012. By that point, agents accounted for over 30 percent of Equity Bank’s to­ tal transactions. Rigorous studies of the effects of agent banking in Africa are beginning to emerge. For example, Finca DRC’s over 500 agents handle over 65 percent of the transactions of one of the largest microfinance institutions in the DRC, and regression analysis of agent activity indicates that they have been successful in reaching the urban poor (Cull et al., 2018). Access to agents also holds the potential to influence clients’ financial behavior. A recent field experiment in Senegal shows that individuals encouraged to open a no-frills account with an agent subsequently performed more transactions than those encouraged to open the same account at a branch, and their account balances also increased suggesting that access to agents made it easier for them to save (Buri et al., 2018). In short, there are en­ couraging signs that agents of African banks and MFIs can reduce transactions costs en­ abling poorer clients to become more financially active, though (p. 1099) early results indi­ cate that this is through cash-in/cash-out transactions and, to a lesser extent, savings rather than credit.

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Banking in Africa

34.3.2 Assessing Tailored Product Interventions with Randomized Field Experiments Although the number of field experiments based on randomized controlled trials (RCTs) in Africa involving financial services is low, patterns are beginning to emerge that point to key impediments to broader financial inclusion. On the savings side, commitment devices that enable users to guard accumulated funds from outside demands (often from relatives and friends) have led to increased investment and more rapid growth of firms. For exam­ ple, Dupas and Robinson (2013) show that female shopkeepers in Kenya were much more likely to take up non-interest-bearing bank accounts that were subject to high withdrawal fees (and thus less attractive than standard interest-bearing accounts) than male busi­ ness owners, and investment in those female-owned businesses was nearly double that of female business owners in the control group. Brune et al. (2011) document changes in the production methods of tobacco farmers in Malawi who were offered a “commitment” savings account that allowed the account holders to freeze their funds until a specified date (typically just prior to the planting season, thus preserving funds for purchases of farm inputs). Deposit and withdrawal activity spiked just prior to the planting season, land under cultivation increased by 9.8 percent, agricultural input use in that planting by 26.2 percent, crop output in the subsequent harvest by 22 percent, and household expen­ ditures in the months immediately after harvest by 17.4 percent (all relative to the mean for the control group). Another study from Western Kenya shows how a commitment sav­ ings device enabled farmers to increase their use of fertilizer (Duflo, Kremer, and Robin­ son, 2011). Recent experimental evidence indicates that access to finance by the poor should be com­ bined with complementary policies. Using data from a field experiment in Uganda and Malawi, Dupas et al. (2016) show that interventions merely focused on expanding access to finance to the poor, like one–time bank account opening subsidies, are unlikely to broaden financial access. Finally, there is also recent evidence that suggests that access to savings products influences interpersonal financial relationships. Dupas, Keats, and Robinson (2019) study the effect of accounts on financial linkages in rural Kenya, docu­ menting that households that were randomly offered a bank account became less finan­ cially reliant on grown children and siblings living outside their village, and more sup­ portive of neighbors and friends within their village. There is less evidence from experiments involving African credit products than for sav­ ings products. But some evidence from micro-credit experiments in Africa suggests that beneficial effects are harder to identify than for savings. For example, Tarozzi, Desai, and Johnson (2015) use data from an RCT conducted in rural Ethiopia to study the impact of access to microcredit on income from agriculture, animal husbandry, non-farm self-em­ ployment, labor supply, schooling, and indicators of women’s empowerment. (p. 1100) The study does not find clear evidence of widespread improvement in socioeconomic indica­ tors in treated areas.16

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Banking in Africa Another key impediment to broader extension of credit in Africa is the lack of reliable methods for personal identification. Individuals who lack collateral and credit histories, which characterizes a large share of the African population, struggle to overcome infor­ mational asymmetries that make it almost impossible to access credit from formal sources. Establishing collateral and credit registries could help, but these can only func­ tion if people can be accurately identified. A field experiment among paprika farmers in Malawi tested whether biometric identification methods can improve the functioning of credit markets in a country where identity theft is common (Giné et al., 2013). Applicants for agricultural input loans from a state-owned bank were randomly assigned to a treat­ ment group in which a fingerprint was collected from each member as part of the loan ap­ plication, or to a control group in which no fingerprint was taken. Both treatment and control groups attended a training session on the importance of a credit history in ensur­ ing future access to credit. For the sub-group of farmers identified as having high ex-ante default risk, fingerprinting led to a 40 percent increase in repayment rates.17 As in other parts of the developing world, microinsurance products could offer benefits in Africa, especially in agricultural areas. For example, rainfall insurance, which pays a set amount when rainfall falls below (or surpasses) a predetermined threshold, could be use­ ful to African farmers.18 In Ghana, Karlan et al. (2014) find that rainfall insurance coun­ ters farmers’ risk aversion and improves decision-making, though effects were largest when insurance was combined with subsidized capital. Farmers that received both in­ creased their spending on agricultural chemical inputs by 47 percent, expanded their land under cultivation by 22 percent, and were less likely to report that their households suffered from hunger. But in another experiment in Malawi, Giné and Yang (2009) find that take-up rates for an agricultural loan product were somewhat lower when the loan was coupled with an insurance policy (priced at an actuarially fair rate) that paid off in the event of poor rainfall. In part, the reluctance to purchase the insurance product may have stemmed from farmers’ belief that they only faced limited liability for their loans in the event of severe weather problems (and thus they already had a form of implicit insur­ ance). In both experiments, the take-up rate for insurance products was puzzlingly low, suggesting a weak match between the insurance products and farmers’ needs and/or farmers not fully understanding how these products could benefit them. More research in the insurance area is clearly warranted. (p. 1101)

34.3.3 Technological Innovation

Mobile money transfer (“m-transfer”) systems facilitate financial transactions via mobile phones, allowing users to deposit and withdraw cash from an account that is accessible by mobile handset. Users can store value in the account and transfer value between users via text messages, menu commands, and personal identification numbers (Aker and Mbiti, 2010). M-transfer arrangements therefore enable users to make payments and transfer funds at relatively low cost across much wider geographic areas than is possible using lo­ calized informal payment solutions. Aker et al. (2011) report that, from 2005 to 2010, m-

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Banking in Africa transfer systems were established in 80 developing countries in Africa, Asia, and Latin America.

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Banking in Africa Table 34.4 Mobile Phone use in Financial Transactions in Africa by Country, 2017 (p. 1102)

Country

Mobile money account (% age 15+)

Used mobile phone or In­ ternet to ac­ cess an ac­ count (% age 15+)

Used mobile phone or Inter­ net to access a fi­ nancial institu­ tion account (% age 15+)

Benin

18

19

27

Botswana

24

25

32

Burkina Fa­ so

33

29

24

Cameroon

15

16

22

Central African Re­

n.a.

2

16

Chad

15

13

15

Congo

6

6

8

Congo, Dem. Re­

16

17

29

Cote d’Ivoire

34

33

21

Ethiopia

0

0

1

Gabon

44

44

32

Ghana

39

35

28

Guinea

14

11

15

Kenya

73

72

57

public

public

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Banking in Africa Lesotho

28

26

27

Liberia

21

21

16

Madagas­ car

12

11

17

Malawi

20

20

27

Mali

24

24

22

Mauritania

4

3

8

Mauritius

6

15

16

Mozam­ bique

22

22

30

Namibia

43

46

42

Niger

9

8

16

Nigeria

6

8

18

Rwanda

31

29

13

Senegal

32

29

27

Sierra Leone

11

10

23

South

19

21

25

South Su­ dan

n.a.

1

6

Tanzania

39

37

31

Togo

21

21

16

Uganda

51

47

27

Africa

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Banking in Africa Zambia

28

26

35

Zimbabwe

49

46

38

Source: Global Findex (2017). The World Bank Global Findex dataset revealed that, by 2011, 67 and 60 percent of the adult population in Kenya used mobile telephones to receive and send money, respective­ ly. In 2017, 73 percent of Kenyans had a mobile money account, and 72 percent had used a mobile phone or the Internet to access an account within the past year. As reported in Table 34.4, mobile banking has also taken off as a means of accessing accounts and per­ forming financial transactions in other African countries such as Gabon, Ghana, Namibia, Tanzania, Uganda, and Zimbabwe. In each of those countries at least 35 percent of the adult population were active users of mobile or Internet banking options in 2017 (Table 34.4, column 2). As noted in Allen et al. (2014a), the penetration of mobile telephones to receive and send money has been deeper in Sub-Saharan Africa than in the rest of the de­ veloping world. That trend has continued and the range of banking services used via mo­ bile telephones has expanded. Mobile banking spread quickly in Kenya thanks, in part, to the fact that the operator of M-Pesa (M is for mobile, “pesa” is Swahili for “money”), Kenyan mobile network operator Safaricom, controlled two-thirds of the telecoms market in Kenya. M-Pesa, the mobile payments wallet launched in 2007 by Safaricom, had 15 million registered users by early 2012, a network of 35,000 cash-in/cash-out agents, and a transaction volume of $665 mil­ lion per month (Mark, 2012; Rotman, Ferrand, and Rasmussen, 2012). At the same time, M-Pesa was rarely used for storing value for any significant period (most transactions were of the cash-in, immediate cash-out variety) and the vast majority of M-Pesa transac­ tions were undertaken by relatively affluent Kenyans, though there were some indications of less intensive use by poorer population segments.19 Recent empirical evidence suggests that this innovation has paid off, not only in terms of financial inclusion, but also in terms of increased consumption. M-Pesa use has brought about a substantial decline in the costs of sending transfers and a substantial increase in their volume (especially remittances), a greater likelihood of being formally banked, and decreased use of informal savings mechanisms (Jack and Suri, 2011; Mbiti and Weil, 2016). In partnership with the Commercial Bank of Africa (CBA), Safaricom also began offering a mobile product called M-Shwari to offer an array of financial services including interest-earning savings and credit. New loans can be applied for (and granted) almost in­ stantaneously. Loan amounts start small and M-Shwari uses the prospect of larger future loans to incentivize loan repayment. Early indications are that take-up rates for M-Shwari loans are substantially higher than for microfinance loans. Like microcredit, M-Shwari loans appear to be used as a tool to smooth consumption and better manage the financial (p. 1103)

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Banking in Africa lives of clients, though there are also indications that some clients use them for educa­ tional expenses (Bharadwaj, Jack, and Suri, 2017). Jack and Suri (2014) have shown that, by reducing the costs of transfers within social net­ works in Kenya, households have been able to smooth consumption in the face of econom­ ic shocks. Specifically, they find that shocks reduce the consumption of non-M-Pesa users by 7 percent, while shocks have no significant effect on the consumption of households with an M-PESA user. Both the volume and diversity of remittance senders also increase after a shock and the average distance from senders to receivers of remittances increases substantially (Jack and Suri, 2014), suggesting that M-Pesa has enabled households to ex­ pand or make fuller use of their social networks at lower cost. Finally, Jack, Ray, and Suri (2013) find that the purposes of remittances differ between users and non-users of M-Pe­ sa. Users are more likely to receive remittances via M-Pesa for credit or in response to an emergency, while the fraction of total M-Pesa transactions for regular support declines. The patterns suggest that M-Pesa enables households to more easily draw on their social networks for support in trying circumstances.20 M-Pesa also had positive effects on firms’ access to trade credit and thus growth, as shown by Beck et al. (2018). Specifically, by providing a safer payment method, enterprises increase their access to, and lower the cost of, supplier credit, with positive repercussions for sales growth. M-transfer systems have also facilitated spatial risk sharing within an economy as illus­ trated by Blumenstock, Eagle, and Fafchamps (2011) who show that the Lake Kivu earth­ quake in 2008 in Rwanda caused individuals living outside the affected area to transfer a large and significant volume of airtime to people living close to the earthquake’s epicen­ ter. They also show that the transfers were consistent with reciprocal risk sharing rather than charity or altruistic motivations, suggesting that mobile payment services facilitate informal interpersonal insurance mechanisms, although it seems again that wealthier segments of the population benefited most. Another example comes from Niger, where an m-transfer system is providing a more cost-effective means of implementing a cash trans­ fer program. While Bold, Porteous, and Rotman (2012) argue that electronic payment methods for social cash transfers work best when piggy-backing upon existing payments infrastructure, the experience in Niger suggests that electronic cash transfer via an msystem could also work where more traditional payments infrastructure is lacking.21 An experiment comparing traditional cash transfers with transfers via an m-sys­ tem called Zap was undertaken in ninety-six “food-deficit” villages in Niger, meaning they had produced less than half of their consumption needs during the 2009 harvest (Aker et al., 2011). Zap substantially reduced the cost of distributing and obtaining the cash trans­ fers, and households used their transfers to purchase a more diverse set of goods, in­ creased the diversity of their diets, depleted fewer assets, and grew a wider variety of crops (including marginal crops typically grown by women). The authors speculate that lower costs, in particular the time savings to recipients of electronic transfers, and greater privacy in receiving those transfers (reducing obligations to share money within social networks) is driving the changes in household outcomes associated with Zap usage. (p. 1104)

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Banking in Africa The experimental results for Africa thus far suggest that financial products that can reach the poor at low cost (both to providers and to the poor themselves), and that incorporate elements that enable borrowers/savers to protect funds to meet financial goals, hold promise for expanding financial inclusion.

34.4 Beyond Financial Inclusion: New Chal­ lenges While we have documented achievements in deepening and broadening African financial systems, challenges remain. In this section, we point to two specific areas where future research could support policy formulation.

34.4.1 The Long-Term Finance Challenge The first of these challenges refers to the short-term nature of finance across the region, as illustrated not only in the balance-sheet structures of banks, but also in the limited de­ velopment of contractual savings institutions and financial markets. While financial inclu­ sion has dominated the recent policy debate and research agenda, the need for long-term finance by households, enterprises, and government is enormous. The cost of addressing Africa’s physical infrastructure needs is estimated at $93 billion per year, roughly 15 per­ cent of Africa’s gross domestic product (GDP) (Foster and Briceño-Garmendia, 2010). De­ mand for housing, especially in urban areas, continues to rise across the continent as Africa rapidly urbanizes. And firms continue to lack the necessary resources for long-term investment. While expanding access to formal financial services continues to be a challenge, there has been less progress in developing long-term finance on the continent, at least as indicated by the limited data that are available. Most of bank finance is short-term (both on the de­ posit and loan side) and non-bank finance, both intermediated and (p. 1105) market-based, is not developed. Given the overall development of financial systems, including shallow banking systems, this is not surprising; as shown by Beck et al. (2008) and De la Torre, Feyen, and Ize (2013), non-bank segments arise at a much later stage of economic devel­ opment. Long-term finance is critical for long-term development of modern societies. Well-func­ tioning intermediaries and capital markets that allow investors and savers easy access to their funding while enabling long-term investment are at the core of financial sector de­ velopment. Beyond this general statement, one can also consider specific beneficiaries of long-term finance and projects that rely on long-term funding streams. Take the example of infrastructure: Given high resource needs and long-time horizons between the start of construction, its completion and the revenue phase, appropriate funding structures are needed. As private–public partnerships in infrastructure gain in importance, correspond­ ing financing structures are needed that match maturity and risk structures of assets with funding. More generally, for governments, better access to long-term funding instru­ Page 30 of 42

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Banking in Africa ments can reduce the procyclicality of government consumption and its costs, as well as allow for more efficient investment decisions. In the case of households, access to longterm savings instruments allows consumption smoothing over the life cycle and provides savings and insurance products for retirement. On the funding side it allows large invest­ ment, prominently into housing, but also into human capital, independent of current in­ come but as a function of future expected income streams. Finally, for firms, availability of long-term finance allows a better maturity matching of assets and liabilities and re­ duces the dependence of investment decisions on cash flow availability (Love, 2003) as well as greater investment in R&D activities, as shown by Aghion et al. (2010). Public capital markets, especially stock exchanges, have often been seen as quintessen­ tial elements of long-term finance provision in an economy. There were, therefore, inten­ sive efforts by donors and local governments to establish such markets across Sub-Saha­ ran Africa in the 1980s, though unfortunately those met with limited success. Albu­ querque de Sousa et al. (2016) show that this can be mainly explained by the small size of financial systems across the region, limited banking sector development (another precon­ dition for capital market development) and limited domestic savings. By 2018, half of the region’s countries had a stock market, but with very low liquidity.22 Development of bond markets is even more rudimentary, with few if any non-financial companies in most coun­ tries being able to issue bonds. While recent reforms in several countries in Sub-Saharan Africa have created private pension systems that are rapidly accumulating assets under management, the pension fund industry only intermediates a fraction of those assets into productive long-term in­ vestments (reverse maturity transformation). Mortgage finance is very limited (Badev et al., 2013) as discussed above, which is again in line with global experience where it is mostly high-income countries where one sees a significant role for mortgage finance. Addressing the long-term finance gap first requires addressing a data gap. While data availability on access to finance has improved enormously across the globe and especially in Africa, driven partly by global data collection efforts, such as the World Bank’s Global Findex and the IMF’s Financial Access Survey, and partly by country-specific efforts, such as the FinScope and FinAccess surveys, very limited data is available on the depth, effi­ ciency, and accessibility of long-term financial markets, though there are currently at­ tempts at increasing the availability of indicators of long-term finance.

34.4.2 Cross-Border Banking and Regulatory Challenges As discussed above, foreign banking has had a long tradition in Africa, first in colonial times, and emerging again in the 1980s. What has been the effect of the increase in for­ eign bank ownership on the development, efficiency, stability, and outreach of African banking?23 Foreign bank entry seems to have several advantages that are specific to Africa: international banks can help foster governance; they can bring in much-needed technology and experience that should translate into increased efficiency in financial in­ termediation; and they can help exploit scale economies in small host countries. Nonethe­ Page 31 of 42

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Banking in Africa less, especially in Africa, with its many small, risky, and opaque enterprises, the down­ sides of foreign bank entry also can become obvious, even more so in countries in which foreign banks have captured almost 100 percent of the banking market. Specifically, the greater reliance of foreign banks on hard information about borrowers as opposed to soft information can have negative repercussions for riskier and more opaque borrowers if foreign banks crowd out domestic banks. The absence of a sound contractual and infor­ mational framework reduces the feasibility of small business lending further and thus the positive effect of foreign bank entry (Claessens and van Horen, 2014). Finally, the small size of many financial markets in Sub-Saharan Africa may make foreign banks reluctant to incur the fixed costs of introducing new products and technologies. While there is limited quantitative evidence across the region, country-specific analysis points to an overall positive effect of private bank ownership and foreign bank entry. Beck, Cull, and Jerome (2005) show for Nigeria that the privatization of state-owned banks led to performance improvements, although those authors also found that main­ taining a substantial minority government ownership share was detrimental to privatized banks’ performance. In Uganda, Uganda Commercial Bank (UCB), the largest govern­ ment-owned bank—and also the largest bank in the system—was successfully privatized in the second attempt to the South African Standard Bank. Although an agreement not to close any branches was in place for two years following the sale of (p. 1107) UCB, Stan­ dard Bank kept all branches in place and even opened new ones. It introduced new prod­ ucts and even increased agricultural lending (Clarke, Cull, and Fuchs, 2009). In Tanzania, the National Bank of Commerce was privatized after splitting it into a commercial bank that assumed most of the original bank’s assets and liabilities, and the National Microfi­ nance Bank that assumed most of the branch network and the mandate to foster access to financial services. The new National Bank of Commerce’s profitability and portfolio quali­ ty improved, although credit growth was initially slow. Although finding a buyer for the National Microfinance Bank proved difficult, profitability eventually improved, and lend­ ing grew, while the share of non-performing loans remained low (Cull and Spreng, 2011). Ultimately, Rabobank took management control of NMB. On a global level, World Bank (2018) shows that post-crisis entry by foreign bank sub­ sidiaries was driven largely by banks headquartered in developing countries, and that they tended to enter neighboring countries, thus contributing to greater regionalism in international banking. The so-called South–South entry trend was especially pronounced in the African context. Understanding the channels through which cross-border banking can help deepen financial systems and foster real integration, and the channels through which cross-border banks can threaten financial stability, is critical. Claessens and van Horen (2014) confirm this conjecture on the aggregate level; any positive effect of crossborder banking on a host country’s financial development is lower the more distant the parent banks’ headquarters are. Beck (2015) shows that it is critical to distinguish be­ tween different groups of foreign banks. Specifically, he presents tentative evidence of a positive relationship between the share of foreign banks from the region, or other emerg­

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Banking in Africa ing markets, and firms’ access to finance, and of a negative relationship between the share of foreign banks from Europe or the US and entrepreneurial finance. While cross-border banking brings many benefits for host economies, regional financial integration also entails new potential sources of risks. New channels of contagion will de­ velop— indeed, they are already developing—as national banking systems and financial markets become increasingly interwoven, allowing for the transmission of shocks across borders. These new potential risks underscore the importance—both for banks and their supervisors—of having in place adequate provisions for risk management and mitigation. They also call for a greater commitment and adherence to common “rules-of-the-game,” as embodied in internationally accepted standards and practices, to foster greater confi­ dence in the financial sectors on the continent. Given the serious repercussions both for financial stability and financial deepening associated with bank fragility, particularly when it concerns larger pan-African banking groups, both the banks and the authorities have a mutual interest in upgrading bank oversight and cross-border supervisory cooper­ ation. In this context, the optimal design of cross-border cooperation between regulators and supervisors to minimize risks from cross-border banking, while maximizing its bene­ fits, is important (Beck et al., 2014; Beck and Wagner, 2016). There is a broader issue on regulatory reform beyond cross-border cooperation. African countries have made enormous upgrades to their regulatory and supervisory (p. 1108) frameworks over the past decades. It is important to keep in mind, however, that recent regulatory reform processes were driven and dominated by the global financial crisis and the fragility concerns of economies with developed, if not sophisticated, financial mar­ kets. Africa’s fragility concerns are different and its reform capacity lower. Some of the suggested or implemented reforms seem irrelevant for almost all African countries (such as centralizing over-the-counter trades) or might have substantially worse effects in the context of shallow financial markets than in sophisticated markets increasingly dominat­ ed by high frequency trading (such as securities trading taxes). Kasakende, Bagyenda, and Brownbridge (2012) esteem the proposed Basel III reforms as not sufficient in the African context, and call for additional regulatory tools, including the possibility of impos­ ing restrictions on banks’ asset exposures and regulations on loan concentration and for­ eign exchange exposure. More generally, in the context of regulatory reform, an approach of best fit would be more appropriate than a best practice approach that blindly adopts international standards. Prioritizing regulatory reforms according to risks and opportuni­ ty costs for financial deepening and inclusion is therefore critical.

34.5 Conclusion While Africa’s banking systems are shallow, they have made substantial progress over the past decade, a trend that can only be partially captured in aggregate data. Decades of regulatory upgrades have borne fruit in the form of more stable banking systems and sub­ stantially less fragility. Financial innovation has helped broaden the share of the popula­ tion with access to basic formal financial services, and technology has helped African fi­ Page 33 of 42

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Banking in Africa nancial systems leapfrog traditional delivery channels. While observers often focus on the mobile money revolution, there are many forms of financial innovation, including new products, new providers and new delivery channels. However, for innovative approaches to financial service delivery to be adopted, a competitive environment and a flexible regu­ latory approach are needed. While we have documented achievements in deepening and broadening financial systems, long-term finance remains a challenge. The dominance of banks and their focus on shortterm transactions has prevented the financial system from playing a stronger role in fund­ ing the infrastructure Africa needs so urgently, the housing needs that the ongoing urban­ ization and population growth require, and the long-term investment by firms. While cross-border banking has been a hallmark of African banking for many decades, the recent shift from North–South to South–South banking has created new opportunities but also new challenges. It has created new opportunities in terms of financial innovation and competition, but it has created new challenges in terms of the need for more cross-border regulatory and supervisory cooperation. This need for cross-border cooperation arises amid a more general discussion on regulatory standards in low-income countries. (p. 1109)

While many of the implemented and planned reforms follow either in the foot­

steps of other developing countries or have been identified by regulators and analysts as helpful, there is an important political economy aspect to financial sector reform. Politi­ cians primarily maximize private interests, whether the interests of their voters or special interest groups. Short-term election cycles undermine the focus on long-term financial development objectives; objectives that maintain the dominant position of elites under­ mine the incentives of these elites to undertake reforms that can open up financial sys­ tems and, thus, dilute the dominant position of the elites. Path dependence in political structures and the underlying socioeconomic distribution of resources and power make the adoption of growth-enhancing policies, such as financial sector policies, difficult or impossible if the policies threaten to reduce the relative dominance of the incumbent elites. On the other hand, the financial sector is critical for an open, competitive, and con­ testable economy because it provides the necessary resources for new entrants and can thus support economic transformation. Better understanding the political constraints in financial sector reforms and identifying windows of opportunity are therefore important. Focusing on the creation of broader groups with a stake in further financial deepening can help develop a dynamic process of financial sector reforms. As discussed in this chapter, research into banking in Africa has expanded rapidly over the past years, using increasingly micro-level data, including credit registry data, thus fol­ lowing a trend from other regions of the world. Close cooperation between researchers, central banks but also commercial banks and MFIs can help produce critical insights into which practices and policies work to deepen, broaden, and lengthen banking in Africa. There is an exciting and policy-relevant research agenda going forward.

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Banking in Africa

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Allen, F., Carletti, E., Qian, J., and Valenzuela, P. (2014b). Does Finance Accelerate or Re­ tard Growth? Theory and Evidence Towards a Better Global Economy: Policy Implications for Citizens Worldwide in the 21st Century (Oxford: Oxford University Press). Alliance for Financial Inclusion (2012). “Agent Banking in Latin America,” AFI Discussion Paper, March, Kuala Lumpur, Malaysia. Arcand, J.L., Berkes, E., and Panizza, U. (2015). “Too Much Finance?” Journal of Economic Growth, 20(2), 105–48. Aterido, R., Beck, T., and Iacovone, L. (2013). “Access to Finance in Sub-Saharan Africa: Is there a Gender Gap?” World Development, 47, 102–20. Badev, A., Beck, T., Vado, L., and Walley, S. (2013). “Housing Finance across Countries: New Data and Analysis,” The World Bank Policy Research Working Paper No. 6756.

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Buri, S., Cull, R., Giné, X., Harten, S., and Heitmann, S. (2018). “Banking with Agents: Ex­ perimental Evidence from Senegal,” World Bank Policy Research Working Paper No. 8417. Christy, J.H. (1998). “Bright Spots on the Dark Continent,” Forbes, October 5, available at: http://www.forbes.com/global/1998/1005/0113068a.html. Claessens, S. and Laeven, L. (2004). “What Drives Bank Competition? Some International Evidence,” Journal of Money, Credit, and Banking, 36(3, Part 2), 563–83. Claessens, S. and van Horen, N. (2014). “Foreign Banks: Trends and Impact,” Journal of Money, Credit and Banking, 46(9), 295–326. Clarke, G.R.G., Cull, R., and Fuchs, M. (2009). “Bank Privatization in Sub-Saharan Africa: The Case of Uganda Commercial Bank,” World Development, 37(9), 1506–21. Cull, R. and Spreng, C.P. (2011). “Pursuing Efficiency While Maintaining Outreach: Bank Privatization in Tanzania,” Journal of Development Economics, 94(2), 254–61. Cull, R. and Trandafir, M. (2010). “Credit Market Segmentation in Uganda,” World Bank, mimeo. Cull, R., Giné, X., Harten, S., Heitmann, S., and Rusu, A. (2018). “Agent Banking in a Highly Under-Developed Financial Sector: Evidence from the Democratic Republic of Congo,” World Development, 107, 54–74. Cull, R., Martínez Pería, M.S., and Verrier, J. (2018). “Bank Ownership and Economic De­ velopment,” in T. Beck and R. Levine (eds.), Handbook of Finance and Development (Amsterdam: Elsevier). De la Torre, A., Feyen, E.H.B., and Ize, A. (2013). “Financial Development: Structure and Dynamics,” World Bank Economic Review, 27(3), 514–41. Demirgüç-Kunt, A. and Klapper, L. (2012). “Measuring Financial Inclusion: The Global Fi­ nancial Inclusion Index,” World Bank Policy Research Working Paper No. 6025. Duflo, E., Kremer, M., and Robinson, J. (2011). “Nudging Farmers to Use Fertilizer: Theo­ ry and Experimental Evidence from Kenya,” American Economic Review, 101(6), 2350– 90. Dupas, P. and Robinson, J. (2013). “Savings Constraints and Microenterprise Develop­ ment: Evidence from a Field Experiment in Kenya,” American Economic Journal: Applied Economics, 5(1), 163–92. Dupas, P., Karlan, D., Robinson, J., and Ubfal, D. (2016). “Banking the Unbanked? Evi­ dence from Three Countries,” NBER Working Paper No. 22463. Page 37 of 42

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Banking in Africa Dupas, P., Keats, A., and Robinson, J. (2019). “The Effect of Savings Accounts on Interper­ sonal Financial Relationships: Evidence from a Field Experiment in Rural Kenya,” The Economic Journal, 129(617), 273–310. Flaming, M., McKay, C., and Pickens, M. (2011). “Agent Management Toolkit: Building a Viable Network of Branchless Banking Agents,” Consultative Group to Assist the Poor (CGAP) Technical Guide, CGAP, Washington, DC. Foster, V. and Briceño-Garmendia, C. (2010). Africa’s Infrastructure: A Time for Transfor­ mation (Washington, DC: World Bank). Giné, X. and Yang, D. (2009). “Insurance, Credit, and Technology Adoption: Field Experi­ mental Evidence from Malawi with D. Yang,” Journal of Development Economics, 89(1), 1– 11. Giné, X., Goldberg, J., Sankaranarayanan, S., Sheerin, P., and Yang, D. (2013). “Use of Bio­ metric Technology in Developing Countries,” in R. Cull, A. Demirgüç-Kunt, and J. Mor­ duch (eds.), Banking the World: Empirical Foundations of Financial Inclusion (Cambridge, MA: MIT Press), 429–46. Honohan, P. and Beck, T. (2007). Making Finance Work for Africa (Washington, DC: World Bank). (p. 1112)

Jack, W. and Suri, T. (2011). “The Economics of M-Pesa,” MIT Sloan Working Paper. Jack, W. and Suri, T. (2014). “Risk Sharing and Transactions Costs: Evidence from Kenya’s Mobile Money Revolution,” American Economic Review, 104(1), 183–223. Jack, W., Ray, A., and Suri, T. (2013). “Money Management by Households and Firms in Kenya,” American Economic Review: Papers and Proceedings, 103(3), 1–8. Karlan, D., Osei, R., Osei-Akoto, I., and Udry, C. (2014). “Agricultural Decisions after Re­ laxing Credit and Risk Constraints,” Quarterly Journal of Economics, 129(2), 597–652. Kasakende, L., Bagyenda, J., and Brownbridge, M. (2012). “Basel III and the Global Re­ form of Financial Regulation: How Should Africa Respond? A Bank Regulator’s Perspec­ tive,” Bank of Uganda mimeo, Kampala, Uganda. Laeven, L. and Valencia, F. (2013). “Systemic Banking Crises Database: An Update,” IMF Economic Review, 61(2), 225–70. Levine, R. (2005). “Finance and Growth: Theory and Evidence,” in P. Aghion and S.N. Durlauf (eds.), Handbook of Economic Growth (Amsterdam: Elsevier), 865–934. Love, I. (2003). “Financial Development and Financing Constraints: International Evi­ dence from the Structural Investment Model,” Review of Financial Studies, Society for Fi­ nancial Studies, 16(3, July), 765–91.

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Banking in Africa Lyman, T., Ivatury, G., and Staschen, S. (2006). “Use of Agents in Branchless for the Poor: Rewards, Risks, and Regulation,” Consultative Group to Assist the Poor (CGAP), Focus Note No. 38, CGAP, Washington, DC. Mark, O. (2012). “M-Pesa Drives Safaricom as Profit Declines to Sh12.8bn,” Business Dai­ ly May 10. Mbiti, I. and Weil, D. (2016). “Mobile Banking: The Impact of M-Pesa in Kenya,” in S. Ed­ wards, S. Johnson, and D. Weil (eds.), African Successes: Modernization and Develop­ ment, Vol. III (Cambridge, MA: NBER and Chicago, IL: University of Chicago Press). Roodman, D. (2012). “Latest Impact Research: Inching Toward Generalization,” CGAP Blog, April 11, available at: https://www.cgap.org/blog/latest-impact-research-inch­ ing-towards-generalization. Rotman, S., Ferrand, D., and Rasmussen, S. (2012). “The Jipange KuSave Experiment in Kenya,” CGAP Brief, October, Washington, DC. Siedek, H. (2008). “Extending Financial Services with Banking Agents,” Consultative Group to Assist the Poor (CGAP) Brief, CGAP, Washington, DC. Suri, T. and Jack, W. (2016). “The Long-Run Poverty and Gender Impacts of Mobile Mon­ ey,” Science, 354(6317), 1288–92. Tarozzi, A., Desai, J., and Johnson, K. (2015). “The Impacts of Microcredit: Evidence from Ethiopia,” American Economic Journal: Applied Economics, 7(1), 54–89. Van Rooyen, C., Stewart, R., and de Wet, T. (2012). “The Impact of Microfinance in SubSaharan Africa: A Systematic Review of the Evidence,” World Development, 40(11), 2249– 62. World Bank (2018). Global Financial Development Report 2017/2018: Bankers Without Borders (Washington, DC: World Bank).

Notes: (1) This chapter’s findings, interpretations, and conclusions are entirely those of the au­ thors and do not necessarily represent the views of the World Bank, its Executive Direc­ tors, or the countries they represent. (2) In the following we will use Sub-Saharan Africa and Africa interchangeably. However, the analysis in this chapter focuses almost exclusively on Sub-Saharan Africa thus exclud­ ing Northern Africa. While some of the characteristics of Sub-Saharan African financial systems extend to Northern Africa, there is a similar variation across countries in the northern part of the continent, ranging from a fairly developed system in Morocco to rather shallow financial markets in Tunisia and Egypt, to a state-dominated financial sys­

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Banking in Africa tem in Algeria. Beck et al. (2011) offer a discussion of both Sub-Saharan and Northern African financial systems. (3) See Beck, Demirgüç-Kunt, and Levine (2000, 2010); Demirgüç-Kunt and Klapper (2012); Laeven and Valencia (2013). (4) For example, the World Bank’s Enterprise Surveys now offer an expansive array of economic data on 131,000 firms in 139 countries. For the case of Africa, the Enterprise Surveys team has already released survey data for forty-three Sub-Saharan African coun­ tries. (5) The countries not included in the statistical comparison are: Botswana, Equatorial Guinea, Gabon, Mauritius, Namibia, Seychelles, and South Africa. (6) In our analyses, 2015 data are available for most countries in our sample. We employ 2014 data when 2015 data are not available. (7) The median is computed over a balanced sample of thirty-two African countries and twenty-eight non-African developing countries, for which data were available over all six­ teen years. (8) Unlike the previous comparisons, which are all for 2015, data for Enterprise Surveys were averaged over 2010 to 2015. Comparisons from the Global Findex Database are for 2017. (9) For a more detailed discussion, see Cull and Trandafir (2010) and Beck et al. (2011). (10) That said, for those with mobile phones, alternative scoring based on usage of digital platforms offers one potential route to better credit access. (11) This might be related to the Sharia prohibition of interest payment. The share that cite religious regions as an impediment to having a bank account is typically higher in countries with a significant Muslim population. (12) These numbers are based on data from the Doing Business database (http:// www.doingbusiness.org.) (13) For similar studies, see Bruhn and Love (2014) on the extension of Banco Azteca in Mexico; Burgess and Pande (2005) on an exogenous change in branching restrictions in India to identify the effects of increased branch penetration on poverty reduction; and Brown, Guinn, and Kirschenmann (2016) who document substantial gains in financial in­ clusion associated with the expansion of a major microfinance provider (ProCredit) in Al­ bania, Bulgaria, Macedonia, and Serbia. (14) Allen et al. (2018) provide detailed evidence of how Equity Bank’s business model is profitable both at the bank and branch level since it allowed the bank to pursue an ag­

Page 40 of 42

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Banking in Africa gressive loan pricing schedule, reduce delinquency rates, and secure inexpensive funding in the form of retail deposits. (15) Anecdotal evidence suggests that agent banking allows overcoming not only geo­ graphic but also socio-cultural barriers that might prevent low-income population seg­ ments from entering formal bank offices. (16) See Roodman (2012) and Bauchet et al. (2011) for summaries of evidence from earli­ er randomized evaluations of microfinance. In their review of early microfinance studies in Africa, Van Rooyen, Stewart, and De Wet (2012) find that microcredit and microsavings interventions have mixed effects on household income and accumulation of assets. In part, this could stem from the uneven quality of the studies they review. (17) Moreover, a rough cost–benefit analysis suggests that the benefits from improved re­ payment greatly outweighed the cost of equipment and fingerprint collection. (18) Because farmers’ behavior does not influence payments, rainfall insurance eliminates moral hazard problems and could therefore be a viable product for financial services providers. (19) One potential explanation for limited time savings is that balances stored in an M-Pe­ sa account accrued no interest (though that could change as M-Pesa teams up with bank­ ing partners to link M-Pesa accounts to mainstream bank accounts). (20) Suri and Jack (2016) provide analysis that M-Pesa increased per capita consumption levels and lifted an astounding 194,000 households, or 2 percent of Kenyan households, out of poverty. (21) In Niger, there is less than one bank per 100,000 residents. (22) This is illustrated by the following statement by a market practitioner, “an entire year’s worth of trading in the frontier African stock markets is done before lunch on the New York Stock Exchange” (quoted in Christy, 1998). It should be noted that some coun­ tries are served by regional stock exchanges. (23) For a general overview of the literature on the effects of foreign bank entry, see Cull, Martínez Pería, and Verrier (2018).

Thorsten Beck

Thorsten Beck is Professor of banking and finance at Cass Business School in Lon­ don. He is also a research fellow of the Centre for Economic Policy Research (CEPR) and the CESifo. He was Professor of Economics from 2008 to 2014 at Tilburg Univer­ sity and the founding chair of the European Banking Center from 2008 to 2013. Pre­ viously he worked in the research department of the World Bank and has also worked as consultant for, among others, the European Central Bank, the Bank of England, the BIS, the IMF, the European Commission, and the German Development Corpora­ Page 41 of 42

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Banking in Africa tion. His research, academic publications, and operational work have focused on two major questions: What is the relationship between finance and economic develop­ ment? What policies are needed to build a sound and effective financial system? Re­ cently, he has concentrated on access to financial services, including SME finance, as well as on the design of regulatory and bank resolution frameworks. He holds a Ph.D from the University of Virginia and an M.A. from the University of Tübingen in Ger­ many. Robert Cull

Robert Cull is acting research manager and Lead Economist in the Finance and Pri­ vate Sector Development Team of the World Bank’s Development Research Group. His most recent research is on the performance of microfinance institutions, African financial development, Chinese financial development and firm performance, and the effects of the global financial crisis on foreign banks in developing economies. He has published numerous articles in peer-reviewed academic journals including the Economic Journal, Journal of Development Economics, Journal of Economic Perspec­ tives, Journal of Financial Economics, Journal of Law and Economics, and the Journal of Money, Credit, and Banking. The author or editor of multiple books, his most re­ cent co-edited book, Banking the World: Empirical Foundations of Financial Inclusion was published by MIT Press in January, 2013. He is also co-editor of the Interest Bearing Notes, a bi-monthly newsletter reporting on financial and private sector re­ search. Patricio Valenzuela

Patricio Valenzuela is an Assistant Professor of Finance and Economics at University of Chile and a research fellow at the Millennium Institute for Research in Market Im­ perfections and Public Policy (MIPP). His primary areas of research are corporate fi­ nance, financial economics, international finance, and development economics. He has published in several peer-reviewed academic journals, including the Review of Finance, Journal of International Money and Finance, Journal of Banking and Fi­ nance and Economic Inquiry. He has also contributed chapters of several books on developing financial systems, including Handbook of the Economics of Finance, To­ wards a Better Global Economy: Policy Implications for Citizens in the 21st Century, and African Successes: Modernization and Development.

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Banking in China

Banking in China   Leora Klapper, María Soledad Martínez Pería, and Bilal Zia The Oxford Handbook of Banking (3rd edn) Edited by Allen N. Berger, Philip Molyneux, and John O. S. Wilson Print Publication Date: Oct 2019 Subject: Economics and Finance, Financial Economics Online Publication Date: Nov 2019 DOI: 10.1093/oxfordhb/9780198824633.013.35

Abstract and Keywords The Chinese financial sector has grown at an impressive pace over the last decade, and its banking sector is now the largest in the world. China has also experienced a credit boom, which makes the need to better understand how the Chinese financial sector func­ tions even more important. In this chapter, we first describe the structure and perfor­ mance of the financial sector in China, focusing largely on banks. Next, we discuss how regulators’ efforts to slow the growth of bank intermediation have been accompanied by rapid growth in shadow-banking products, as banks try to circumvent limits on their abili­ ty to grow. Finally, we document China’s progress in expanding consumer access to for­ mal financial services and track the recent expansion of FinTech, especially digital pay­ ment products. Keywords: China, financial development, financial inclusion, financial institutions, government policy and regula­ tion, household finance

35.1 Introduction OVER the last decade, China has been among the fastest growing economies in the world and is poised to become the largest. Between 2007 and 2017, China grew at an average annual real rate of 8.8 percent.1 With a GDP of 11.9 trillion dollars as of the end of 2017,2 China is the second largest economy in the world after the US and is expected to surpass the US economy by 2030.3 In tandem with the performance of the economy, the Chinese financial sector has also ex­ perienced rapid growth during the last decade. The assets of the Chinese financial sector grew from 61.7 trillion RMB and 227 percent of GDP in 2007 to 339.5 trillion RMB and 455 percent of GDP in 2016 (Figure 35.1). Currently, China has the second largest finan­ cial sector and the largest banking sector in the world (Figure 35.2).

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Banking in China

(p. 1115) Figure 35.1 Chinese Financial Sector As­ sets Over Time.

Figure 35.2 Financial Sector Size across Countries in US dollars as of 2016.

By many accounts China is experiencing a credit boom. Over the last decade, total credit to the private non-financial sector (as a percentage of GDP) has been growing at an annu­ al average rate of 9.3 percentage points, and has risen above its long-run trend (Figure 35.3). This so-called “credit gap” stood at close to 20 percent in 2017 and is well above the median level for advanced and emerging markets.4

Figure 35.3 Credit-to-GDP Gap for China and Other Countries.

The relevance of the Chinese economy and the size of its financial sector alone would merit an examination of how the financial sector operates. In addition, the fact that (p. 1114) China has been experiencing a credit boom, and that these episodes often pre­ cede crises (see Jordà, Schularick, and Taylor, 2011; Dell’Ariccia et al., 2012; Gourinchas and Obstfeld, 2012; Schularick and Taylor, 2012; Gorton and Ordonez, 2016), makes the need to better understand how the Chinese financial sector functions even more impor­ Page 2 of 23

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Banking in China tant. This chapter also examines the benefits and risks of the growing use of technology to deliver financial services. The chapter proceeds as follows: section 35.2 describes the structure and performance of the financial sector, focusing largely on banks. Section 35.3 discusses developments in the shadow-banking sector. Section 35.4 focuses on China’s progress in expanding financial inclusion and tracks the recent expansion of FinTech, es­ pecially digital payment products. Finally, section 35.5 concludes the chapter.

35.2 The Structure and Performance of the Chinese Financial Sector The Chinese financial sector is broadly characterized by two types of financial service providers. “Traditional” financial service providers, including state-owned commercial banks, (e.g., the Postal Savings Bank of China, joint-stock commercial banks and city com­ mercial banks, rural commercial banks, rural cooperative banks, and rural credit cooper­ atives) play a vital role in the Chinese financial sector. This network of traditional providers is supported by alternative or new providers such as village and township banks and microcredit companies, which were set up to improve the outreach of the fi­ nancial system among unserved customers in rural areas. More recently, FinTech compa­ nies, including non-bank digital payment providers, peer-to-peer lending platforms, inter­ net-based microlenders, internet banks, internet-based insurance, internet-based fund management, and internet equity-based crowdfunding have emerged and are competing with the traditional providers by adopting new innovative business models, delivery chan­ nels, and financial products, many of which have helped leverage the massive scale of on­ line e-commerce. Banks dominate the Chinese financial sector. They accounted for 66 percent of financial sector assets and 298 percent of GDP at year-end 2016 (Figure 35.4). Four of the five largest banks, typically known as the Big Five, are the largest publicly listed banks in the world in terms of assets, and rank in the top ten in terms of Tier 1 capital, market valua­ tion and profits.5 But the share of the Big Five in the system has declined by half, from 53 percent in 2005 to 26 percent in 2016, while that for other institutions such as the city bank and rural banks has grown from 6 percent to 14 percent between 2005 and 2016. China’s accession to the World Trade Organization (WTO) in 2001 brought pressure to re­ form the, until then largely government-owned and almost completely closed, (p. 1116) Chinese banking sector in 2001. China first allowed foreign banks to provide foreign cur­ rency services for Chinese residents and enterprises, and in 2004 China opened its local currency market and allowed foreign banks to provide local currency services to Chinese enterprises in selected cities and areas. By April 2007, four foreign banks (Citigroup, HSBC, Standard Chartered, and Bank of East Asia) received approval from Chinese regu­ lators and began accepting deposits in renminbi (RMB) from Chinese residents (Berger, Hasan, and Zhou, 2009). Chinese regulators have also, since then, relaxed the rules con­ cerning foreign acquisition of domestic banks. Nevertheless, the participation of foreign banks in the system has remained very flat at roughly 1 to 2 percent. In an effort to im­ Page 3 of 23

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Banking in China prove the management and governance of Chinese banks, regulators have also allowed banks to list on stock exchanges. For example, between 2005 and 2006, Bank of Commu­ nications, Bank of China, China Construction Bank, and the Industrial and Commercial Bank of China had successful initial public offerings in the Hong Kong and Shanghai stock markets, raising over $40 billion in total.

Figure 35.4 Evolution of Financial Institutions in As­ set Share. Source: IMF (2017b).

Several papers have investigated the consequences of banking sector reforms in China following WTO accession. Focusing on the period of 1994 to 2003, Berger, Hasan, and Zhou (2009) compare the efficiency levels of China’s state-owned banks, foreign banks, and private domestic banks to find that foreign minority ownership within the Chinese banking system is associated with a higher level of profit and cost efficiency and, more specifically, that foreign minority ownership of the state-owned and private domestic banks leads to an amelioration in their efficiency and performance. Yao and Jiang (2007) offer complementary findings in studying Chinese commercial banks between 1995 and 2005, noting that state-owned banks lag behind in terms of efficiency, (p. 1117) despite overall improvements in banking efficiency. Moreover, the authors find that foreign acqui­ sition is associated with long-term efficiency improvements but find no such evidence for banks that undergo an IPO. Building a regionally disaggregated measure of foreign bank presence and relying on three separate measures of performance (net-interest margins, non-interest income, and costs), Xu (2011) explores the relationship between the foreign bank presence in China and the performance of its domestic banks and suggests that an increase in foreign bank presence in China is conducive to a more efficient and strongerperforming banking system. Jiang, Yao, and Feng (2013) find that partial privatization of the Chinese financial system has improved the performance of its banks. Moreover, banks with minority foreign ownership display a higher degree of efficiency while state-owned commercial banks are the least efficient. Joint-stock commercial banks are associated with a higher level of cost efficiency while city commercial banks are the most profit effi­ cient.

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Banking in China Despite the recent reforms, Chinese commercial banks have lower levels of capital and profits than banks in most large developing countries and, in the case of capital, some ad­ vanced economies. Chinese banks have less capital than many other countries if we con­ sider both the total level of capital or tier 1 capital relative to risk-weighted assets. Simi­ larly, looking at return on assets, it is clear that Chinese banks are less profitable than those operating in most other large developing countries (Table 35.1).

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Banking in China Table 35.1 Bank Performance Across Countries, 2016 Country

Equity to Assets (%)

Tier 1 Capital (%)

Return on Assets (%)

NPL to Loans (%)

China

8.14

11.25

0.98

1.74

Brazil

9.27

13.7

1.11

3.92

India

7.16

10.7

0.37

9.19

Indonesia

14.41

22.22

2.12

2.9

Mexico

9.94

13.22

1.69

2.09

Russia

10.36

9.17

1.2

9.44

South Africa

8.2

14.51

1.71

2.86

Emerging Markets and Developing Economies (Medi­ an)

11.23

15.13

1.72

4.88

France

5.94

14.48

0.4

3.64

Germany

5.98

16.28

0.37

1.69

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Banking in China Italy

5.49

11.35

−0.53

17.12

Hong Kong SAR

9.78

16.37

1.14

0.85

United States

11.59

13.17

0.37

1.32

United Kingdom

7.03

16.88

0.25

0.94

Advanced Economies (Medi­ an)

7.35

16.28

0.79

3.21

Source: IMF Financial Soundness Indicators.

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Banking in China At the same time, Chinese banks have lower non-performing loans (NPLs) than most oth­ er countries (Table 35.1). There are a number of important reasons why NPLs in China are deceptively lower than in most other countries. First, loan classification requirements (p. 1118) allow banks to categorize loans that are overdue by more than 90 days as “spe­ cial mention” rather than “non-performing,” if they deem collateral to be of good quality. At the end of 2016, the share of special mention loans stood at 3.9 percent. Regulations also allow loans to small firms to be classified as non-performing only when they are more than 180 days past due. Second, some banks have moved credit assets into their invest­ ment book to circumvent credit quotas and restrictions, or to reduce capital charges and loss provisions. Third, many banks pre-emptively predisposed of loans6 that could become NPLs by means of write-offs, through sales to Asset Management Companies (AMCs) or by transferring assets off-balance sheet but retaining credit risk through financial engi­ neering and implicit guarantees. In particular, because banks provide loans to AMCs to fi­ nance their operations or to the securitization vehicles they sell their loans to, loan sales to these entities reduce bad loans on bank balance sheets, but the banking sector as a whole maintains an exposure to bad loans.

35.3 Shadow Banking: Causes and Conse­ quences of its Spectacular Growth 35.3.1 Drivers of Shadow Banking Another important characteristic of the Chinese financial sector during the last decade has been the significant growth of shadow banking (Figure 35.5). The People’s Bank of China (PBoC) Financial Stability Report (People’s Bank of China, 2013) defines shadow banking as “credit intermediation involving entities and activities outside the regular banking system, with the functions of liquidity and credit transformation, which could po­ tentially cause systemic risks or regulatory arbitrage.”7 In tracking the evolution of shad­ ow banking, the International Monetary Fund (IMF) considers the sum of entrusted loans, trust loans and bankers’ acceptances. Combined, these have increased from RMB 0.6 tril­ lion in 2002 to RMB 26.9 trillion in 2017. As a percentage of GDP, these have increased from 5 percent to 33 percent over the 2002–17 period. The rise of shadow-bank credit was made possible by the emergence of shadow savings instruments as wealth management products (WMPs). Between 2007 and 2017, the vol­ ume of WMPs grew from RMB 0.5 trillion (i.e., 2 percent of GDP) to RMB 29.5 trillion (i.e., 36 percent of GDP) (Figure 35.6). WMPs are deposit-like instruments (p. 1119) that are typically issued by banks and are not explicitly covered by the deposit insurance scheme. These became popular as a way for banks to circumvent the low deposit rate ceiling, which was only abolished in October 2015 (Lardy, 2008; Wang et al., 2016). More­ over, because they are issued by banks and are structured similarly to deposits many re­ tail investors perceive them as equally safe as deposits. This has enabled their growth and popularity. Page 8 of 23

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Banking in China

Figure 35.5 The Rise of Shadow Banking.

Figure 35.6 Wealth Management Products, 2007–17.

One of the primary motives for the rise of shadow banking has been governmental sup­ pression of interest rates below market levels, particularly through its enforcement of a deposit rate ceiling (Dang, Wang, and Yao, 2014). This policy grew out of the need to ster­ ilize the PBoC’s massive foreign currency market intervention, while also keeping (p. 1120) banks profitable (Lardy, 2008).8 Financial repression has also been a core feature of China’s reform-era growth, as household savings earning low interest rates were trans­ ferred through the banking system to supply subsidized credit to SOEs, capital-intensive industries, and real estate developers (Tsai, 2015). Given the limited opportunities in the bonds and stock markets, the main alternatives to traditional deposits for investors seek­ ing higher yields became the real estate market and wealth management products. In­ vestment in WMPs and trust funds are perceived as more attractive because they are more liquid and considered safer than real estate because banks are involved in structur­ ing and distributing these products, even though they are typically not contractually li­ able when the underlying borrowers do not repay (Borst, 2014; Dang, Wang, and Yao, 2014; Yan, 2016). Aside from controls on interest rates, the rise of shadow banking has been motivated by other regulatory constraints on bank operations. On the asset side, the PBoC imposed loan quotas that prevent banks from lending as much as they would otherwise (Elliott and Qiao, 2015). Banks are also subject to constraining macro-prudential regulations includ­ ing high deposit reserve requirements, a strict 75 percent limit on their loan-to-deposit Page 9 of 23

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Banking in China ratios, and costly capital requirements (Elliott et al., 2015). Furthermore, regulators dis­ courage lending in certain industries that the government feels the need to shrink, which currently includes local government financing vehicles, coal mining, shipbuilding, and re­ al estate development (Hsu and Li, 2015). Since 2005, China has relaxed its regulations banning banks from venturing into the op­ eration of securities houses, trust companies, money market funds, and insurers, instead allowing mixed-operations of banks to increase their competitiveness (Dang, Wang, and Yao, 2014). In response to these changes and because the regulatory constraints have be­ come sufficiently onerous in recent years, banks have chosen to create their own shadowbanking products and to cooperate with shadow financial institutions. In fact, about twothirds of shadow-bank lending in China results from such regulatory arbitrage (Elliott et al., 2015). Cooperation between banks and shadow financial entities makes perfect sense, as their competitive edge complements each other’s weakness. Banks utilize their vast sales network to help shadow banks raise funds and screen potential borrowers whereas shadow banks can help banks to extend credit creation beyond what is allowed by exist­ ing regulations (Dang, Wang, and Yao, 2014). Hachem and Song (2015) focus on stricter liquidity regulation and asymmetric competi­ tion among large and small banks as the main driver for the rise in shadow banking. Specifically, they argue that stricter enforcement of the 75 percent cap on bank loan-todeposit ratios in conjunction with large increases in reserve requirements—the PBoC tripled the requirement from 7 percent in 2004 to 21 percent in 2011—was the regulatory trigger. These changes impacted Chinese banks asymmetrically. Whereas small and medium-sized banks found themselves constrained from lending since they were un­ (p. 1121)

able to attract more deposits in the presence of the deposit rate ceilings, the Big Four banks were much less impacted because their extensive branches across the country pro­ vided them with a distinct advantage in the deposit market (Acharya, Qian, and Yang, 2016). Consequently, smaller banks began issuing WMPs to move activities off-balance sheet and avoid regulation, prompting the Big Four banks to begin issuing their own WMPs to protect market share, despite not needing to move them off-balance sheet (Hachem and Song, 2015). Acharya, Qian, and Yang (2016) posit that, in addition to stricter regulatory enforcement, the Chinese government’s $586 billion stimulus package in response to the global finan­ cial crisis was a primary cause of the deposit competition among banks.9 In essence, be­ cause the Big Four banks were the main source of funding for the stimulus plan, they ex­ perienced a rapid increase in their loan balances, causing them to become much more ag­ gressive in the deposit market to maintain their loan-to-deposit ratio (Acharya, Qian, and Yang, 2016). Regardless of why the Big Four began issuing their own WMPs, doing so forced the cap-constrained banks to become more aggressive and offer even higher re­ turns in order to attract enough WMPs to skirt loan-to-deposit rules. These developments also coincided with inflationary spells during the financial crisis, particularly between February 2007 and October 2008 and from February 2010 to October 2011 when the real one-year interest rate on deposits in Chinese banks was negative, which encouraged Page 10 of 23

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Banking in China savers to move deposits out of banks into higher-yielding investments to preserve the pur­ chasing power of their savings (Elliott and Yan, 2013). Hsu and Li (2015) offer an alternative explanation for the growth of shadow banking, which also focuses on the Chinese government’s fiscal and monetary policy responses to the global financial crisis. Although infrastructure projects comprised 72 percent of the stimulus package, the central government financed only 30 percent of the package, whereas the rest of the investment spending was implemented and financed through local governments (Chen, He, and Liu, 2017). Furthermore, because local governments could not borrow funds themselves, the central government encouraged local governments to use local government financing vehicles (LGFVs) for off-balance financing, mainly from banks (Chen, He, and Liu, 2017). However, some LGFVs struggled with issues such as overstated equity capital, high leverage, and poor financial management, as well as ex­ tremely low rates of return (Tsai, 2015). Furthermore, by late 2010, the economy showed signs of overheating, with inflation rising above 5 percent. Consequently, the PBoC switched from an expansionary to a tightening monetary policy, cutting back the stimulus and ordering banks to reduce their lending (Wang et al., 2016). This, somewhat unexpect­ ed, credit tightening created a problem for banks, since they had lent significantly to long-term and credit-intensive infrastructure projects that risked both (p. 1122) project failure and a substantial rise in bank NPLs absent continued credit infusion (Dang, Wang, and Yao, 2014). To resolve these financing problems and protect their balance sheets, banks further expanded their off-balance-sheet operations and became increasingly re­ liant on shadow banking for credit intermediation (Wang et al., 2016; Chen, He, and Liu, 2017).

35.3.2 Who Participates in Shadow Banking? In terms of borrowers, shadow banking has expanded from private entrepreneurs lacking access to traditional banks’ loans, and willing to pay higher rates for credit, to local gov­ ernments facing unfunded mandates and incentives to demonstrate continued economic growth (Tsai, 2015). In terms of creditors, households, middle-class professionals and cor­ porate savers seeking higher yields provided funds by buying WMPs sold and managed by banks, and financial products originated by trusts or brokers but sold through banks (Ehlers, Kong, and Zhu, 2018). The entities that provide credit intermediation in China’s shadow-banking system can be classified into three broad categories. The first and largest class involves banks as the di­ rect intermediaries, where WMPs sold by banks or their subsidiaries are the main compo­ nent. Despite their direct involvement, these activities are recorded off banks’ balance sheets and, hence, are not subject to official oversight (Dang, Wang, and Yao, 2014). The second class consists of non-bank financial institutions like trusts, brokers, insurance companies, and security firms. Although some of these entities can raise funds directly from investors, most need to cooperate with banks. Funding costs for these institutions are typically higher than WMPs structured by banks, forcing them to make riskier loans such as to property developers, mining companies and local government financing vehi­ Page 11 of 23

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Banking in China cles (Dang, Wang, and Yao, 2014). The last and most opaque segment of the shadow-bank­ ing system comprises interpersonal lending through credit associations, rural cooperative foundations, and pawnshops. Peer-to-peer business lending, including through online platforms, is also becoming increasingly common, whereby companies lend to other com­ panies, sometimes arranged through banks (Tsai, 2015). Approximately two-thirds of the flow of business into shadow banking is “bank-centric” wherein a bank is at the core of the transaction, taking most of the risks and benefits, yet paying non-banks to participate in order to avoid regulatory constraints and costs. Banks dominate the shadow-banking system both because they have a pre-eminent position in terms of accessing individual and institutional savings, and because bank deposits re­ ceive implicit credit and liquidity guarantees from the state. Since the scope of the guar­ antee is vague, there is a deep-rooted perception that the government will bail out the en­ tire bank in case of financial distress (Wang et al., 2016). The other third or so of the busi­ ness results from a combination of competitive advantages for the non-banks, many due to looser regulation as well as a willingness and ability to reach out to smaller, private sector businesses (Elliott and Qiao, 2015).

35.3.3 What are the Risks Involved? Is Shadow Banking Good or Bad? (p. 1123)

Shadow banks can help spur economic growth by making financial services cheaper and more widely available. Shadow-banking activities enabled long-term projects to obtain fresh funds to avoid default and have been especially important in China as a source of funding to the private sector, particularly small to medium-sized enterprises (SMEs) tradi­ tionally underserved by the formal banking sector (Tsai, 2017). Shadow banking also helps to correct the capital mispricing and misallocation problems caused by interest rate repression and bank credit restriction in China, resulting in more efficient channeling of financial resources and providing a testing ground for interest rate liberalization (Dang, Wang, and Yao, 2014; Wang et al., 2016). Furthermore, the injection of additional credit protects the broader economy from the dangers of a collapse in the supply of credit, while more diversified financial products and services may make the financial system more ro­ bust in the face of negative shocks (Schwarcz, 2016). Shadow banking can also provide banks and investors with a range of tools for liquidity, maturity, and credit risk manage­ ment (Shen, 2016). However, realizing the benefits of shadow banking entails a tradeoff in terms of reduced financial stability. First, maturity mismatch, unspecified investment, and poor cash-flow management result in high levels of liquidity risk for shadow banking (Gang, 2012). The use of short-term funding sources, such as WMPs and trust loans, to finance illiquid longterm projects such as real estate development, infrastructure projects, and the manufac­ turing sector has made their operations particularly risky (Elliott, Kroeber, and Qiao, 2015). Furthermore, recognition of potential liquidity problems has made the practice of ever-greening more common (Yan, 2016). This may only serve to exacerbate the problem when investors lose confidence and reduce their buying or withdraw from WMPs. These Page 12 of 23

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Banking in China dangers are compounded by the fact that shadow banks do not have access to central bank liquidity, are less regulated, and operate with smaller safety margins such as much lower capital and liquidity requirements (Elliott and Qiao, 2015). Second, since shadow banks operate outside the regular banking system, they have more flexibility to make profits through securitization. For example, WMPs are used to facili­ tate the securitization of bank loan assets, taking them off banks’ balance sheets and freeing up funds to make loans. Furthermore, trust companies use funds from WMPs to purchase repackaged bank loans as well as extend credit on banks’ behalf to third parties (Borst, 2014). The resulting build-up of high levels of leverage and the complex financial techniques employed by the shadow banks expose them to greater operational risks (Luo, 2016). Third, shadow banks often lend to riskier customers or in riskier forms such as foregoing collateral protection (Luo, 2016). For example, shadow banks make loans to industries that, after years of aggressive expansion, have overcapacity, raising the risk that indebted companies may fall into default or hit severe cash-flow problems (Yan, 2016). Another risk lies in possible defaults by local governments that have turned to LGFVs to (p. 1124) raise funds. Although LGFVs are supposed to repay debts from profits accruing from land transfers and post-development business operations, a recent survey by China’s National Audit Office revealed that less than half of the funds for debt repayment come from project profits, suggesting LGFVs are money-losing ventures (Lu et al., 2015). Therefore, China’s local governments are facing a high risk of solvency when the local government debts begin to mature, or in the event of an economic slowdown and/or declining land prices (Elliott, Kroeber, and Qiao, 2015). Shadow banking also provides a large part of the credit that is extended to export-related SMEs (Lu et al., 2015), which might not be able to repay their loans in the face of rising costs, more intensive global competition, or tar­ iffs. Last, there is a rising risk of moral hazard in the banking system. Promised returns from shadow banking are usually based on unrealistic future returns and expected high asset prices. Investors continue to fund shadow-banking activities largely because there is a widespread belief that either the bank at the beginning of the chain of transactions will rescue them in the event of a crisis or, failing that, the government will guarantee them against losing their investment (Borst, 2014). The strength of this implicit guarantee is re­ inforced by the fact that banks and trust companies effectively assure customers that their investments would be guaranteed in order to raise funds at low cost (Wang et al., 2016). Although banks may be reluctant to completely shed responsibility due to reputa­ tional risks and social stability concerns, the danger of implicit guarantees is that they may not be honored, either because of incapacity during a crisis or because the two sides to the transaction had different expectations of the implicit guarantee. Following the fail­ ure of one implicit guarantee, there is considerable risk of contagion as other lenders be­ come uncertain about the safety of their investments and withdraw their funds.

Page 13 of 23

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Banking in China Lacking adequate regulation and oversight, these risks may accumulate unnoticed and unchecked, raising the systemic risk posed to China’s financial sector. In a crisis, the opacity of the shadow-banking system can lead to panic as perceptions of the real strength of a bank or other financial institution can plunge sharply as investors and de­ positors realize that they do not really know what the balance-sheet categories represent (Elliott and Qiao, 2015). Furthermore, since shadow banking falls outside the public safe­ ty nets of deposit guarantees and lender of last resort facilities that protect banks, the public mechanisms to halt such panic are ad hoc in nature and therefore have less credi­ bility and a higher risk of failure, allowing instability at shadow-banking institutions to spread and accelerate faster than with banks (Lu et al., 2015). The potential for contagion into the traditional banking system is further compounded due to the complex intercon­ nections between the banking system and shadow banks (Shen, 2016). This interconnectedness with formal banks, combined with its high leverage that increas­ es the availability of credit, also means that shadow banks are likely to amplify pro-cycli­ cality, heightening the risks of causing asset price bubbles (Shen, 2016). Although credit expansion provided by shadow banks was needed after the global financial crisis, it also left the economic system heavily in debt. Such rising indebtedness, coupled with poten­ tial slower growth, may make businesses more susceptible to financial distress and fail­ ure, and also increase the level of NPLs for the banking sector. At this time, even if a potential crisis were to emerge, the financial system and the central government appear well positioned to handle it. First, liquidity remains abun­ (p. 1125)

dant due to high levels of deposits from households and businesses. In the event of a cri­ sis, banks’ non-performing assets would increase, but their funding would not be imper­ iled (Elliott, Kroeber, and Qiao, 2015). Furthermore, since most shadow-bank products were purchased by wealthy individuals or cash-rich businesses, mass failure of shadowbanking products might result in losses but would not require a fire sale of other assets to meet their debt obligations. Such a crisis of confidence in shadow-banking products would also lead to individual investors flying to the safety of state-guaranteed bank de­ posits, further improving the liquidity position of the banks. Second, given relatively low central government debt to GDP ratios, even when adjusted for off-balance-sheet obliga­ tions such as the need to rescue some local and regional governments, the central gov­ ernment has the fiscal capacity to write off bad loans and recapitalize the banks (Elliott and Qiao, 2015). Third, tight capital control in China and the restrictions on foreign port­ folio investments help to reduce the risk of capital flight. China’s external debt is only 7.5 percent of GNI and it has amassed $3.4 trillion in foreign exchange reserves. All this en­ sures that most of the debt is internal and hence can be met with sovereign credit cre­ ation (Elliott, Kroeber, and Qiao, 2015).

35.3.4 What is the Future of Shadow Banking in China? The shadow-banking sector in China has seen impressive growth since the financial cri­ sis, however recent regulatory changes are expected to slow down if not reverse this trend. Page 14 of 23

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Banking in China The stricter regulation has targeted the sale of WMPs as well as other segments of shad­ ow banking such as peer-to-peer lending. Specifically, WMP customers are now required to acknowledge the risks involved on video before banks can accept their deposits. Simi­ larly, the government has imposed caps on peer-to-peer lending and now asks lenders to partner with custodian banks before making loans. Combined with new asset manage­ ment regulations issued in the second quarter of 2018, these requirements have resulted in an abrupt halt to the previously booming shadow-banking sector.10 The banking sector initially responded to the new rules by offering alternative deposit ve­ hicles, such as structured deposits, but the government could extend its regulation fur­ ther to meet its de-leveraging targets. The government initially imposed a fast-tracked deadline of mid-2019 for the asset management curbs to be adopted by banks but have since extended it until the end of 2020. Only time will tell what the true impact of the new regulations will be.

(p. 1126)

35.4 Financial Inclusion in China

China has succeeded in providing a wide range of financial services to individuals, includ­ ing poor adults, women, and rural residents. With support from regulatory bodies, the country has seen large-scale, policy-driven initiatives, including improvements in finan­ cial infrastructure, expansion of rural branch network and access points, digitalization of large-scale recurrent payments, a surge in new innovative business models with the ad­ vent of FinTech companies and other alternative financial providers, and the promotion of greater usage of accounts. Today, China’s rate of account ownership—a basic metric of fi­ nancial inclusion—is not far behind many high-income economies like Japan, Singapore, and the Republic of Korea. In this section, we provide a quantitative analysis of China’s progress in expanding finan­ cial inclusion.11 The primary focus of the analysis is on understanding both ownership of financial accounts and their usage for savings, credit, and digital payments. We also dis­ cuss the importance of digital technology in widening access to financial services.

35.4.1 Access to and Use of Financial Services China has achieved considerable success in expanding account ownership over the years.12 In 2017, 80 percent of adults in China had an account at a bank or other financial institution, up from 64 percent in 2011 and unchanged from 2014. But the benefits of having an account come from using the account for savings, develop­ ing a credit history and borrowing, and making safer, more transparent, and often less ex­ pensive digital payments. About 15 percent of account owners in China have inactive ac­ counts, defined as accounts with no deposit or withdrawal within the past year. This is in comparison to almost half of account owners in India with inactive accounts. Women ac­

Page 15 of 23

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Banking in China count owners are as likely as men account owners to hold an inactive account in China, and inactive accounts are more prevalent in rural areas. So how are adults in China using their accounts? Formal savings rates are high, with over 40 percent of account owners reported having saved formally in the past year, while the share was about 20 percent in Brazil, India, and the Russian Federation. Formal borrowing is also high: 45 percent of adults report borrowing in some way in 2017, and about a half of borrowers (or 25 percent of adults) report borrowing for­ mally, either from a bank or using a credit card. The remaining share borrows primarily from family and friends. (p. 1127)

There has been a surge in the percentage of adults using their account for digital pay­ ments.13 For instance, nearly 85 percent of Chinese adults made or received digital pay­ ments in 2017, up from 56 percent in 2014. In addition, 35 percent of Chinese adults re­ ceived private wages in 2017, and between 60 and 70 percent of private sector wage earners reported receiving their wage payments into an account. In fact, nearly 20 per­ cent of Chinese adults received private wages digitally in 2017 which is higher than the average share of adults receiving private wages digitally in India, Indonesia, or Thailand. China has also experienced a surge in online payments and the use of mobile phones or the internet to make purchases or pay bills. Mobile phones and the internet increasingly offer an alternative to debit and credit cards for making direct payments from an ac­ count. According to the Global Findex, 40 percent of adults make mobile payments pri­ marily through third-party payment service providers such as Alipay and WeChat, using smartphone apps linked to an account at a bank or another type of financial institution. Despite these improvements in digitizing payments in the private sector, public sector payments are still mostly paid in cash. Only 13 percent of adults in China receive govern­ ment payments digitally, significantly lower than the high-income country average of 34 percent. This despite evidence that electronic government payments are cheaper and faster and reduce leakages and corruption. Likewise, agriculture is a prominent industry in China, but only 3 percent of Chinese adults receive agricultural payments into an account. This is not surprising since millions of rural adults in China continue to remain outside the formal financial system. However, because a farmer might need to stretch payments between harvest and finance input costs, a formal financial relationship is especially important and can be established through electronic payments to a farmer’s bank account.

35.4.2 Understanding the Unbanked Despite China’s noteworthy progress toward universal financial access and greater us­ age, with 225 million adults without an account, China still has one of the largest un­ banked populations in the world, followed by India, Pakistan, and Indonesia. Moreover, there are great disparities among adults in China. For example, women are 8 percentage Page 16 of 23

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Banking in China points less (p. 1128) likely than men to have an account. In addition, adults living in the poorest 40 percent of households are 20 percentage points less likely to have an account in comparison to adults living in the wealthiest 60 percent of households. The Findex data also finds that older adults are 8 percentage points less likely than younger ones to have an account. To help shed light on the reasons for the large percentage of unbanked in China, we ana­ lyze the question that was asked as part of the 2017 Global Findex survey of adults with­ out an account at a financial institution, asking why they do not have an account. Respon­ dents could offer more than one reason, and most gave two. The most commonly cited barrier was lack of enough money. Sixty percent of Chinese adults without an account at a financial institution said that they have too little money to use one, and roughly 1 in 4 adults cited this as their sole reason (Figure 35.7). More than 30 percent of unbanked Chinese adults said that they do not have an account because a family member already has one. Women were significantly more likely than men to cite this reason. A lack of the proper documentation required to open an account is another important reason, with 20 percent of unbanked adults reporting this as a barrier. The cost of opening and maintain­ ing an account is reported by 13 percent of the unbanked.

Figure 35.7 Barriers to Account Ownership (% of Adults with No Account). Source: Global Findex Database 2017. Note: The height of the bar is the percentage of adults reporting “any” barrier.

35.4.3 Opportunities for Increasing Financial Inclusion Expanding usage of digital technology in China provides various opportunities to further improve financial inclusion. China’s large unbanked numbers present significant opportu­ nities to introduce new financial services. About 185 million unbanked adults in the coun­ try have a mobile phone, out of which nearly 105 million are women. High mobile owner­ ship among the unbanked can be leveraged to provide them with convenient access to fi­ nancial services and further accelerate the country’s progress toward universal financial access.

Page 17 of 23

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Banking in China Millions of unbanked adults in China still receive regular payments in cash—for wages, from the government, and for the sale of agricultural products. Digitizing such payments is a proven way to increase account ownership. About 30 million unbanked adults in China receive cash payments for the sale of agricultural goods, including 25 mil­ lion who have a mobile phone. If those payments were moved into accounts, the share of unbanked adults could drop by up to 12 percent. (p. 1129)

Just as there are opportunities to increase account ownership, so are there opportunities to help people who already have an account make better use of it. For example, 165 mil­ lion banked adults continue to save “semi-formally” in China, generally making regular payments to a community savings group or other savings scheme, including 75 million banked women. Digital technology could also offer an alternative to cash for utility pay­ ments. In China, about 60 percent of account owners who pay utility bills in cash have ac­ cess to both a mobile phone and the internet.

35.5 Conclusions The Chinese financial sector has grown at an impressive pace over the last decade and its banking sector is now the largest in the world. The fast growth in credit has not translat­ ed yet into high NPLs, but there are questions about the adequacy of loan classification in China and close monitoring is required. Regulators’ efforts to slow down the growth of bank intermediation have been accompa­ nied by rapid growth in shadow-banking products, as banks try to circumvent limits on their ability to grow. Both the growth in bank credit and the fact that shadow-banking products might move to banks’ balance sheets in the future is an important source of con­ cern for anyone looking at the Chinese financial sector. In this sense, recent efforts by regulators to curtail shadow banking are a welcome development. China has made important advances in terms of expanding financial inclusion with ac­ count ownership, which is now close to the levels observed in high-income countries. Not only is account ownership high, but, importantly, so is account usage. China has also been at the forefront of digital payments promoted by the private sector. Yet, more needs to be done since there are still important disparities in financial inclusion between men and women, urban and rural citizens, and those at the top of income distribution and those at the bottom. Widespread access to mobile phones and the internet in China offer opportu­ nities to leverage technology to more affordably and conveniently expand inclusive access to financial services, such as digitizing government and utility payments.

Acknowledgments We are very grateful to Lukas Autenried, Antoine Malfroy-Camine, Deeksha Kokas, and Jeanne Verrier for excellent research assistance. We appreciate help with finding and in­ terpreting data on China from Ding Ding at the IMF. The views expressed in this chapter Page 18 of 23

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Banking in China are those of the authors and not those of the IMF or the World Bank, or these institutions’ executive directors and management.

References Acharya, V., Qian, J., and Yang, Z. (2016). “In the Shadow of Banks: Wealth Management Products and Issuing Banks’ Risk in China,” New York University, mimeo, available at: http://pages.stern.nyu.edu/~sternfin/vacharya/public_html/pdfs/ShadowBank-Chi­ na-AQY20161111_all.pdf. Berger, A., Hasan, I., and Zhou, M. (2009). “Bank Ownership and Efficiency in China: What Will Happen in the World’s Largest Nation,” Journal of Banking and Finance, 33(1), 113–30. Borst, N. (2014). “Flying Blind,” International Economy, 28(1), 12–71. Chen, Z., He, Z., and Liu, C. (2017). “The Financing of Local Government in China: Stimu­ lus Loan Wanes and Shadow Banking Waxes,” NBER Working Paper No. 23598. Cong, L.W., Gao, H., Ponticelli, J., and Yang, X. (2018). “Credit Allocation Under Economic Stimulus: Evidence from China,” The Review of Financial Studies, Chicago Booth Re­ search Paper No. 17–19, available at: https://doi.org/10.1093/rfs/hhz008. Dang, T.V., Wang, H., and Yao, A. (2014). “Chinese Shadow Banking: Bank-Centric Misper­ ceptions,” Hong Kong Institute for Monetary Research No. 22. Dell’Ariccia, G., Igan, D., Laeven, L., Tong, H., Bakker, B., and Vandenbussche, J. (2012). “Policies for Macrofinancial Stability: How to Deal with Credit Booms,” IMF Staff Discus­ sion Note No. 12/06. Demirgüç-Kunt, A., Klapper, L., Singer, D., Ansar, S., and Hess, J. (2018). “Global Findex Database 2017: Measuring Financial Inclusion and the FinTech Revolution,” Washington, DC, World Bank. Drehmann, M., Pradhan, S., Wooldridge, P., and Szermere, R. (2016). “Recent Enhance­ ment to the BIS Statistics,” BIS Quarterly Review, September. Ehlers, T., Kong, S., and Zhu, F. (2018). “Mapping Shadow Banking in China: Structure and Dynamics,” BIS Working Paper No. 701. Elliott, D. and Qiao, Y. (2015). “Reforming Shadow Banking in China,” Economic Studies, The Brookings Institution. Elliott, D. and Yan, K. (2013). “The Chinese Financial System: An Introduction and Overview,” John L. Thornton China Center at the Brookings Institution Monograph Series No. 6.

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Banking in China Elliott, D., Kroeber, A., and Qiao, Y. (2015). “Shadow Banking in China: A Primer,” Eco­ nomic Studies, The Brookings Institution. Financial Stability Board (2018). “Global Shadow Banking Monitoring Report 2017,” March. Gang, X. (2012). “Regulating Shadow Banking,” China Daily, available at: http:// www.chinadaily.com.cn/opinion/2012-10/12/content_15812305.htm. Gorton, G. and Ordoñez, G. (2016). “Good Booms, Bad Booms,” National Bureau of Eco­ nomic Research Working Paper No. 22008. Gourinchas, P.O. and Obstfeld, M. (2012). “Stories of the Twentieth Century for the Twen­ ty-First,” American Economic Journal: Macroeconomics, 4(1), 226–65. Hachem, K.C. and Song, Z.M. (2015). Liquidity Regulation and Unintended Financial Transformation in China (Cambridge, MA: National Bureau of Economic Research). Hsu, S. and Li, J. (2015). “The Rise and Fall of Shadow Banking in China,” Political Econo­ my Research Institute Working Paper No. 375. IMF (2017a). World Economic Outlook Database, October. IMF (2017b). “People’s Republic of China: Financial System Stability Assessment,” IMF Country Report No. 17/358. Jiang, C., Yao, S., and Feng, G. (2013). “Bank Ownership, Privatization and Per­ formance: Evidence from a Transition Country,” Journal of Banking and Finance, 37(9), (p. 1131)

3364–72. Jordà, Ò., Schularick, M., and Taylor, A. (2011). “Financial Crises, Credit Booms, and Ex­ ternal Imbalances: 140 Years of Lessons,” IMF Economic Review, 59(2), 340–78. Lardy, N.R. (2008). “Financial Repression in China,” Peterson Institute Policy Brief No. PB08-8. Lu, Y., Guo, H., Kao, E.H., and Fung, H. (2015). “Shadow Banking and Firm Financing in China,” International Review of Economics and Finance, 36, 40–53. Luo, D. (2016). The Development of the Chinese Financial System and Reform of Chinese Commercial Banks. London: Palgrave Macmillan. People’s Bank of China (2013). “Financial Stability Report,” People’s Bank of China, Bei­ jing. Schularick, M. and Taylor, A.M. (2012). “Credit Booms Gone Bust: Monetary Policy, Lever­ age Cycles, and Financial Crises, 1870–2008,” American Economic Review, 102(2), 1029– 61.

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Banking in China Schwarcz, S.L. (2016). “Shadow Banking and Regulation in China and Other Developing Countries,” available at: https://scholarship.law.duke.edu/faculty_scholarship/3694/. Shen, W. (2016). Shadow Banking in China: Risk, Regulation and Policy (Cheltenham: Ed­ ward Elgar Publishing). Tsai, K.S. (2015). “The Political Economy of State Capitalism and Shadow Banking in Chi­ na,” Issues and Studies, 51(1), 55–97. Tsai, K.S. (2017). “When Shadow Banking Can Be Productive: Financing Small and Medi­ um Enterprises in China,” Journal of Development Studies, 53(12), 2005–28. Wang, H., Wang, H., Wang, L., and Zhou, H. (2016). “Shadow Banking: China’s DualTrack Interest Rate Liberalization,” mimeo. Yan, L. (2016). “Shadow Banking in China: Implications for Financial Stability and Macro­ economics Rebalancing,” The Chinese Economy, 49(3), 148–60. Yao, S. and Jiang, C. (2007). “The Effects of Governance Changes on Bank Efficiency in China: A Stochastic Distance Function Approach,” University of Nottingham Research Pa­ per 2007/19. Xu, Y. (2011). “Towards a More Accurate Measure of Foreign Bank Entry and its Impact on Domestic Banking Performance: The Case of China,” Journal of Banking and Finance, 35(4), 886–901.

Notes: (1) IMF (2017a). (2) IMF (2017a) estimate. (3) The Center for Economic and Business Research predicts (in December 2017) that this will happen in 2030; see https://www.bloomberg.com/news/articles/2019-01-08/world-sbiggest-economies-seen-dominated-by-asian-ems-by-2030. (4) Credit-to-GDP gaps are computed by the Bank for International Settlements as an indi­ cator of excessive credit build-up. The long-term trend is calculated using a one-sided HP filter with a smoothing parameter of 400,000 and at least ten years of data for each coun­ try. The methodology is discussed in detail in Drehmann et al. (2016). (5) Forbes 2017 rankings and The Banker 2017 rankings. (6) Banks are incentivized by their management to keep NPLs low by having NPL targets they have to meet. (7) In 2018 the Financial Stability Board produced a shadow-banking monitoring report which defined shadow banking as “credit intermediation involving entities and activities (fully or partially) outside the regular banking system” (Financial Stability Board, 2018). Page 21 of 23

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Banking in China (8) To sterilize the inflationary impact of its massive sales of domestic currency, the PBoC continually raised the required reserve ratio of banks and sold them large quantities of central bank bills. To compensate banks for putting so much cash into these low-yielding accounts, the PBoC established regulatory limits on deposit and lending rates, ensuring healthy profit margins. (9) Related to the impact of the fiscal stimulus, Cong et al. (2018) document that the stim­ ulus-driven credit expansion disproportionately favored state-owned firms and lower pro­ ductivity firms. (10) https://www.economist.com/finance-and-economics/2018/06/14/chinas-tighter-regula­ tion-of-shadow-banks-begins-to-bite. (11) We use data from Global Findex, which provides in-depth data on how individuals save, borrow, make payments, and manage risks. See Demirgüç-Kunt et al. (2018) for a description of the data and recent trends. The data is based on interviews with about 150,000 adults in 145 countries. The complete database is available at https:// globalfindex.worldbank.org. (12) The 2017 Global Findex database defines account ownership as having an individual or jointly owned account either at a financial institution or through a mobile money provider. The first category includes accounts at a bank or another type of formal, regu­ lated financial institution, such as a credit union, a cooperative, or a microfinance institu­ tion. The second consists of mobile phone-based services, not linked to a financial institu­ tion, that are used to pay bills or to send or receive money. These mobile money accounts allow people to store money and to send and receive electronic payments. (13) Digital payments include sending or receiving domestic remittances from or to an ac­ count; using a debit or credit card to make a payment; making a payment over a mobile phone or using the internet; paying a utility or school fee from an account; or receiving a wage, government transfer or agricultural sale payment directly into an account.

Leora Klapper

Leora Klapper is a Lead Economist in the Finance and Private Sector Research Team of the Development Research Group at the World Bank. Her publications focus on corporate and household finance, banking, entrepreneurship, and risk management. Her current research studies the impact of digital financial services, especially for women. She is a founder of the Global Findex database, which measures how adults around the world save, borrow, make payments, and manage risk. Previously, she worked at the Board of Governors of the Federal Reserve System and Salomon Smith Barney. She holds a Ph.D in Financial Economics from New York University Stern School of Business. María Soledad Martínez Pería

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Banking in China María Soledad Martínez Pería is Chief of the Macro-Financial Division in the IMF Re­ search Department. She manages a team of economists responsible for conducting research and policy work on macroeconomic and financial issues critical to fund sur­ veillance activities, with a focus on macro-financial linkages, financial flows, and fi­ nancial systems. Her published research addresses questions related to financial crises, market discipline, foreign bank participation, bank competition, bank regula­ tion, SME financing, financial inclusion, and remittances. Prior to joining the IMF, she worked at the World Bank, the Brookings Institution, the Central Bank of Ar­ gentina, and the Federal Reserve Board. She holds a Ph.D in economics from the Uni­ versity of California, Berkeley and a B.A. from Stanford University. Bilal Zia

Bilal Zia is a Senior Economist in the Finance and Private Sector Development Team of the Development Research Group at the World Bank in Washington, DC. His re­ search focuses on financial development at the household, firm, and bank levels, and has appeared in top academic journals such as the Journal of Finance, Journal of Fi­ nancial Economics, American Economic Journal: Applied Economics, Management Science, and Journal of Development Economics. He uses both experimental and nonexperimental methods and some of his recent work includes rigorous impact evalua­ tions of financial and business education programs, testing innovative methods to im­ prove financial access for households and firms, alternative credit scoring and digital financial engagement, and applying insights from behavioral economics to develop­ ment finance.

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Banking in the Transition Countries of Central, Southern, and Eastern Eu­ rope and the Former Soviet Union

Banking in the Transition Countries of Central, South­ ern, and Eastern Europe and the Former Soviet Union   Zuzana Fungáčová, Iftekhar Hasan, Laura Solanko, and Paul Wachtel The Oxford Handbook of Banking (3rd edn) Edited by Allen N. Berger, Philip Molyneux, and John O. S. Wilson Print Publication Date: Oct 2019 Subject: Economics and Finance, Financial Economics Online Publication Date: Nov 2019 DOI: 10.1093/oxfordhb/9780198824633.013.36

Abstract and Keywords This chapter explains the functioning of the banking sectors in the European transition countries. First, we reflect on the thirty-year history of transition banking from the cre­ ation of banking institutions out of the planning structures through the effect of the glob­ al financial crisis and the post-crisis challenges. We show that experiences across the re­ gion are by no means uniform, both with respect to the path since transition started and the current state of the industry. Second, we focus on the state of the banking industry when transition is finalized and show the similarities and differences between banking in this region and elsewhere. Finally, we analyze financial inclusion as one of the critical is­ sues that affects contemporary banking in the region. Keywords: banking in transition, crisis, financial inclusion, institutions, ownership, transition

36.1 Introduction BANKING in the transition countries of Central, Southern, and Eastern Europe and the former Soviet Union is particularly interesting because banks played a very limited role in planned Soviet-style economies. In the formerly planned economies banks provided trans­ actions services and acted as agents of the government planning process. They rarely en­ gaged in the primary function of a modern banking system which is to intermediate funds between savers and investors in order to allocate capital efficiently. A manufacturing firm in the Soviet Union had the same production process as its counterparts in the West, a bank did not. Thus, the creation of modern banking systems was arguably the most im­ portant element of the transition process. Thirty years after the collapse of the Soviet bloc, the transition in banking is largely com­ pleted with, in some instances, remarkable success. Many advanced transition countries can boast of robust, competitive, modern, market-oriented banking sectors that look no different from those in old EU countries. Nevertheless, there are also many aspects of the Page 1 of 26

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Banking in the Transition Countries of Central, Southern, and Eastern Eu­ rope and the Former Soviet Union industry which reflect the legacy of the transition experience. For example, persistent structural problems in some countries have led to equally persistent bad loan problems. Foreign bank entry led to the rapid improvement in banking technology (p. 1133) which was often applied to mortgage and consumer lending. The development of a business lending culture, particularly to small to medium-sized enterprises (SMEs), lagged and businesses often complain of the difficulty in finding funding. Finally, a related issue that inhibits banking sector development is the slow pace of institutional reform in many coun­ tries and the continued government interference in the sector in some countries. Experiences across the region are by no means uniform, both with respect to the path since transition started and the current state of the industry. To start with, there are tran­ sition countries that are now EU members in Central Europe (Czech Republic, Hungary, Poland, Slovakia) and in South East Europe (Slovenia, Bulgaria, Croatia, Romania) and the Baltics (Estonia, Latvia, Lithuania). Their experiences are different from the other countries in SEE that are not EU members (Serbia, Bosnia and Herzegovina, North Mace­ donia, Montenegro, and Albania) as well as the Former Soviet Union (FSU) countries (principally Russia, Ukraine, and Kazakhstan). The most advanced transition countries in Central Europe joined the EU in 2004, several more followed later and a few have adopt­ ed the Euro. Thus, the gap in banking sector development across the region has widened over time. In this chapter we will try to provide an understanding of the banking sectors in the tran­ sition countries, three decades after the start of transition and one decade past the global financial crisis. First, we will reflect on the thirty-year history of transition banking from the creation of banking institutions out of the planning structures through the effect of the global financial crisis and the post-crisis experiences. Second, we will focus on the state of the banking industry at the present time and show similarities and differences be­ tween banking in this region and elsewhere. Third, we will examine one important conse­ quence of transition banking reforms: the extent to which there is financial inclusion or access to finance.

36.2 History of Transition Banking Transition from a planned to a market economy started with the creation of banking insti­ tutions. This birthing process was hardly smooth; it took place amidst massive macroeco­ nomic collapse and considerable economic uncertainty. Not surprisingly, these nascent banking sectors experienced crises ranging from serious bad loan problems to total col­ lapse. Every transition country experienced at least one banking crisis and a variety of re­ sponses including recapitalizations, write-offs, privatization and, importantly, the en­ trance of foreign bank owners. The situations began to stabilize in the early years of the 21st century but the financial crisis and global recession tested the resilience of new in­ stitutions and regulatory structures and brought the issue of foreign ownership to the fore. The decade since the crisis has seen continued progress and gradual recovery, al­ though instances of poor banking practice, performance, and regulation persist and there Page 2 of 26

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Banking in the Transition Countries of Central, Southern, and Eastern Eu­ rope and the Former Soviet Union have been some instances of reform reversals as well. In this section, we provide a brief overview of the history of transition banking.1 (p. 1134)

36.2.1 The First Decades

Banking sectors in the European transition economies were relatively underdeveloped compared with the real economies in these countries, due mainly to the legacies of the pre-transition centrally planned economy. In the planning framework, financial intermedi­ ation between savers and borrowers was internalized wholly within the state planning process and banks existed to carry out the plan. Credit evaluation and risk management played no role in lending decisions. The national monobank served only as an accounting clearing house for inter-enterprise transactions. Money was entirely passive in that it was used solely as a unit of account in enterprise transactions and as a medium of exchange between households and the state distribution sector. Household savings, oftentimes the result of forced accumulation of monetary balances due to the unavailability of desirable consumer goods, were collected by a state savings bank. There were some exceptions to this rigid planning structure. Pre-transition banking sec­ tors typically included a foreign trade bank, which handled all foreign currency transac­ tions to isolate these from the domestic financial system, and often contained separate specialty banks to oversee the financing of the agricultural and construction sectors. Yu­ goslavia was always an outlier in the Communist bloc; from the 1950s it had a two-tier banking system with a central bank and commercial banks that were owned collectively. Transition banking starts with the creation of a two-tier system with commercial activities carved out of the portfolio of the national monobank. The top tier consists of a traditional central bank that is charged with pursuing monetary policy, including exchange rate poli­ cy, and was usually given responsibility for supervising the nascent banking sector. The second tier consists of the newly created state-owned commercial banks (SOCBs), the state-owned specialty banks, which themselves morphed into SOCBs, any operating for­ eign and joint-venture banks, and all private domestic banks, including those that entered after the political transition. As a rule, lax entry requirements led to the creation of many new private banks, some of which were of dubious quality, or even fraudulent, and virtual­ ly all of which were severely undercapitalized. Hence, the seeds for a banking crisis were planted at the beginning of the transition, or even before, due partly to lax entry require­ ments which were put in place to foster competition with the dominant state-owned banks. Moreover, the nascent regulatory systems were overwhelmed by the mismatch be­ tween their capabilities, which were severely restricted by a lack of human capital, and their mandates, which were provided by quickly adopted standard financial rules and reg­ ulations, especially given the inherited loan portfolios of the SOCBs. Although each country’s financial restructuring program involved hiving off the commer­ cial bank portfolio of the national bank to establish the two-tier system, different ap­ proaches were taken toward the creation of SOCBs, all of which were established initially as wholly state-owned joint-stock entities. In Hungary, the commercial portfolio was divid­ Page 3 of 26

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Banking in the Transition Countries of Central, Southern, and Eastern Eu­ rope and the Former Soviet Union ed along sectoral lines, for example, industry, agriculture, and infrastructure plus the nascent small business sector, to create three SOCBs. In Poland, the commercial (p. 1135) portfolio was divided along regional lines to create nine SOCBs from regional offices of the national monobank. In an extreme example, designed to foster competition, each of the 145 branch offices of the Bulgarian national bank was granted a universal banking li­ cense and a portion of the loan portfolio. A two-tier banking system was established in the Soviet Union in 1987 with the separa­ tion of all commercial bank functions from the national monobank and the creation of sec­ toral banks by enterprises or former branch ministries. With the dissolution of the Soviet Union, branches of the national bank became independent entities and then regrouped in­ to larger banks. There were large numbers of new entrants in newly independent Russia; by 1995, about 2,300 banks were licensed and operating in Russia. Most of the newly cre­ ated banks were small and poorly capitalized. Many of them were merely internal or house banks owned by industrial enterprises although a few of the de novo domestic pri­ vate banks were among the largest banks in Russia. However, the sector was dominated by two large SOCBs, the former state foreign trade bank and the former state savings bank. However, the Russian private banking sector contracted due to numerous bank fail­ ures during the 1998 Ruble crisis and Russian banking is still dominated by two large state banks (Steinherr, 2006). In the first decade of transition, policies toward foreign bank participation, both in estab­ lishing subsidiaries and in purchasing equity stakes in SOCBs, differed considerably across the region. In some countries, policies that invited entry, for example, providing tax holidays, encouraged greenfield foreign operations. Foreign participation in the bank­ ing sector was viewed initially by most governments as a vehicle for importing banking expertise and training to augment the scarce domestic human capital in the sector. How­ ever, there was also a strong nationalistic resistance to allowing foreign control of the monetary system and a concern that foreign banks would facilitate capital flight. Some governments followed an infant industry approach according to which domestic banks are nurtured to become strong enough to fend off foreign competition when it arrives. Many countries limited foreign participation with restrictive licensing, such as restricting for­ eign banks to minority stakes in SOCBs or to participating in the resuscitation of ailing domestic banks. Foreign bank ownership started in Hungary which had allowed foreign participation even before transition (Citibank Budapest Ltd. began operations as a foreign-majority-owned, joint-venture bank in 1986). By 1995, about one-third of Hungarian bank assets were owned by foreign financial institutions (Hasan and Marton, 2003). In the former Czecho­ slovakia some state-owned banks were included in the voucher privatization program, thus restricting foreign ownership. In Poland, the nine SOCBs were slated early on for privatization with minority foreign ownership through a program supported by the US Treasury. In most other countries foreign ownership was miniscule in the mid-1990s though this soon changed.

Page 4 of 26

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Banking in the Transition Countries of Central, Southern, and Eastern Eu­ rope and the Former Soviet Union Developing efficient banking sectors required the completion of three interrelated tasks, namely, the resolution of non-performing loans (NPLs), the privatization of the SOCBs, and the establishment of effective regulatory institutions. Privatization and (p. 1136) the establishment of market-oriented banking laws legislation and institutions did not lead automatically to good banking practices. To the contrary, the SOCBs and the newly creat­ ed banks often did not behave like proper commercial banks due to distorted incentives. First, the SOCBs continued to maintain banking relationships with their large clients, that is, state-owned enterprises (SOEs). Such lending was either politically mandated or sim­ ply the result of long-standing relationships between clients having little experience in choosing viable projects and banks unable to evaluate the risk of loans. Second, in many countries, de novo banks were created without adequate regulatory oversight. As a re­ sult, some de novo banks were used to channel loans improperly to their owners, many of which were enterprises, so that these banks acted as pocket (or house) banks for their owners. Entry requirements for de novo domestic banks were initially very lenient be­ cause policy was based on the mistaken notion that competition would be enhanced by easy entry. The proliferation of new, often undercapitalized, banks placed an added bur­ den on an underdeveloped regulatory structure. Not surprisingly, bad loans were a serious problem for all transition economies, due part­ ly to the inherited legacies but also to continuing lending practices. Most governments re­ sponded to failing banks with efforts to save them from closure by recapitalization and the removal of bad loans from their balance sheets. However, this did not change bank behavior; lending to SOEs and related entities continued. In the absence of independent market-oriented banking institutions, the flow of new bad loans continued to accumulate. To some extent the bad loan problem was unavoidable because transition recessions and the dissolution of trading relationships within the Soviet bloc generated severe real sec­ tor shocks that were mirrored on the balance sheets of the banks. The surprising aspect of banking in the transition countries is not the depth of the crises after the end of communism but the speed with which financial restructuring took place subsequently. The rapid changes in the 1990s and early 2000s can in part be attributed to two related phenomena. First, the desire of European transition countries to qualify for EU membership was a strong force for reform, not only in the eight original transition ac­ cession countries but also in the later joiners and in countries still hoping to join. Second, the prospect of EU membership (and ultimately the adoption of the Euro) made these un­ derserved banking markets attractive to European banks once macroeconomic stability was attained and a reasonably effective regulatory structure was in place. Of course, most FSU countries did not enjoy the benefits of such external anchors and banking re­ form lagged across the FSU. After 1995 the EBRD index of banking reform increased gradually in all the countries (de­ noting an improvement); although there were a few reversals, several countries attained a score of 4.0.2 Hence, banking sectors in many transition countries prior to the crisis reached, or were rapidly approaching, levels found in developed market economies Page 5 of 26

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Banking in the Transition Countries of Central, Southern, and Eastern Eu­ rope and the Former Soviet Union with one major difference, namely, an extremely high foreign bank presence. Banking in most countries was highly concentrated, although the concentration ratios were similar to the ones found in countries of a similar size and having similar financial deepening. The relatively high concentration ratios have not prevented competition from developing in many of these banking sectors. The spreads between lending and deposit rates were often in excess of 10 percent in the early transition years, due to instability and high inflation. Spreads declined considerably over the first two decades of transition which may be attributable as much to improvements in the macroeconomic environment as to increased banking competition. (p. 1137)

Foreign ownership started to spread as governments realized that privatization to foreign buyers is not only a source of revenue but also a means of improving bank performance (Haselmann, 2006). After a decade and a half of transition, privatization of SOCBs with extensive foreign ownership was largely completed in CEE (Central and Eastern Europe), SEE (Southeastern Europe) and the Baltics. Exceptions were Russia and the Ukraine as well as Slovenia, which continued to protect its domestic banks, and countries that con­ tinued to be politically unstable. Although foreign-owned banks may prefer large, interna­ tionally active firms, both foreign and domestic banks are important sources of credit; moreover, there are significant industry externalities from the presence of foreign banks. Bonin, Hasan, and Wachtel (2005a and 2005b) show that privatization by itself was not sufficient to improve bank performance; rather, joint ownership with foreign strategic in­ vestors was the crucial determinant in behavioral change. Foreign ownership restrictions were relaxed in the former Soviet Union in the early 2000s. Kazakhstan, with large capital inflows related to the energy industry, began to al­ low foreign banks to operate in 2005. Russia relaxed its limits on the overall size of the foreign banking sectors but it retained minima for the number of Russian employees and board members in foreign banks. The largest banks in Russia are still the state-owned gi­ ants and there are no apparent plans to privatize these banks, which act as agents for state intervention in the economy. In addition, unstable supervisory environments and weak legal protection have deterred foreign interest in such investments in many FSU countries. Many of the small private banks in Russia were involved in speculative activity and many were insolvent when the Russian government defaulted on its debt in 1998. At the time, weak bankruptcy laws and poor regulation made it difficult to close institutions so that the managers or owners were able to strip banks of any remaining good assets. The Russ­ ian banking sector improved after the 1998 crisis with bank closures and consolidations, a growing foreign bank presence, and increasing financial intermediation. However, the Russian banking sector continues to be crisis prone. In all countries, successful restructuring and privatization in the financial sector depends on the establishment of an effective institutional and legislative framework for regulation as well as bankruptcy laws and appropriate accounting standards. In general, armslength relationships between banks and regulators, and banks and the state, generally Page 6 of 26

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Banking in the Transition Countries of Central, Southern, and Eastern Eu­ rope and the Former Soviet Union are required in order to change the behavior of economic agents who are accustomed to operating in a non-market environment. Moreover, training of bank supervisors and other types of professional human capital development are needed to promote effective (p. 1138) implementation of the legislation. Although the basic legal framework for mod­ ern banking was established early in the transition, additional related elements that are crucial for its effective functioning took more time to develop. These include modern banking legislation, the adoption of international accounting standards, revised bankrupt­ cy and collateral laws, and effective supervision. A modern banking sector does need a functioning credit information system, which includes a credit registry and ratings agen­ cies, and a reliably functioning court system to mediate contract disputes. Household credit, especially mortgage lending, depends on well-defined property rights over collateral and an effective legislative infrastructure to facilitate the collection of col­ lateral in case of default. Hence, the dramatic growth in household credit reflects signifi­ cant improvements in supportive institutions. The explosion of retail credit contributed to housing price booms, excessive debt, and instability in some transition countries. The ex­ pansion of household lending may be related to the dominance of foreign-owned banks. Using the first EBRD Banking Environment and Performance Survey, Haselmann and Wachtel (2007 and 2010) show that banks in many transition economies shifted their as­ set portfolios out of government securities toward mortgages and consumer credit. Once the legal environment is in place, lending to households is a commodity. Still, ratios of household credit to GDP are not large by developed country standards. However, the ratio of household credit to the financial wealth of the consumer sector is often high and borrowing in foreign currencies persists, making consumers vulnerable to economic shocks. Lending to enterprises requires developing client relationships and having the ability to evaluate unique situations, both of which require expertise that is generally lacking in foreign banks, although acquired banks may bring such local knowledge. Beck and Brown (2015) find that foreign banks “cherry pick” the best customers and leave opaque borrow­ ers to the domestic banks. The EBRD/World Bank surveys of enterprises in transition countries indicate that many firms, perhaps with the exception of international firms, were financially constrained in the sense that they are unable to obtain bank lending. Based on these surveys, the EBRD concludes that “despite some regional variation, bank loans still play a limited role in enterprise financing” (EBRD, 2006, p. 47).

36.2.2 Challenges from the Global Financial Crisis The resilience of the newly emerging mature and stable banking systems throughout the region was put to the test by the global financial crisis starting in 2008. First, foreign ownership of banks, which had been an important source of managerial and technological improvements in the industry, also served to link the financial systems of the home and host countries. As a result, transition country banks were exposed to the global financial crisis shock coming from the US and Europe. Second, many transition countries experi­ Page 7 of 26

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Banking in the Transition Countries of Central, Southern, and Eastern Eu­ rope and the Former Soviet Union enced retail credit booms in the years leading up to the crisis and, so the banks were ex­ posed to credit risks when the recession spread from the more developed countries to (p. 1139) the transition region. The impact of the global financial crisis on the region test­ ed the regulatory and supervisory capabilities of these, still relatively new, financial sys­ tems. Although the impact of the financial crisis on the region was severe, systemic prob­ lems were rare and many banks in the region generally outperformed their counterparts in more developed countries. When foreign banks began to enter the transition countries, the flow of resources and capital was entirely from the developed countries to the transition country hosts. The ex­ pertise, technology and know-how, as well as the equity investments in banks and the spillover effect on the domestic industry, were important elements in the transformation of transition country banking. In the credit boom of the 2000s, capital also flowed through these banks to the transition countries. No one discussed the possibility of re­ sources flows in the opposite direction, as weakened international banks transmitted the crisis shock to the transition economies. The crisis showed that foreign ownership could amplify the effect of a home country shock on host transition countries (De Haas, 2014; De Haas et al., 2015). It was feared that foreign-owned banks, particularly if they relied on funding and liquidity from their parent, would transmit the crisis shock to the region. Poor conditions in the home country might lead the parent banks to reduce funding or even try to withdraw capital. If parent banks attempted to limit their losses by reducing foreign exposures, they could trigger systemic crises in banking systems dominated by foreign ownership. Concern about the transmission of the crisis shock led to a joint action plan, the Vienna Initiative (VI), which was adopted in January 2009. Both the International Financial Insti­ tutions (IFIs) such as the EBRD, the IMF, and the European Investment Bank and private institutions (i.e., the principal parent banks in the region) participated in the VI. The banks agreed to maintain their exposures to the transition countries and recapitalize banks as necessary, while the IFIs offered support of 33 billion Euros to maintain stability in the region. An expanded plan, VI 2.0, was adopted in 2012 in response to the European sovereign debt crisis. According to De Hass et al. (2015), the contraction in credit by foreign bank subsidiaries in thirty transition countries occurred earlier and was deeper than that of domestic banks during the crisis years of 2008 and 2009. However, these authors find that banks that participated in the Vienna Initiative were less likely to contract credit in the region than banks that did not participate. Popov and Udell (2012) show that transition country firms’ access to credit during the crisis was affected by the balance-sheet conditions of foreign parent banks. Similarly, Bonin and Louie (2017) find that bank lending by foreign banks in transition countries was adversely affected by the financial crisis and the Eurozone cri­ sis. Thus, there is evidence of the international transmission of the crisis shock to the transition countries. Nonetheless, Bonin and Louie (2017) find that the large multination­ al banks retained their commitment to their second home market, as did Epstein (2014) Page 8 of 26

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Banking in the Transition Countries of Central, Southern, and Eastern Eu­ rope and the Former Soviet Union who argues that it was the business models of the banks themselves, rather than the in­ tervention of the IFIs, that influenced the behavior of the large foreign owners. Hungary was among the first emerging market countries to suffer the fallout of the global crisis. It was vulnerable because of a large fiscal deficit, its reliance on external (p. 1140) financing and the extent of domestic, particularly household, borrowing in foreign curren­ cy. In October 2008, the IMF, the World Bank and the EU joined forces to provide a $25 billion support program. Importantly, the program included provisions for pre-emptive ad­ ditions to bank capital and guarantees for the interbank market in order to forestall a sys­ temic banking crisis. As the Hungarian currency depreciated, the country faced a serious problem since the vast majority of loans in its large mortgage market were denominated in Swiss francs. The regulatory authorities and the government intervened, with limited success, by allowing the repayment of these mortgages at a preferential exchange rate. Although the recession in Hungary deepened and credit contracted, Hungary was able to avoid a systemic banking crisis like that which occurred at the start of transition. Croatia also faced a rapid expansion of household borrowing in the years prior to the cri­ sis, which was fueled by improvements in the banking sector’s capabilities, the entrance of foreign banks, and low external borrowing costs. Croatia imposed prudential con­ straints on lending activity through a series of innovative central bank actions starting with a ceiling on credit growth above 16 percent in 2003. In 2006, the central bank in­ creased the risk weights on foreign currency loans to domestic customers with the ex­ press purpose of discouraging such loans. Although the variety of programs and the fre­ quent changes in their application introduced some uncertainty into the banking environ­ ment, Croatia was able to maintain the stability of its banking sector throughout the cri­ sis period. The Russian banking system encountered serious liquidity problems before the crisis. A lack of trust paralyzed the interbank market for a short period in 2004, though this did not have much effect since deposits were concentrated in the large state-owned banks. From 1998 to 2008, the ratio of bank credit to GDP in Russia doubled. Thus, problems were more serious in 2008 when oil prices fell and the Ruble depreciated, while many in­ stitutions borrowed abroad in foreign currencies. This time the closure of the Russian in­ terbank market threatened a significant systemic crisis. Deposits were switched into for­ eign currency and total deposits declined. Non-performing loans increased, loans out­ standing fell, and there were some bank closures. The central bank eased its refinancing terms and extended deposit insurance coverage and the government offered support to those enterprises in trouble. The decline in oil prices and Western sanctions put enormous pressure on the Russian economy and the banking system after 2014. The central bank established a bailout fund and three large private banks were closed in late 2017. Similarly, the economic and politi­ cal crisis in the Ukraine led to the failure of the country’s largest bank in 2016.

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Banking in the Transition Countries of Central, Southern, and Eastern Eu­ rope and the Former Soviet Union

36.2.3 Going Forward Credit grew rapidly in the transition countries prior to the global financial crisis which was followed by the European sovereign debt and banking crises, which had spillover ef­ fects in many emerging-market banking systems. Thus, the economic contractions in (p. 1141) many transition countries were severe and the effects were long-lasting. Nonperforming loans increased rapidly, which choked off the ability of banks to lend and of firms to borrow. The volume of loans decreased and loan-to-deposit ratios fell sharply. The overhang of NPLs in a stagnating economy perpetuates itself and the crisis impact on the transition country banking systems lasted for almost a decade. Although institutional structures were largely in place, regulators, bankers and firms lacked the experience needed to quickly resolve bad loan problems (see EBRD, 2015, p. 25). First, standards for loan classification were often unclear and regulators were reluc­ tant to enforce requirements for additional provisioning. Second, banks and firms lacked the expertise needed to restructure viable but overleveraged firms. Over time, banks and regulators began to deal with NPL problems with loan sales and improved recovery ef­ forts. In some instances, governments intervened and created asset management compa­ nies to take bad loans off bank balance sheets and introduced programs to convert for­ eign currency loans. The creation of the first pillars of the European banking union (the single supervision mechanism and single resolution mechanism) in 2014 changed the nature of bank regula­ tion by introducing uniform standards and information sharing that eliminates much of the cross-border uncertainty regarding supervision. A European deposit insurance scheme, the third pillar of the banking union, is not yet in place. However, the banking union is only compulsory for Eurozone members, other EU countries can choose to partic­ ipate. Only Bulgaria and Romania have done so, partially in response to EU pressure and also in an effort to import European regulatory and anti-corruption standards and super­ visory expertise. The other non-Euro Area transition economies have taken a wait-and-see attitude. Policymakers feel that the crisis-related problems were not of their making, par­ ticularly the spillover effects on interest rates and cross border flows from the Greek cri­ sis. As a result, there is an increasing reluctance to accept any supranational approach to banking regulation and a desire to retain discretion over supervisory decisions. Moreover, there is a resurgence of what might be called “banking nationalism” in the re­ gion, resulting in renewed suspicion of foreign banks (Mérő and Piroska, 2016). Bank consolidations and acquisitions in some countries have led to the purchase of foreign sub­ sidiary banks by domestic institutions and efforts to favor national champions. For exam­ ple, Polish officials talk about the “domestication” of banking, and banks with majority foreign ownership now control only about one-half of bank assets, down from close to three-quarters just prior to the crisis. In Hungary, there have been some bank nationaliza­ tions and efforts to favor domestic banks, like OTP which is itself the owner of banks throughout the region.

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Banking in the Transition Countries of Central, Southern, and Eastern Eu­ rope and the Former Soviet Union Although banks in the transition countries have made rapid strides in improving perfor­ mance and services since the early 1990s, the banking sectors in the transition economies still do not possess the financial depth of their EU counterparts, nor are bank­ ing services as well developed. State monobanking structures have been replaced by pri­ vately owned, market-oriented, well-capitalized banking institutions that are largely inde­ pendent from the government and from state-owned clients. The legal environment has improved with respect to bankruptcy laws, collateral laws, and confidence in (p. 1142) the application of the law. Furthermore, banking regulatory and supervisory capabilities have developed considerably. However, there are dangerous signals of increased political inter­ ference in transition banking sectors which represents a significant step backwards. In the next section, we take a closer look at the question: is the transition in banking over?

36.3 Banking Industry Today: Is Transition Over? The discussion above could easily lead to the conclusion that transition in banking is over in the sense that the socialist banking systems are long gone now and firms and house­ holds are free to choose a banking institution that best serves their needs. All European transition economies now have a viable banking industry largely based on competing uni­ versal and retail banks. After thirty years of transition, banking sectors in most European transition countries largely resemble those in the old EU countries. Some important dif­ ferences remain, however. This section will briefly describe the current state of banking in the transition countries and where possible make comparisons to the Euro Area.

36.3.1 Intermediation and the Role of Banks Until the global financial crisis, banking sectors grew faster than GDP almost everywhere in Europe, and the transition economies were no exception. The size of the banking sec­ tor in relation to GDP peaked in 2009. The deleveraging that followed the 2009 crisis has been notable in the CEE countries but much less pronounced in most of the SEE and FSU areas. The size of the banking sector (measured by banks’ claims on the domestic non-fi­ nancial sector from the World Bank, 2017–18) is on average about 60 percent in relation to GDP in the transition countries, significantly lower than in the Euro Area. Total assets of monetary financial institutions in the Euro Area is above 300 percent of GDP, while on­ ly slightly above 100 percent in Estonia and Latvia and even less in other transition economies (ECB, 2017). The ratio of deposit money bank assets to GDP for each region is shown in Table 36.1. The financial sectors in CEE, SEE, and FSU are more bank-based than their counterparts in the Euro Area. The role of non-bank financial entities like pension funds, insurance cor­ porations, investment funds, and other financial institutions is very limited in these economies. For example, in terms of total assets, the share of the non-bank financial sec­ tor in Estonia and Slovakia is less than one-third of the total financial sector. In the Euro Area the corresponding figure is above a half. Even in Poland, a country with by far the Page 11 of 26

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Banking in the Transition Countries of Central, Southern, and Eastern Eu­ rope and the Former Soviet Union most advanced capital markets, non-bank financial institutions’ assets equal only roughly 30 percent of GDP (Impavido, Rudolph, and Ruggerone, 2013). Non-bank (p. 1143) finan­ cial sectors are particularly underdeveloped in FSU economies, where domestic institu­ tional investors are all but nonexistent.

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Banking in the Transition Countries of Central, Southern, and Eastern Europe and the Former Soviet Union Table 36.1 Deposit Money Banks’ Assets to GDP (%), Average for the Region 2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

New EU mem­ bers

53

59

68

82

77

73

71

69

66

64

SEE (nonEU mem­ bers)

34

43

53

58

58

58

59

59

59

60

FSU3

34

43

50

61

54

50

51

53

55

55

Euro Area

90

96

105

114

112

111

110

108

101

103

Note: The new EU member states are Bulgaria, Croatia, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovakia, and Slovenia; non-EU members in the SEE are Albania, Bosnia and Herzegovina, Koso­ vo, North Macedonia, Montenegro, and Serbia; the FSU3 group includes Kazakhstan, Russia, and Ukraine. Finally, the composition of the Euro Area changes over the years shown. Source: World Bank Global Financial Database. https://www.worldbank.org/en/publication/gfdr/data/global-financialdevelopment-database. Data compiled by the authors.

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Banking in the Transition Countries of Central, Southern, and Eastern Eu­ rope and the Former Soviet Union

36.3.2 Banking Sector Structure Due to the socialist legacy, banking sectors in our focus countries largely comprise com­ mercial banks only. Traditional cooperative or savings banks have not emerged in the transition region, and in most cases the privatization of former state banks has resulted in a small number of relatively large banks. Only a limited number of de novo banks sur­ vived the turbulent 1990s and the tightening regulation and crisis in the 2000s. Russia is a clear outlier with a large number of banks, due to both its economic size and to relative­ ly lax supervision up until 2013. Consolidations and acquisitions have reduced the num­ ber of banks everywhere in Europe since the crisis and the transition countries are no ex­ ception. Both the number of banks and the number of bank employees have decreased. In per capita terms, the banks in CEE tend to have few employees. In Romania, Lithuania, and Slovakia one bank employee serves over 280 inhabitants, whereas the EU average is still below 180 (EBF, 2017). The current ownership structure of banking sectors in the region differs greatly from the Euro Area average where domestic ownership prevails. As discussed previously, banking sector assets are predominantly foreign-owned in most SEE, CEE, and Baltic countries. The share of foreign banks’ assets exceeded 90 percent in Croatia, the Czech Republic, Estonia, Lithuania, and Romania in 2016 (ECB, 2017b). Also the share of foreign banks in the total number of banks is significantly higher than in any other emerging markets’ group (Arakelyan, 2018). Most foreign banks operating in CEE and SEE are headquar­ tered in other EU member countries. This has greatly helped to streamline banking regu­ lation in the region toward European practices. As most countries of the former Soviet Union never experimented with large-scale bank privatizations to outside owners, the role of foreign banks remains limited in the FSU. Further, especially in Russia, not all foreign-owned banks are genuinely foreign. A large number of Russian banks are registered in various EU countries but are controlled by Russian nationals. State ownership is rare in most of SEE and CEE, and in the Baltics, whereas state-controlled banks continue to dominate banking sectors in many FSU coun­ tries. As an example, the asset share of state-controlled banks in Russia currently ex­ ceeds 60 percent.

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Banking in the Transition Countries of Central, Southern, and Eastern Europe and the Former Soviet Union (p. 1146)

Table 36.2 Balance-Sheet Structure of Banking Sectors at end 2016

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Banking in the Transition Countries of Central, Southern, and Eastern Europe and the Former Soviet Union Es to ni a

Li th ua ni a

La tv ia

Sl ov ak ia

Sl ov en ia

E ur o Ar ea

B ul ga ri a

Cr oa ti a

Cz ec h R ep u bl ic

H u n ga ry

Po la n d

R o m an ia

E U28

Al ba ni a

Bi H

M ac ed on ia

N or th M on te ne gr o

Se rb ia

lo an stoas se ts

88 %

80 %

65 %

67 %

70 %

57 %

67 %

72 %

66 %

53 %

68 %

66 %

56 %

42 %

61 %

64 %

60 %

62 %

de po sit stoas se ts

63 %

75 %

48 %

73 %

74 %

55 %

71 %

68 %

61 %

63 %

67 %

68 %

52 %

81 %

75 %

74 %

76 %

76 %

Page 16 of 26

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Banking in the Transition Countries of Central, Southern, and Eastern Europe and the Former Soviet Union lo an -to -d ep os its

14 0 %

10 6 %

13 6 %

93 %

95 %

10 3 %

95 %

10 6 %

10 9 %

84 %

10 2 %

97 %

10 7 %

51 %

82 %

87 %

79 %

81 %

Source: European Banking Federation: Facts and Figures 2017. Data compiled by the authors.

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Banking in the Transition Countries of Central, Southern, and Eastern Eu­ rope and the Former Soviet Union All customer deposits account for about a half of banking sector liabilities in the Euro Area, but the role of deposit funding continues to be larger in the transition region (see Table 36.2). Deposits cover two-thirds of banking sector liabilities in most of the region. Moreover, the share of household and non-financial corporations in total deposits tends to be high, underlying the fact that many banks in the region focus on traditional financial intermediation. With the exception of a few large countries, banking systems in the EU tend to be fairly concentrated, with the share of the five largest banks in total banking sector assets (p. 1144) just below half in 2016 (ECB, 2017a). The concentration ratio is even higher in the transition economies. The five largest banks control well above 60 percent in most countries, reaching the highest values of almost 90 percent in Estonia and Latvia. Only Russia (until recently) and Ukraine (lately) have had somewhat lower concentration ra­ tios. High concentration ratios reflect both the small absolute size of most of these economies and the dominant role of a small number of very large foreign-owned institu­ tions. High concentration does not necessarily mean low competition. Measuring bank competi­ tion clearly is challenging, but banking literature frequently uses the Lerner index, which relies on individual banks’ data. The index estimates a bank’s market power by assessing the bank’s ability to price above its marginal costs. Using this measure, banking competi­ tion in the transition economies does not seem to differ from the EU average. Lerner in­ dex values (World Bank, 2018) are higher in the Baltics and Russia, but in most countries Lerner index values are very similar to the Euro Area average.

36.3.3 Bank Lending Dollarization and later euroization have been a defining feature of banking in transition. In the early days of transition, dollarization emerged due to a low degree of trust in the domestic monetary authorities and in the new national currencies. As the economies de­ veloped, levels of dollarization reduced markedly. In the FSU dollarization has, however, remained at around 30 percent of corporate loans and deposits. In the case of Russia, this is largely due to the fact that major exporters continue to have an obligation to repatriate their typically US dollar-denominated export revenue. In most CEE and SEE economies, however, euroization in lending to both households and enterprises has re-emerged due to the large market shares of foreign banks, expectations of joining the (p. 1145) Euro Area or unilateral euroization, and in some SEE economies historical mistrust in domestic currencies. The role of foreign-owned banks in fostering euroization has indeed been re­ markable. Almost a half of loans extended by Austrian bank subsidiaries in CEE and SEE have been in foreign currency, predominantly in euros (IMF, 2013). Also, the expansion of direct cross-border lending to the non-bank private sector has increased exposure to for­ eign exchange risks in a number of CEE and SEE countries. Banks in transition countries tend to engage more in lending, with loans-to-assets ratios well above the Euro Area average in most of the countries shown in Table 36.2. Moreover, Page 18 of 26

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Banking in the Transition Countries of Central, Southern, and Eastern Eu­ rope and the Former Soviet Union these banks tend to have a larger share of their assets in loans to domestic non-financial corporations and households. This results from the limited international activities of these banks, but also reflects the very small role of local interbank markets and non-bank finan­ cial institutions in these economies. Many banks in the CEE and SEE regions focus on re­ tail lending, which shows up in relatively high shares of household lending in bank portfo­ lios. The shift away from government securities in banks’ portfolios also reflects the rela­ tively moderate levels of public debt in most transition countries. The rise in consumer credit and mortgages is a much more recent phenomenon in the FSU and in Russia, for example, loans to households constitute only about 30 percent of the total aggregate lending and only 16 percent of total assets. The focus on traditional banking activities and the relatively low exposure to global finan­ cial markets did help in alleviating the effects of the global financial crisis and the Euro­ pean debt crisis on banking sectors of the transition region. For the last decade, bank profitability has, on average, been higher than in the Euro Area. One factor behind better profitability has arguably been banks’ high net interest margins, especially in SEE and in a number of FSU countries. Relatively higher net interest margins in, for example, Ukraine, Montenegro, and North Macedonia reflect both weaker banking competition and a shakier macroeconomic situation in these countries. Interest margins tend to be clearly smaller in the countries that have joined the Euro Area, Estonia, Latvia, and Lithuania in particular.

36.4 Financial Inclusion in Transition Coun­ tries Although modern banking sectors have been established in the region, it remains to be shown whether they are functioning as such. In this section we examine the extent of fi­ nancial inclusion, that is, the access to and use of financial services. Financial inclusion has been shown to contribute to poverty reduction and economic growth as well as im­ prove financial stability. Increasing financial inclusion has become one of the key policy objectives around the world. The analysis draws on the Global Findex Database, which consists of nationally representative surveys of more than 150,000 adults in over 140 economies around the world, that were carried out in 2011, 2014, and 2017. We use data from the surveys con­ ducted in 29 formerly planned economies.3 (p. 1147)

36.4.1 Measuring Financial Inclusion—Account Ownership The Global Findex data provides three main measures of financial inclusion; account own­ ership and usage, saving behavior, and borrowing. Using all three measures, there has been significant improvement in financial inclusion in recent years. Despite this positive

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Banking in the Transition Countries of Central, Southern, and Eastern Eu­ rope and the Former Soviet Union trend, the transition economies still lag behind the Euro Area. The measures also reveal considerable heterogeneity across the region. The main measure of financial inclusion is the ownership of an account4 by an individual. An account is an entry into a financial institution which is used to save or borrow money and also to make transactions. Overall, 69 percent of adults worldwide now have an ac­ count, up from 51 percent in 2011 (Demirgüç-Kunt et al., 20185). Unlike some developing economies where accounts by mobile money providers are common, in our sample coun­ tries individuals have accounts at formal financial institutions. In the new EU member countries, the proportion of people with accounts was high in 2011 at 77 percent and reached 83 percent in 2017; in the Baltic countries it approached the Euro Area average of 95 percent. On the other hand, in the main FSU countries (Russia, Ukraine, Kaza­ khstan) about two-thirds of the adults reported having an account. Other FSU countries are less developed in general and also less developed in terms of financial inclusion. While the proportion of adults with an account has more than doubled in these countries between 2011 and 2017, it only reaches 47 percent. The variation within the other FSU countries group is, however, wide ranging, from 29 percent in Azerbaijan to 81 percent in Belarus. As elsewhere, also in transition countries, the extent of financial inclusion mea­ sured by account ownership increases with the level of economic and financial develop­ ment. In addition to the relation between income per capita and financial inclusion mentioned above, there are several individual characteristics that influence account ownership. The gender gap in account ownership, which is observed in developing countries, is not found in transition countries. Generally, financial inclusion is higher in high-income countries and the gap in account ownership between poor and rich is lower in these countries. Within our sample, this gap between poor and rich is higher than the world’s average in all FSU as well as SEE countries including Bulgaria and Romania. In most of these coun­ tries the gap has increased over time which might point to a more unequal (p. 1148) distri­ bution of income. Surprisingly, despite high levels of financial inclusion, there are large differences (a double-digit gap) in account ownership between poorer and richer adults in some more developed CEE countries (Czech Republic, Hungary, and Slovakia). Financial inclusion increases with age but the gap between the young and the old is about the same in transition countries as in the Euro Area. Exceptions are Slovenia, Ukraine, and Tajik­ istan, where account ownership is higher for young adults than for the older generation.

36.4.2 Account Usage Having an account is crucial for financial inclusion but even more important is if and how this account is used. In the 2017 survey, about 60 percent of adults in the transition coun­ tries report making or receiving at least one payment in the past year, a 19 percentage points increase from the survey three years earlier. In the Euro Area, however, 92 percent of respondents report at least one payment and thus the intensity of financial inclusion in transition countries is still significantly lower.

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Banking in the Transition Countries of Central, Southern, and Eastern Eu­ rope and the Former Soviet Union Governments contribute to higher account usage when they use accounts for wages, pen­ sions, and transfers. Overall, in the transition economies 41 percent of individuals report receiving at least one payment from government in the past year, the highest shares be­ ing in Latvia (70 percent) and Ukraine (60 percent). About 40 percent of those receiving the payments have opened their accounts in order to be able to receive government pay­ ments. The data indicates that in less developed transition economies (Azerbaijan, Geor­ gia, Moldova, Uzbekistan, and Tajikistan) this accounts for the significant increase in fi­ nancial inclusion. The usage of credit and debit cards in the transition countries is still well below the Euro Area figures. About 35 percent of adults report using a debit or credit card to make a pur­ chase in the past year, in both the 2014 and 2017 surveys, while the average in the Euro Area exceeds 70 percent. Mobile phones and the Internet provide a convenient way to ac­ cess accounts. In 2017, about 29 percent of account owners in transition economies re­ ported that they have used a mobile phone or the Internet to access their account in the past year while about half of the respondents did so in the Euro Area. Usage varies wide­ ly, ranging from about two-thirds responding positively in Estonia and the Czech Republic to below 10 percent in Turkmenistan, Azerbaijan, and Albania.

36.4.3 Financial Inclusion—Saving and Borrowing The use of financial institutions for saving and borrowing is an alternative measure of fi­ nancial inclusion. The most general question asked about savings is if individuals have saved or set aside money in the past year. In the transition countries 42 percent an­ swered positively in 2017, only a minor increase in comparison to 2014. FSU countries and SEE countries report about one-third of individuals who save and this has not changed over (p. 1149) time. On average, this indicator in the transition countries is below figures for the whole world and not increasing recently. The level of financial inclusion can also be assessed by credit usage; there is greater inclusion if more individuals bor­ row. Just about half of the adults in the Euro Area report having borrowed any money in the past year. This proportion is lower in the transition countries (about 40 percent). For­ mal borrowing from financial institutions is more significant in the more developed transi­ tion countries that are now EU members, with the exception of Romania and Bulgaria. In the former FSU countries and SEE countries borrowing from family and friends is the most important source of borrowing. In Russia there is about equal reliance on each of these sources. People borrow for different purposes. Very common is getting a loan to acquire housing. In the Euro Area about one-fourth of adults report outstanding housing loans while glob­ ally the average stands at about 10 percent. In the transition countries the average is 13 percent but the variation is very high, from almost no housing loans in Uzbekistan to more than the Euro Area average in Estonia and the Slovak Republic. Interestingly, bor­ rowing money to start, operate, or expand a business has basically the same importance as taking out a housing loan. On the other hand, borrowing for health or medical purpos­

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Banking in the Transition Countries of Central, Southern, and Eastern Eu­ rope and the Former Soviet Union es is common only in former FSU and SEE countries where, on average, over 10 percent of adults report this as the purpose for borrowing.

36.4.4 Barriers to Financial Exclusion Despite the recent increase in financial inclusion in the transition countries, there are still many adults without an account. Global Findex surveys indicate that the most common barrier to having an account is insufficient funds (as reported by about half of the people without an account). The second reason, reported by almost one-third of the respondents in the transition countries, is that another family member already has an account. High costs constitute the third most cited reason for not having an account in the transition countries. High costs were cited by about half of the people without an account in Hun­ gary and Slovakia. Distrust in the financial system as a barrier does not score high global­ ly but it is important in our sample countries, most of which experienced financial crises, bank closures, and hyperinflation in the 1990s. Distrust is cited as a reason for not having an account by almost one-fourth of the respondents with higher proportions in Ukraine (50 percent) and Hungary (49 percent). This is consistent with the World Values Survey measure of trust in banking where the average response for Ukraine was 2.1 on the scale from 1 to 4, while the world average is about 2.5. Ironically, trust in banks is high in Uzbekistan (the average response, 3.24, is the highest among the 52 countries surveyed) where corruption is rampant and financial inclusion is really low. Increasing financial inclusion has become an important policy target in recent years. Sev­ eral transition countries have taken steps in this direction (e.g., the strategy for increas­ ing financial inclusion adopted in Russia in 2018 or national financial sector strategies addressing financial inclusion in Azerbaijan 2016, Belarus 2017–20, Latvia 2017–19 and Ukraine 2017–20). Although our analysis based on Global Findex data indicates a positive develop­ ment in the level of financial inclusion, even the most developed of transition countries usually do not reach the levels observed in the Euro Area. Account ownership indicates improvement in financial inclusion. There have been improvements in account usage, of­ ten driven by government policy, but the gap with the euro zone countries remains large and greater than the differences in account ownership. Account usage for savings and borrowing is significantly lower than in the euro zone and often lower than global aver­ ages. (p. 1150)

36.5 Conclusion Although banks in the transition countries have made rapid strides in improving perfor­ mance and services since the early 1990s, the banking sectors in the transition economies still do not possess the financial depth of their EU counterparts, even if bank­ ing services are often well developed in these countries. With a few exceptions, the tran­ sition in banking is complete. State mono-banking structures have been replaced by pri­ vately owned, market-oriented, well-capitalized banking institutions that are independent Page 22 of 26

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Banking in the Transition Countries of Central, Southern, and Eastern Eu­ rope and the Former Soviet Union of the government and state-owned clients. The legal environment has improved with re­ spect to bankruptcy laws, collateral laws, and confidence in the application of the law. Furthermore, banking regulatory and supervisory capabilities have developed consider­ ably. Thus, any evaluation of the structure of banking in transition countries must be posi­ tive. Except for some of the FSU countries, banks in the transition economies have be­ come part of the competitive global financial industry.

References Arakelyan, M. (2018). “Foreign Banks and Credit Dynamics in CESEE,” IMF Working Pa­ per No. 18/3. Barisitz, S. (2007). Banking in Central and Eastern Europe 1980–2006: A Comprehensive Analysis of Banking Sector Transformation in the Former Soviet Union, Czechoslovakia, East Germany, Yugoslavia, Belarus, Bulgaria, Croatia, the Czech Republic, Hungary, Kaza­ khstan, Poland, Romania, the Russian Federation, Serbia and Montenegro, Slovakia, Ukraine, and Uzbekistan (New York and London: Routledge). Beck, T. and Brown, M. (2015). “Foreign Bank Ownership and Household Credit,” Journal of Financial Intermediation, 24, 466–86. Bonin, J. P. (2004). “Banking in the Balkans: The Structure of Banking Sectors in South­ east Europe,” Economic Systems, 28, 141–53. Bonin, J. P. and Louie, D. (2017). “Did Foreign Banks Stay Committed to Emerging Europe During Recent Financial Crises?” Journal of Comparative Economics, 45(4), 793–808. Bonin, J. P. and Wachtel, P. (2003). “Financial Sector Development in Transition Economies: Lessons from the First Decade,” Financial Markets, Institutions, and Instru­ ments, 12, 1–66. Bonin, J. P. and Wachtel, P. (2005). “Dealing with Financial Fragility in Transition Economies,” in D. Evanoff and G. Kaufman (eds.), Systemic Financial Crises: Resolving Large Bank Insolvencies (Singapore: World Scientific Publishing), 141–59. Bonin, J. P., Hasan, I., and Wachtel, P. (2005a). “Bank Performance, Efficiency and Ownership in Transition Countries,” Journal of Banking and Finance, 29, 31–53. (p. 1151)

Bonin, J. P., Hasan, I., and Wachtel, P. (2005b). “Privatization Matters: Bank Efficiency in Transition Countries,” Journal of Banking and Finance, 29, 2155–78. De Haas, R. (2014). “The Dark and the Bright Side of Global Banking: A (Somewhat) Cau­ tionary Tale from Emerging Europe,” Comparative Economic Studies, 56, 271–82. De Haas, R., Korniyenko, Y., Pivovarsky, A., and Tsankova, T. (2015). “Taming the Herd? Foreign Banks, the Vienna Initiative and Crisis Transmission,” Journal of Financial Inter­ mediation, 24(July), 325–55.

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Banking in the Transition Countries of Central, Southern, and Eastern Eu­ rope and the Former Soviet Union Demirgüç-Kunt, A., Klapper, L., Singer, D., Saniya, A., and Hess, J. (2018). “The Global Findex Database 2017: Measuring Financial Inclusion and the Fintech Revolution,” World Bank. EBF (European Banking Federation) (2017). “EBF Facts & Figures,” available at: https:// www.ebf.eu/facts-and-figures/. EBRD (European Bank for Reconstruction and Development) (2006). “Finance in Transi­ tion. Transition Report 2006,” available at: https://www.ebrd.com/downloads/re­ search/transition/TR06.pdf. EBRD (2015). “Rebalancing Finance. Transition Report 2015–16,” available at: https:// www.ebrd.com/documents/oce/pdf-transition-report-201516-english.pdf. ECB (European Central Bank) (2017a). “Report of Financial Structures,” October 2017. ECB (2017b). “European Central Bank, Statistical Data Warehouse,” available at: https:// sdw.ecb.europa.eu/. Epstein, R. (2014). “When Do Foreign Banks “Cut and Run”? Evidence from West Euro­ pean Bailouts and East European Markets,” Review of International Political Economy, 21, 847–72. Hasan, I. and Marton, K. (2003). “Banking in Transition Economy: Hungarian Evidence,” Journal of Banking and Finance, 27, 2249–71. Haselmann, R. (2006). “Strategies of Foreign Banks in Transition Economies,” Emerging Markets Review, 7, 283–99. Haselmann, R. and Wachtel, P. (2007). “Risk Taking by Banks in the Transition Coun­ tries,” Comparative Economic Studies, 49, 411–29. Haselmann, R. and Wachtel, P. (2010). “Bankers Perception of the Legal Environment and the Composition of Bank Lending,” Journal of Money, Credit and Banking, 42, 965–84. IMF (International Monetary Fund) (2013). Financial Stability Assessment/Article IV 2013 on Austria. Impavido, G., Rudolph, H., and Ruggerone, L. (2013). “Bank Funding in Central, Eastern and South Eastern Europe Post Lehman: A ‘New Normal’?” IMF Working Paper No. 148/2013. Mérő, K. and Piroska, D. (2016). “Banking Union and Banking Nationalism—Explaining Opt Out Choices of Hungary, Poland and the Czech Republic,” Policy and Society, 35, 215–26. Popov, A. and Udell, G. (2012). “Cross-Border Banking, Credit Access and the Financial Crisis,” Journal of International Economics, 87, 147–61. Page 24 of 26

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Banking in the Transition Countries of Central, Southern, and Eastern Eu­ rope and the Former Soviet Union Steinherr, A. (2006). “Russian Banking since the Crisis of 1998,” Economic Change and Restructuring, 39, 235–59. World Bank (2018). Global Financial Development Database, available at: https:// www.worldbank.org/en/publication/gfdr/data/global-financial-development-data­ base.

Notes: (1) For additional information see Bonin and Wachtel (2003 and 2005), Bonin (2004) and Barisitz (2007). (2) The scale runs from 1 to 4+ where 1 represents little or no change from a rigid cen­ trally planned economy and 4+ represents the standards of an industrialized market economy. (3) Armenia, Azerbaijan, Belarus, Georgia, Kazakhstan, Kyrgyz Republic, Moldova, Tajik­ istan, Turkmenistan, Uzbekistan, Estonia, Latvia, Lithuania, Czech Republic, Hungary, Poland, Slovak Republic, Bulgaria, Croatia, Romania, Slovenia, Russian Federation, Alba­ nia, Bosnia and Herzegovina, Kosovo, North Macedonia FYR, Montenegro, Serbia, Ukraine. (4) Global Findex database 2017 defines “account ownership” as having an individual or jointly owned account either at a financial institution or through a mobile money provider. (5) All other figures concerning global data reported here come from this source.

Zuzana Fungáčová

Zuzana Fungáčová is a Senior Advisor at the Bank of Finland Institute for Economies in Transition in Helsinki. Her research interests are in banking, emerging markets and their financial sectors as well as financial stability. She has experience from the European Central Bank and was also a Visiting Economist at the Austrian Central Bank. She obtained her Ph.D in Economics from the Center for Economic Research and Graduate Education in Prague and served also as a research affiliate at the Insti­ tute of Economic Studies at Charles University in Prague. Her research has been published in academic journals including Journal of Banking and Finance, Journal of Financial Services Research, Journal of Economic Behavior & Organization, World Development, Journal of Macroeconomics, Economics of Transition, Regional Studies and China Economic Review. Iftekhar Hasan

Iftekhar Hasan is the E. Gerald Corrigan Chair in International Business and Finance at Gabelli School of Business, New York, USA. He serves as the scientific advisor at the Bank of Finland and is affiliated with the University of Sydney as a fractional Pro­ fessor. He is the managing editor of the Journal of Financial Stability and serves as Page 25 of 26

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Banking in the Transition Countries of Central, Southern, and Eastern Eu­ rope and the Former Soviet Union an associate editor for several other academic journals. His research interests are in the areas of financial institutions, corporate finance, and emerging economies. Pro­ fessor Hasan has numerous publications in print, including books and edited vol­ umes, and peer-reviewed journal articles in finance, economics, accounting, informa­ tion systems, and management journals. Laura Solanko

Laura Solanko is Senior Advisor at the Bank of Finland Institute for Economies in Transition (BOFIT), specializing in Russian economic developments. She received her doctoral degree from the University of Helsinki in 2007, majoring in economics. She was the Editor of BOFIT Discussion Papers and responsible for BOFIT Visiting Re­ searchers Programme for 2011–15, and continues to regularly contribute to BOFIT Weekly Review on Russia. Her current research interests include banking and finan­ cial markets in Russia and China, Russia–EU energy relations, and political economy in Russia. Her research has been published in, for example, the Journal of Banking and Finance, Public Choice, and Review of International Economics. Paul Wachtel

Paul Wachtel is a Professor of Economics at New York University Stern School of Business. He has been with Stern for over forty years and has served as department chair and Vice Dean. He is currently the Academic Director for the BS in the Busi­ ness and Political Economy Program. He has been a research associate at the Nation­ al Bureau of Economic Research, a senior economic advisor to the East West Insti­ tute, and a consultant to the Bank of Israel, the IMF, and the World Bank. He re­ ceived his B.A. from Queens College in 1966, his M.A. in Economics from the Univer­ sity of Rochester, and his D.Phil from the University of Rochester in 1971. His prima­ ry areas of research include the relationship of financial development to economic growth, monetary policy, central banking in the post-crisis world, and financial sector reform in economies in transition. He has published widely in these areas.

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Banking in Latin America: Developments and Prospects

Banking in Latin America: Developments and Prospects   Fernando J. Cardim De Carvalho, Luiz Fernando De Paula, and Jonathan Williams The Oxford Handbook of Banking (3rd edn) Edited by Allen N. Berger, Philip Molyneux, and John O. S. Wilson Print Publication Date: Oct 2019 Subject: Economics and Finance, Financial Economics, Urban, Rural, and Regional Economics Online Publication Date: Nov 2019 DOI: 10.1093/oxfordhb/9780198824633.013.37

Abstract and Keywords This chapter offers a unique portrayal of the evolution of banking in Latin America. We contextualize our analysis by providing a detailed assessment of how financial policy has evolved across the region beginning with development models of the post-1945 period. Events of the 1980s and 1990s are a source of recent developments, which we succinctly summarize as the financial deepening and growth of a market-oriented and more compet­ itive environment. Specific developments include the repeal of state involvement in bank­ ing, and bank privatization including wider penetration of domestic banking by foreign banks. We examine the effects of consolidation on banking activity before considering the special role development banks have come to play, especially following the global finan­ cial crisis. Throughout the chapter, we present data to inform our comparative analysis across regional banking sectors, and between Latin America and other economies. Keywords: bank privatization, consolidation, development banks, financial deepening, foreign banks, Latin Ameri­ ca

37.1 Introduction A deep transformation of banking systems in Latin America has taken place during the concluding years of the twentieth century and the nascent years of the new millennium. Liberal reforms were widely adopted in the region, frequently related to the financial crises experienced in Latin America in the 1980s and the first half of the 1990s. Common features of these reforms were the liberalization of interest rates, the attenuation of bar­ riers to entry in the provision of banking services, large-scale privatization of state-owned banks, and the facilitation of entry for foreign banks. In parallel, but in a largely indepen­ dent process, liberalization of the capital account of the balance of payments also influ­ enced the evolution of domestic financial systems, since it opened new opportunities of investment for resident wealth-holders at the same time in which it made possible for Page 1 of 60

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Banking in Latin America: Developments and Prospects non-residents to buy assets and offer financial services to residents. The downside of such a process, of course, is the increasing exposure of these economies to the volatility of in­ ternational financial markets. The joint impact of all these changes was to transform deeply the ways financial systems work in Latin America. In fact, the transformation process is still unfolding. Among the most visible changes already achieved is the strong process of bank consolidation that (p. 1153) has taken place in the period. Of interest are the effects of consolidation on com­ petition and efficiency in banking sectors. In September 2008, Latin American economies were hit by the shock waves generated by the closure of Lehman Brothers. Losses suffered by foreign investors in their markets of origin led them to repatriate their investments, depreciating local currencies (and/or de­ pleting international reserves to the extent that some local authorities tried to limit cur­ rency depreciation). Almost all Latin American countries have suffered, at some point in their recent history, serious balance of payments crises, so capital flow reversals led to a deterioration of expectations that amplified the impact of the initial shock. The economies and financial systems of Latin America were, in 2008, better placed to withstand the effects of such exogenous shocks than at any other time in the recent past. Since 2003, Latin America had enjoyed a general upturn in economic growth and macro­ economic stability, including falling inflation and improved fiscal positions (BIS, 2008). In Latin America, banks’ exposure to securitized credits was minimal because the regional market was relatively nascent and regional subprime mortgage securities markets did not exist. Hence, banks in Latin America were spared the credit and market value losses that plagued banking systems in the US, Europe, and, to some extent, Asia. Notwithstanding, the most important crisis transmission channel was the contractionary impact on trade that resulted from the transmutation of the financial crisis into a full-blown economic cri­ sis in 2009. However, the negative impact on the region was relatively more benign than in other emerging economies. In the aftermath of the global financial crisis (GFC) and in the developed and most emerg­ ing economies, private banks contracted sharply their loan growth rates. In Latin Ameri­ ca, however, the growth in lending by state-owned banks exceeded that of domestic and foreign banks, thereby, performing a countercyclical role. In some countries in Latin America, development banks were of paramount importance. Another factor that helped countries in Latin America to offset the contractions in trade with the US and Europe was the rapid growth of trade with China. China has become the second most important ex­ port market for Latin America and the Caribbean with exports increasing to 1.9 percent of GDP in 2017 from 0.4 percent in 2002 (Ray, 2018). The structure of this chapter is as follows. After this Introduction, section 37.2 provides an overview of the recent consolidation of banking sectors in Latin America. In section 37.3, we consider the evolution of financial policy and its contribution toward the recent consolidation process. Section 37.4 investigates the effects consolidation has had on banking sectors. Section 37.5 considers developments in bank regulation and supervision Page 2 of 60

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Banking in Latin America: Developments and Prospects and trends in regulatory capital and asset quality post GFC. Besides updating the chapter on Banking in Latin America in the previous edition of this Handbook, this chapter now includes a new section (37.6) on development banks, including how authorities across Latin America successfully used these institutions to combat the GFC. Last, we develop some concluding notes in section 37.7.

37.2 Banking Consolidation in Latin Amer­ ica: A Quick Overview (p. 1154)

Banking crises, financial deregulation and the globalization of financial services led to a significant increase in foreign bank penetration of emerging market banking sectors over the second half of the 1990s and into the 2000s, which raised levels of competition and forced both banks and their regulators to change their ways of doing business (Hawkins and Mihaljek, 2001). While these factors shaped the process of bank consolidation in de­ veloped and emerging markets, some specific features characterize consolidation in emerging markets (Gelos and Roldós, 2004; IMF, 2007). First, cross-border mergers and acquisitions (M&A) became an important source of consolidation in emerging markets, yet the exception in developed markets. Second, consolidation was a means to restruc­ ture emerging market banking sectors following financial crises rather than to eliminate excess capacity or improve bank efficiency, as in developed markets. Finally, emerging market governments actively participated in the consolidation process, whereas consoli­ dation tended to be “market-driven” in developed markets since it represented financial institutions’ response to the implementation of liberal and deregulatory policies of the 1970s and 1980s. A higher level of bank consolidation exists in Latin America compared to other emerging markets. National governments actively participated in bank restructuring and imple­ mented substantial bank privatization programs, although in countries such as Argentina and Brazil some large banks remain under state ownership. In the 2000s, the consolida­ tion process—especially in Brazil and Mexico—has become increasingly market-driven (as in developed markets). Generally, the desire to enhance competition and efficiency and, in some cases, to restructure public finances, formed the background to almost all privatiza­ tion programs in the region. The role played by foreign banks in the restructuring and consolidation of domestic banking sectors should not be underestimated. Banking crises across Latin America offered foreign banks an opportunity to expand their business, often by acquiring local financial firms, with encouragement provided by governments’ deregu­ latory policies and the need to recapitalize domestic institutions (CGFS, 2004). This has happened in Argentina, Brazil, and Mexico. Consequently, foreign banks’ shares of bank­ ing sector assets increased substantially in Latin America, exceeding shares found in Asia though not Central and Eastern Europe (Domanski, 2005). Recent developments suggest a partial reversal in the increase in foreign bank penetra­ tion in Latin America. IMF (2016, pp. 26–7) reports a new trend toward greater regional

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Banking in Latin America: Developments and Prospects integration following mergers and acquisitions by Latin American banks of international banks exiting from the region: a) Regional banks, especially Colombian banks, acquired the businesses of HSBC, Santander, BBVA and Citibank as they exited particularly from Central America, (p. 1155) but from also Paraguay and Peru; Colombian banks have attained a signifi­ cant market position in Central America, that is, 22 percent of assets on average; b) Two Brazilian banks have adopted a regional perspective and established a signifi­ cant presence across Latin America: Bank Itaú (a large universal bank) has the strength and the ambition to become the major regional player, expanding mainly via M&A (recent acquisition of Corpbanca in Chile), and through a few greenfield invest­ ments in Colombia and Mexico. Similarly, BTG Pactual (an investment bank) aspires to be the investment bank of the region—expanding throughout much of Latin Ameri­ ca following the withdrawal of global banks. Latin America had received record levels of foreign direct investment (FDI) in the 1990s, and net FDI has been increasing since the late 1990s for most Latin American countries. In 1998 alone, the region received an inflow of $76.7 billion, equivalent to 41 percent of total FDI to developing countries (ECLAC, 2000, pp. 35–6). However, the proportion of in­ flows to Latin America continually fell in the 2000s to 19.7 percent in 2007. A resurgence post crisis (24.8 percent in 2010) has withered with inflows returning to pre-crisis levels (19.9 percent in 2015). Yet, net FDI flows (to GDP) to Latin America compare favorably against other emerging markets. In 2015, Chile recorded the largest net inflow (8.4 per­ cent) followed by Uruguay (4.6 percent), Peru (4.4 percent), Brazil (4.1 percent) and Ecuador (4.0 percent). Regional inflows and the stock of inward FDI are concentrated in Brazil and Mexico. The stock of inward FDI as a share of GDP increased between 1998 and 2015 and now ac­ counts for a significant share of GDP for most countries in Latin America, particularly, Chile and increasingly so in Colombia, Mexico, Peru and Uruguay. The inward stock of FDI for Latin America stood at $1,600.6 billion in 2015. In comparison, China’s stock was equivalent to 76 percent of the Latin America total up from 40 percent in 2010 although China’s stock-to-GDP is relatively low when compared to countries in Latin America. Bank restructuring has increased the level of concentration in regional banking sectors. While bank numbers have fallen—considerably in some countries—the accompanying in­ creases in concentration were not as sharp. Table 37.1 shows five-firm asset concentra­ tion ratios (CR5) for banking sectors in Latin America plus data for a comparator group of emerging economies, the UK and US. Concentration levels in Latin America increased be­ tween 2003 and 2015 consistent with experiences in developed markets, the UK and US. Concentration increased by over 20 percentage points in Brazil (to 81 percent) and Colombia (to 78 percent), which indicates the continuation of a consolidation process, while levels fell by around 10 percentage points in Mexico (to 70 percent) and Bolivia (to 73 percent).

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Banking in Latin America: Developments and Prospects Table 37.1 Market Concentration and Foreign Bank Penetration

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Banking in Latin America: Developments and Prospects 5 Firm Concentration, %

Coun­ try

2003

2007

2010

2015

Ar­ genti­ na

63.1

56.1

59.5

57.5

Bolivia

82.1

97.6

78.5

Brazil

57.6

61.8

Chile

73.4

Colom­ bia

Foreign Bank Number % of All Banks

Foreign Bank Assets % of All Banks

2003

2004

2007

2013

2007

2013

35

32

32

29

27

25

73.0

45

40

30

36

18

16

76.1

80.5

34

36

40

19

25

15

73.2

72.1

67.7

42

45

41

–

42

33

52.7

69.4

67.0

77.9

24

29

42

10

14

15

Ecuad or

68.2

70.0

72.9

78.1

15

15

22

12

13

12

Mexico

81.4

76.8

74.1

70.1

49

39

37

82

78

70

Paragu ay

73.8

71.9

75.5

67.4

62

62

64

68

58

51

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Banking in Latin America: Developments and Prospects Peru

88.3

91.8

88.3

88.0

60

64

69

41

49

51

Urugu ay

72.3

81.7

76.3

84.2

78

80

78

50

47

92

Venezu ela

64.4

50.0

61.3

70.1

22

23

27

31

25

18

China

82.3

69.9

63.9

52.5

7

15

20

–

2

2

India

44.8

42.3

39.9

45.3

9

11

12

4

4

3

In­ done­ sia

66.1

58.4

57.9

56.5

29

46

48

30

23

27

Russia

47.7

28.8

36.2

53.3

12

17

17

7

10

8

S. Africa

99.9

98.9

99.3

99.0

17

22

24

22

23

23

Turkey

87.3

64.3

64.8

65.1

20

39

38

15

16

14

UK

48.2

76.7

75.5

71.4

51

56

58

9

14

14

US

31.0

43.7

48.1

46.5

21

26

31

20

22

11

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Banking in Latin America: Developments and Prospects Note: Data in italics are for the nearest year to that shown in the column. Source: World Bank, Global Financial Development Database; Claessens and Van Horen (2015).

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Banking in Latin America: Developments and Prospects In countries such as Mexico and Argentina, the rise in the level of consolidation was closely tied to foreign bank penetration. In Mexico, foreign banks had unrestricted access to all sectors of the banking market after the financial and exchange rate collapse of 1994–5, which forced the Mexican government to implement measures aimed at reducing the high insolvency of banks (including the acceleration of the process of (p. 1156) open­ ing-up to foreign investment), and became market leaders. By 2004, foreign banks held 82 percent of banking sector assets. Notwithstanding, a marked reduction in foreign bank share has taken place over the past decade, reaching 70 percent in 2013 from 78 percent in 2007 (Claessens and Van Horen, 2015). While foreign banks came to dominate domes­ tic banks in Argentina—as they increased their market share from 16.1 percent of total bank deposits in November 1994 to 51.8 percent in December 2001 (Fanelli, 2003, p. 52) —their presence partially wavered after the 2001–2 financial crisis as their market share declined while the market shares of private and mainly public-owned banks increased. The retrenchment caused foreign bank asset share to fall from 29 percent in 2004 to 25 percent in 2013, with foreign bank numbers falling by three percentage points from 35 percent to 32 percent (Claessens and Van Horen, 2015). Domestic private and public banks are market leaders in Brazil. Indeed, private-owned banks responded proactively to foreign bank penetration and became active in domestic M&A (Paula and Alves, 2007). Consequently, foreign bank assets fell to 15 percent from 25 percent between 2007 and 2015 (Claessens and Van Horen, 2015). The consolidation process in Chile proceeded more gradually: it has increased because of M&A in Spain (the home country of the par­ ent banks of the two largest banks in Chile); technically, the enlarged Spanish parent has operated its Chilean subsidiaries as individual entities (Ahumada and Marshall, 2001). Consistent with experiences across the region, foreign bank assets fell by nine percent­ age points to 33 percent in 2013 from 2007. Bank restructuring and privatization ushered in a new wave of cross-border (and domes­ tic) M&A activity. Cross-border bank M&A partially reflects country-specific factors: posi­ tively related to shared language (Spanish bank entry; Sebastián and Hernansanz, 2000) and geographical proximity (North American bank entry; Buch and DeLong, 2001); and the availability of access to large, relatively poor countries with widely spaced popula­ tions and underdeveloped financial sectors (Buch and DeLong, 2001; Focarelli and Pozzo­ lo, 2001). One can analyze M&A in terms of the financial condition of buyers and targets. An application to Brazil differentiates between M&A involving domestic-owned and for­ eign-owned banks. The results suggest domestic and foreign buyers acquired target banks that had alternative profiles: domestic buyers prefer to buy underperforming banks while foreign buyers tend to acquire large, slow growing institutions; the implication is that foreign banks see M&A as a vehicle to increase bank size and market share (Cardias Williams and Williams, 2008). One important development in Brazil after, and in consequence of, the 2008 crisis was the large bank merger between Itaú and Unibanco. However, the deal was more of an acqui­ sition of Unibanco, which had become weaker after suffering heavy losses from the de­ preciation of the Brazilian currency (the Real) following the collapse of Lehman Brothers. Page 9 of 60

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Banking in Latin America: Developments and Prospects Indeed, many large firms had bet that the Real would continue to appreciate and, as a consequence, suffered large losses. Claessens and Van Horen (2014) have constructed a database on foreign bank ownership from which we highlight the following features between 2003 and 2013. Either foreign bank penetration, measured as the percentage of foreign banks in the banking sector, or foreign bank assets share is much greater in Latin America than other emerging markets we select for comparison. Foreign bank asset penetration is lower than their number in much of Latin America barring Mexico and Uruguay, and Paraguay and Peru to a lesser extent. The level of foreign bank penetration is lower in 2013 compared to a decade earli­ er, which reflects difficulties foreign banks faced in some countries in Latin America, the expansion of private-owned banks, and use of state-owned banks to provide credit during the GFC (see Table 37.1). The changes in foreign bank penetration between 2006 and 2013 suggest one effect of the crisis has been to reduce foreign bank assets share across the region, and in countries such as Brazil and Mexico, by over ten percentage points. Colombia and Peru are exceptions.

37.3 The Evolution of Financial Policy in Latin America The process of transformation of Latin American banking systems shares common fea­ tures across countries including taking place in roughly the same period. However, the causes of the process diverged from country to country. Post-1945, Latin American (p. 1158) financial systems were typically repressed, and governments across the region attempted to accelerate economic growth and transform social and economic structures from the late 1940s albeit with varying success. The objective was to evolve into a devel­ oped country, and the way to achieve this was to industrialize as quickly as possible. In­ spired by the experiences of Central European countries (cf. Gerschenkron, 1962), Latin American governments, particularly in the largest countries (Brazil, Mexico, Argentina, and Chile) saw in the banking system a powerful instrument to centralize and direct the necessary resources to finance the growth of manufacturing production. Unwilling to rely on the eventual ability of freely operating financial markets to support an accelerated growth process, governments in those countries imposed financial repression (Fry, 1995). This consisted mostly of creating, or enlarging the functions of existing, state-owned banks, setting maximum interest rates to be charged on loans by private banks (frequent­ ly adopted in the context of usury laws), and directing the credit supplied by these banks to sectors considered strategic to enhance economic growth.

37.3.1 Financial Liberalization in Latin America: Causes and Out­ comes This chapter is not the place to assess how successful these initiatives were in promoting growth.1 The region suffered heavily with the oil shocks of the 1970s. The attempts to deal with the effects of those shocks by increasing short-term foreign debt led to the debt Page 10 of 60

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Banking in Latin America: Developments and Prospects crisis of the early 1980s. This brought the most important economies of the region to a standstill that lasted so long, commentators know it as the “lost decade of economic growth.” As part of the negotiated resolution package for that crisis, almost all countries in Latin America accepted to promote liberalizing reforms, including in the financial sec­ tor, and thereby ending the financial repression experiment. Chile was the pioneer in this process (see Foxley, 1983; Stallings and Studart, 2006). Lib­ eral reforms in banking markets, including privatization of state-owned financial institu­ tions, began right after the 1973 military coup that ousted then-President Salvador Al­ lende. The root cause of financial liberalization in the case of Chile was the radically con­ servative nature of the military regime led by General Pinochet, which aimed at erasing all and any trace of the policies adopted before. As it has happened in similar experi­ ences, strong liberalization policies created new profitable opportunities for banks that raised their competitiveness. However, financial regulation and bank supervision were de­ ficient, either because regulators lacked experience with open markets, or because the state was assumed to be an inefficient player in the economic game, so no investment in upgrading the skills of regulators and supervisors was made. Inevitably, as has been the general experience, this first wave of liberalization ended up generating a profound bank­ ing crisis in the early 1980s. To resolve the crisis, the government intervened heavily in the banking system. The authorities gave permission for banks to sell to the government their non-performing assets, under the obligation of buying them back over time in expectation of the resolution of the crisis. In addition, the adoption of tougher bank (p. 1159)

regulations aimed to prevent the disorderly expansion of the past from repeating itself. In the case of Mexico, less dramatic events were the inspiration for banking reforms (see Singh et al., 2005; Avalos and Trillo, 2006; Stallings and Studart, 2006). Mexico had also followed the general pattern, set by the largest economies of Latin America in the postwar period, of creating strong state-owned banks to stimulate economic development. Room for private banks was very limited and foreign banks were all but banned from op­ erating in domestic markets. As late as in the early 1980s, rules forbade foreign banks from controlling more than 7 percent of the net worth of the largest banks. The 1982 debt crisis, the ensuing period of economic stagnation, and the conditionality clauses included in the rescue packages negotiated by the Mexican government with creditor banks and multilateral institutions, led the Mexican authorities to a change of heart. The govern­ ment endeavored to promote liberal reforms in the economy, of which banking reform was an important element (see de Vries, 1987). Later, Mexico’s accession to NAFTA strengthened this drive, which led to a gradual but steady reduction of barriers to entry for US and Canadian banks.2 The defining act of Mexico’s reforms, however, was the bun­ gled privatization process of 1991, which took place when there were still strong restric­ tions against foreign participation in the domestic banking sector. Executives with little or no experience of running banks acquired the privatized banks at excessive prices. The rush to recover their investments and to obtain profits led to a credit boom unrestrained by any kind of proper regulation. Credit rapidly expanded without due attention to credit risks. The fast expansion ultimately caused the 1994 crisis and renationalization of bank assets. In fact, the Mexican government, first in 1995, and again in 1996, bought the Page 11 of 60

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Banking in Latin America: Developments and Prospects huge amount of non-performing assets in banks’ balance sheets through a crisis resolu­ tion entity created to manage the problem (Fobaproa).3 Contrary to what was done in Chile, however, those assets were not reabsorbed by the banking system; rather, taxpay­ ers’ money paid for the losses of banks, since Fobaproa’s liabilities were transformed into public debt. The weakness of the banking system led the Mexican government to change the law to allow wider participation of foreign banks in domestic markets, including the acquisition of local problem banks. Consequently, the market share of foreign banks in Mexico was over 80 percent in 2000 (Hernandez-Murillo, 2007, p. 416). In Brazil and Argentina, the causes of the liberalization process were somewhat more complex due to persistently high inflation. In both cases, most (but not all) reforms were elements of price stabilization strategies. Up until the 1970s, the Brazilian banking sys­ tem (p. 1160) had been highly repressed (Carvalho, 1998). State-owned institutions domi­ nated the banking system even though the presence of private banks was strong. Foreign banks serviced mostly foreign companies, and as in other countries, were not allowed to reach domestic clients (Carvalho, 2000). In the mid-1960s, the structure of the Brazilian financial system changed with the imposition of a segmented market model like the one set by the Glass–Steagall Act in the US. Under this model, commercial banks provide short-term credit and payment services; investment banks develop an incipient securities market; specialized institutions finance the acquisition of durable consumption goods; and public institutions give financial support to productive investments in manufacturing, agriculture, and construction.

37.3.2 A New Model and Restructuring Initiatives: Privatization and Universal Banking Thanks to loopholes in the legislation, financial conglomerates, with interests in virtually all segments of the financial system, and in non-financial sectors as well, emerged in the 1970s and early 1980s. In parallel, the acceleration of inflation after the oil shocks of the 1970s steadily reduced the access of private borrowers to credit markets. Banks were in­ creasingly devoting the resources they controlled to buying public debt issued by the fed­ eral government, which was unable to control its fiscal deficits. Market segments other than deposit-taking and public-debt-buying, and the institutions supposed to operate them, gradually faded and disappeared. Under these circumstances, in 1988, the Central Bank of Brazil passed a resolution to adopt a German-type universal banking model in place of the segmented model.4 The same resolution lifted interest rate controls. Finan­ cial liberalization in Brazil, therefore, began as the result of an acknowledgment that past regulations had become obsolete rather than being the first step of a well-defined strate­ gy (Paula, 2011). In Argentina, developments that were to some extent similar took place in the same peri­ od.5 Accelerating inflation, as in Brazil, was the most important problem faced by policy­ makers at the time. By the late 1980s, the many failed attempts at price stabilization had virtually depleted the arsenal of instruments to control inflation. Moreover, foreign credi­ tors demanded the implementation of financial liberalization policies as a conditionality Page 12 of 60

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Banking in Latin America: Developments and Prospects clause in the resolution package for the debt crisis of 1982. The Argentine government had little choice but to begin a liberalization process, by freeing interest rates and mov­ ing toward a universal bank model, leaving to each financial institution the choice of sec­ tors where to operate. After 1991, with the adoption of the Convertibility Plan (also known as the Caval­ lo Plan, named after then Finance Minister Domingo Cavallo), in contrast to the more pragmatic Brazilian experience, a radical liberalization strategy was put in place. A cen­ tral element of this strategy was to open the domestic banking market to foreign banks. The implementation of a restructuring and concentration policy, a response to contagion from Mexico’s Tequila crisis that severely tested both the Convertibility system and the fi­ nancial sector, promoted widening access to foreign banks; consequently, foreign bank penetration of the Argentinean banking system increased dramatically. Among the ten largest banks in Argentina in December 2000, seven banks were foreign-owned, two were public-owned—the market leaders, Banco de la Nación (Federal) and Banco de la Provin­ cia de Buenos Ayres (provincial)—and only one bank was domestic, private-owned (Paula and Alves, 2007, p. 97). (p. 1161)

The process of privatization of state-owned banks in Argentina illustrated an important change of views that had already taken place in countries such as Chile and Uruguay. In these cases, the adoption of liberalization was a strategy rather than an expedient, and privatization was not a temporary convenience or an unavoidable evil. Bank privatization was an element, no matter how important, of an overall liberalization process expected to help the region to overcome its long-term inefficiencies. The deep crisis of the early 2000s led to a partial repudiation of this view in Argentina. It is still dominant in Chile and Uruguay, even after the election of center-left administrations at the beginning of the new century. In Brazil, in contrast, this path was explored with caution. In fact, the end of inflation in 1994 caused severe stress in many banks that earned their profits mostly from securing deposits to finance the purchase of public debt, with yields indexed to the rate of infla­ tion. When inflation fell precipitously, after the implementation of the Real Plan in 1994, many banks were practically bankrupt. The Brazilian government, to avoid panic, took measures to allow for splitting problem banks into two parts: a “sane” one, with healthy assets and its corresponding share of liabilities; and the failed one, with the non-recover­ able assets. Other banks eventually bought into the sane part while the Central Bank liq­ uidated the failed part. Argentina adopted the same scheme based on rules used in the US to deal with Continen­ tal Illinois Bank in the mid-1980s (De la Torre, 2000). Like in Brazil, Argentina avoided a panic at the cost of pushing bank consolidation forward. In Brazil, the Central Bank de­ cided to invite foreign banks to buy the domestic banks that the authorities wanted to pri­ vatize, or the banks facing difficulties that would probably lead them to fail. The rationale behind the decision to widen access to foreign banks was to prevent excess concentration

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Banking in Latin America: Developments and Prospects that the authorities expected to ensue, should the leading domestic banks acquire prob­ lem banks. Although, the Brazilian government never lifted the legal restriction banning the entry of new foreign banks in the domestic system, it does allow “exceptions” if needed. On stabi­ lizing the economy, and after selling problem banks, the government authorized practical­ ly no new foreign bank into the country. Mexico was the last large country in Latin Ameri­ ca to open its market to foreign banks. However, Mexico granted foreign (p. 1162) banks the most unrestrained access to domestic markets, leading to an almost complete disap­ pearance of domestic private banks, let alone state-owned banks.

37.3.3 Global Financial Crisis and Consolidation The GFC changed the appreciation of the role of state-owned banks in some countries. In the case of Brazil, the three largest federal-owned banks (the National Development Bank, BNDES, Bank of Brazil and the National Savings Bank, CEF) served as instruments for the implementation of anticyclical policies, supplying credit when private banks re­ treated in the face of increased uncertainty. As a result, the market share of federalowned banks increased during the crisis. These banks maintained their lead position, even after private banks expanded to recover at least part of their lost market share. Ar­ gentina has empowered state-owned banks as instruments of anticyclical policy (BCRA, 2012). In fact, since April 2012, the Argentine Central Bank is responsible for promoting growth, full employment, and income distribution, besides maintaining the purchasing power of the peso. This had led to the creation of many programs to spur growth of credit to non-financial firms. The trend toward consolidation is not new to the region. Previously, waves of bank consol­ idation had taken place in some countries, mostly induced by domestic policies. In Brazil, for instance, in the early 1970s, the Federal government promoted consolidation under the expectation that taking advantage of supposedly strong economies of scale would al­ low the reduction of interest rates necessary to keep the economy growing as rapidly as it was. Financial repression was still in force and foreign participation was limited. Increas­ ing efficiency via scale economies should lighten the burden of interest rate controls on banks, attenuating the incentives to evade these controls. In any case, Latin American economies are still relatively small. If to the small dimension of these economies one also adds the generally high degree of income concentration, markets for banking services would be even smaller. If scale economies exist in banking, one would expect to find a rel­ atively high degree of concentration in the region anyway. The push for consolidation came from many sources. Political and ideological factors were very important in the case of Chile in the mid-1970s, to allow banks to decide their own policies, including larger and stronger banks to absorb smaller ones. After the early 1980s crisis, the push for consolidation was strengthened by the assumption that larger banks, especially foreign ones, could manage risk more efficiently, especially if prudential regulation was improved, thereby making the system more stable. Page 14 of 60

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Banking in Latin America: Developments and Prospects Concerns with systemic stability help to explain consolidation, in one way or another, in nearly all the region’s recent experiences. Many of the regulatory initiatives adopted to strengthen the stability of banking systems contributed to push consolidation forward. The introduction of modern payments systems, the increasing use of ATMs, Internet banking and so forth, also led to increased consolidation if individual banks must provide their own equipment and other facilities. Even privatization initiatives were defended with systemic safety arguments, on the notion that state-owned financial institutions (p. 1163) increase the risk of feeding dangerous forms of crony capitalism. Consequently, at the turn of the millennium, the most important banking systems in Latin America came to exhibit a relatively similar ownership structure.

37.4 Financial Penetration in Latin America Latin American financial systems share similar features: financial depth is limited; finan­ cial sectors are bank-based since stock markets are mostly small and illiquid, and corpo­ rate debt markets even more so; intermediation margins are high by international stan­ dards; banking sector concentration has increased; and bank lending is low relative to overall economic activity. A limited access to bank credit and uncertainty about financial stability contributed to economic volatility in the region (Singh et al., 2005). In the previ­ ous edition of this chapter, we noted that the trajectory of financial deepening and access to financial services would depend on developments to institutional environments that condition the effective operation of financial intermediaries and financial markets. In what follows, we note a recent, general increase in financial depth and improvements in access to financial services in Latin America but add the caveat that heterogeneity re­ mains an important feature. Whereas financial systems across Latin America grew deeper since the mid-1990s (Rojas Suarez, 2007), the level of financial depth is low in comparison with industrialized coun­ tries and other emerging market regions such as East Asia. Table 37.2 portrays trends in financial depth based on alternative indicators for the region and comparator countries. The data show the heterogeneity across Latin America and we summarize the following observations. The ratio of liquid liabilities-to-GDP shows levels of financial depth have ac­ celerated between 2003 and 2015 with few ill effects from the GFC, for instance, Brazil and Paraguay, Peru and Uruguay, albeit to a lesser extent. Financial deepening stalled somewhat between 2007 and 2010 but resumed positive trajectory to 2015 in Chile, Colombia, and Ecuador. Although central bank lending increased as part of resolution strategies to deal with the GFC, nevertheless, the trend is toward a general and significant deepening of private sec­ tor financial activity in most countries. Using the ratio of stock market capitalization-toGDP to proxy developments in equity markets, stock market depth in Latin America lags behind banking sectors except in Chile where depth compares to industrialized countries (Betancour, De Gregorio, and Jara, 2006; Rojas Suarez, 2007). Despite a deepening of stock markets pre-2008, the trend has reversed subsequently with notable reversals in Page 15 of 60

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Banking in Latin America: Developments and Prospects Brazil, Colombia, and Peru. Broadly speaking, stock market depth in Latin America com­ pares unfavorably to some other developing economies. Besides the historically and generally low, albeit deepening, levels of credit, the pattern of credit growth in Latin America has been marked by boom and bust cycles, particularly (p. 1164) in economies with lower proportions of bank credit-to-GDP. Credit had expanded sharply across the region in the early 1990s, in part due to increased capital inflows, but it collapsed in many cases after the mid-1990s banking crises and remained subdued for many years. Only after 2004, did credit begin to recover on the back of stronger econom­ ic growth, easier global monetary conditions, and progress in bank restructuring (Jean­ neau, 2007). Yet, in most Latin American countries, macroeconomic instability has been a critical factor in holding back financial system development and generating a high volatil­ ity of credit growth. For example, high short-term interest rates used to combat inflation or defend an exchange rate simply added to banks’ funding costs and increased loan-de­ fault rates (Singh et al., 2005). The third indicator in Table 37.2 shows the amount of private credit by banks and other fi­ nancial institutions in GDP. The post-crisis data confirm the heterogeneous nature of fi­ nancial developments in Latin America. Private credit is more important to the economy in Chile (106.9 percent in 2015) and Brazil (71.3 percent) with strong growth in private bank credit between 2010 and 2015 in Paraguay (23.4 percent) and Bolivia (18.4 per­ cent). However, private credit holds a greater share of GDP in industrialized countries and in other emerging economies like China.

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Banking in Latin America: Developments and Prospects (p. 1165)

Table 37.2 Financial Depth and Credit Indicators

Liquid Liabilities-toGDP, %

Stock Market Cap-toGDP, %

Private Credit-to-GDP

Bank Credit-to-Bank Deposits

Co un try

20 03

20 03

20 03

20 03

20 03

20 07

20 10

20 15

20 03

20 07

20 10

20 15

20 03

20 07

20 10

20 15

Ar­ ge nti­ na

27. 1

21. 0

12. 0

55. 6

21. 0

6.5

7.5

11. 7

37. 8

21. 6

19. 8

16. 7

21. 0

19. 4

13. 2

8.0

Bo­ livi a

52. 6

16. 4

46. 9

10 2.7

16. 4

6.2

7.1

12. 7

50. 9

53. 6

51. 7

62. 1

16. 4

17. 3

15. 5

15. 9

Br azil

45. 1

32. 0

28. 2

64. 6

32. 0

12. 5

17. 9

20. 4

61. 6

82. 4

94. 7

11 0.2

32. 0

77. 1

69. 6

31. 1

Chi le

32. 8

88. 1

71. 2

13 5.9

88. 1

2.3

1.7

0.5

75. 2

79. 2

10 2.8

12 3.0

88. 1

11 2.1

13 7.2

82. 1

Col om bia

14. 4

12. 0

20. 9

15 3.1

12. 0

0.5

0.5

0.0 3

29. 3

36. 9

65. 1

51. 7

12. 0

40. 2

64. 4

33. 3

Page 17 of 60

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Banking in Latin America: Developments and Prospects Ec ua dor

17. 0

6.1

16. 6

10 2.7

6.1

2.3

0.3

1.2

18. 4

21. 2

23. 6

28. 5

6.1

8.1

6.8

6.7

Me xi­ co

23. 0

15. 1

15. 0

65. 2

15. 1

0.0

0.0

0.0

33. 3

38. 7

47. 5

59. 7

15. 1

35. 6

39. 5

35. 0

Par ag ua y

20. 0

2.6

16. 7

10 3.8

2.6

3.8

3.0

0.1

18. 2

16. 0

31. 4

55. 1

2.6

3.2

2.0

3.8

Pe­ ru

29. 5

21. 9

20. 1

86. 1

21. 9

0.0

0.0

0.5

23. 6

20. 7

25. 9

36. 6

21. 9

54. 2

61. 1

33. 7

Ur ug ua y

51. 9

0.5

52. 8

10 7.1

0.5

7.3

9.1

11. 0

63. 8

27. 5

24. 9

35. 4

0.5

0.6

0.4

0.3

Ve nez uel a

19. 5

4.1

8.6

55. 7

4.1

0.4

1.5

13. 7

12. 4

22. 3

22. 3

39. 2

4.1

3.5

1.5

3.7

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Banking in Latin America: Developments and Prospects Chi na

14 3.5

31. 0

11 6.6

26 7.5

31. 0

3.6

3.9

2.2

12 7.2

10 9.0

12 9.9

15 3.4

31. 0

80. 2

63. 8

64. 1

In­ dia

58. 8

44. 6

29. 9

61. 2

44. 6

2.0

3.3

4.0

50. 1

57. 7

62. 2

69. 3

44. 6

11 3.3

89. 6

71. 5

In­ do ne­ sia

45. 1

18. 4

19. 2

47. 2

18. 4

7.7

4.3

3.2

38. 7

31. 5

29. 9

41. 9

18. 4

40. 5

39. 9

42. 0

Ru ssi a

25. 9

41. 6

17. 8

96. 4

41. 6

0.9

0.8

0.5

24. 3

36. 2

45. 4

63. 2

41. 6

10 0.8

57. 5

24. 1

So uth Afr ica

41. 9

14 8.4

11 4.7

11 6.2

14 8.4

0.7

0.4

1.3

15 9.5

19 2.6

19 1.8

19 5.8

14 8.4

25 2.4

24 7.8

24 5.4

Tu rke y

33. 7

17. 3

13. 1

41. 2

17. 3

2.1

1.0

0.5

37. 3

46. 3

67. 4

75. 0

17. 3

35. 3

37. 3

25. 7

UK

10 4.1

10 9.3

13 0.0

0.0

10 9.3

0.6

0.4

0.0

13 0.0

16 4.1

19 0.2

13 4.7

10 9.3

12 9.5

12 1.8

11 2.1

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Banking in Latin America: Developments and Prospects US

62. 7

11 0.7

16 5.0

76. 9

11 0.7

5.3

12. 4

23. 5

18 9.6

21 6.4

22 0.5

21 9.9

11 0.7

13 7.4

10 8.3

14 3.3

Note: Data in italics are for the nearest year to that shown in the column. Source: World Bank, Global Financial Development Database.

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Banking in Latin America: Developments and Prospects There are legitimate concerns that the composition of bank portfolios probably led to some crowding out of private sector credit. This was because of banks’ tendencies to hold high proportions of government securities in their portfolios, which possibly reflected his­ torical patterns of behavior associated with hyperinflation. In the latter 1990s, banks re­ placed non-performing loans with sizable portfolios of government securities in Argenti­ na, Mexico, and Venezuela. Whereas banks reacted to fiscal consolidation (in Argentina, Mexico, and Brazil) by reducing the amount of government securities in their portfolios, the onset of the GFC in 2007 caused a reversal as bank liquidity ratios increased in most countries, often by significant amounts (Argentina, Bolivia, Mexico, and Peru). In most other countries, the private sector receives the bulk of domestic credit although govern­ ment and state-owned firms receive relatively more credit in the larger economies of Brazil (41 percent of GDP in 2015), Mexico (17.7 percent) and Argentina (8.8 percent). Despite a general growth in deposit-taking, the opportunity to raise deposits in Latin America in general remains, especially in countries such as Mexico (29.3 percent of GDP) and Peru (28.7 percent). The final indicator is the ratio of bank credit-to-bank deposits and a proxy for intermedia­ tion. In the previous edition, we reported that the level of intermediation increased in most countries between 1990 and 2000. Consistently high levels of banking sector inter­ mediation occur in Chile (149.8 percent in 2015), Colombia (180.8 percent in 2015) and Paraguay (101.3 percent in 2015). Post-crisis, intermediation is higher in Brazil (by 51.3 percent between 2007 and 2015) and Peru (23.4 percent). However, intermediation levels have weakened over time in Bolivia and Ecuador. If financial depth and access to financial services are to increase, there should be devel­ opments in the institutional environment, which conditions the effective operation of fi­ nancial intermediaries and financial markets. Honohan (2007) provides comparative data on households’ access to financial services. He reports that access in Chile is (p. 1166) closest to the levels observed in industrialized countries; over 90 percent of households have access to financial services in Western industrialized countries compared with 60–80 percent in Chile, 40–60 percent in Brazil and Colombia, and 20–40 percent in Argentina and Mexico. Recent World Bank (2015) data show the percentage of adults with an ac­ count has increased in Brazil (to 68 percent) and Argentina (to 50 percent); access in Bo­ livia, Ecuador, and Uruguay lies between 40 and 50 percent with a higher level in Venezuela (57 percent) and a lower level in Peru (29 percent). Whereas debit card use has increased across the region, the proportion of account holders with cards exceeds 50 percent only in Brazil (59 percent) and Chile (54 percent). Payments by debit cards and credit cards are highest in these two countries. The financial inclusion data exhibit the heterogeneity that characterizes financial development in Latin America, which infers the potential for future growth. The World Bank’s Global Financial Development Database contains time series on several indicators of access to financial services. We consider trends in branching and automated teller machines (ATM) provision (commercial bank branches and ATMs both per 100,000 adults). In contrast to developing economies where bank branching is declining, there is Page 21 of 60

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Banking in Latin America: Developments and Prospects mild growth in Latin America over 2007 to 2015 although the branch numbers are lower than in the UK (25.2 in 2013) and US (32.9 in 2015) with the exception of Colombia and Ecuador (257.7 and 75.8 in 2015, respectively). While the growth in ATMs is considerably higher than branches in Latin America, only Peru (119.2) and Brazil (114.0) come any­ where near to the UK (131.6). Nevertheless, ATM provision has increased significantly between 2007 and 2015 in Argentina (from 28.5 percent to 60.6 percent in 2015). Chile, Mexico, and Uruguay each have more than 50 ATMs per 100,000 persons in 2015. ATMs are the main mode of withdrawal; 71 percent of account holders use ATMS for this pur­ pose in Latin America as a whole with higher levels in Argentina (78 percent), Brazil (75 percent), Chile and Colombia (both 81 percent), Uruguay (85 percent) and Venezuela (79 percent). The evolution of interest rate spreads infers how effective financial liberalization has been in Latin America. Weaknesses in the institutional environment are a partial explana­ tion for the relatively high, by international standards, spreads observed and the disper­ sion of spreads across the region (Gelos, 2006). In the first edition of this book, we high­ lighted a narrowing of bank interest spreads in Latin America from 1993 to the mid-2000s. Table 37.3 updates the story for 2005 to 2016. The convergence of spreads has continued to 2016 with very low rates in Chile (1.8 percent) and Mexico (3.4 percent). Current spreads range between 10 and 15 percent in Paraguay, Peru, and Uruguay, but Brazil re­ mains an outlier (40 percent). Table 37.3 shows deposit rates, loan rates and the real lending rate. Spreads move more with loan rates than deposit rates, meaning that a shock that causes spreads to widen will raise lending rates rather than decrease deposit rates. Lending rates remain relatively and stubbornly high in Latin America in comparison to other emerging economies. Lending rates in Brazil exceeded 50 percent in 2005 and 2016 with real rates exceeding 40 percent. Negative real lending rates existed in 2016 in Argentina and Venezuela. (p. 1167)

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Banking in Latin America: Developments and Prospects Table 37.3 Interest Rates, % Deposit Rate

Lending Rate

Real Lending Rate

Loan–Deposit Spread

Country

2005

2016

2005

2016

2005

2016

2005

2016

Argenti­ na

3.8

24.3

6.2

31.2

−3.8

−6.7

2.4

6.9

Bolivia

4.9

1.4

16.6

8

10.1

9.9

11.7

6.6

Brazil

17.6

12.4

55.4

52.1

44.6

40.4

37.8

39.7

Chile

3.9

3.8

6.7

5.6

−0.9

1.8

2.8

1.8

Colombia

7

6.8

14.6

14.6

8.5

8.3

7.6

7.8

Ecuador

3.6

4.8

9.6

–

1.8

–

6

–

Mexico

3.5

1.3

9.7

4.7

4.1

0.1

6.2

3.4

Paraguay

1.7

3.8

29.9

18.1

18

12.2

28.2

14.3

Peru

2.6

2.6

25.5

16.5

21.3

12.4

22.9

13.9

Uruguay

2.8

5.6

13.6

16.2

12.8

8.5

10.8

10.6

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Banking in Latin America: Developments and Prospects Venezuel a

11.6

15.1

16.8

20.8

−9.9

−16.5

5.2

5.7

China

2.3

1.5

5.6

4.4

1.6

3.1

3.3

2.9

India

–

–

10.8

9.7

6.2

5.8

–

–

Indonesia

8.1

7.2

14.1

11.9

−0.2

9.2

6

4.7

Russia

4

7

10.7

12.6

−7.2

8.7

6.7

5.6

South Africa

6

7.2

10.6

10.5

4.9

3.2

4.6

3.3

UK

–

–

4.6

0.5

2

−1.2

–

–

US

3.5

–

6.2

3.5

2.9

2.2

2.7

–

Source: World Bank Development Indicators, Monetary Indicators.

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Banking in Latin America: Developments and Prospects Across Latin America and despite a deepening of credit markets, credit is not only scarce but costly too. IADB (2005) data show interest margins in Latin America (at 8.5 percent) exceeded margins in East Asia and the Pacific (5.1 percent) and the developed countries (2.9 percent), although these were slightly lower than Eastern Europe and Central Asia (8.8 percent) between the mid-1990s and mid-2000s. World Bank data through to 2015 confirm the relatively high bank net interest margins in Latin America. Notwithstanding, margins are narrowing, and are lower than pre-crisis levels in Brazil, Chile, Colombia, Mexico, Paraguay, Peru, and Uruguay. The downward trend in bank net interest margins, however, is associated with diminishing levels of bank profitability measured by return on assets in Brazil, Chile, Colombia, and Mexico. One possible explanation might be the in­ creased holdings of liquid assets by banks in those countries before and after the GFC (see Table 37.4). Liquidity levels are larger in Latin America compared to other emerging market countries, such as China and India. Liquidity appears to have increased between 2007 and 2010 because of the GFC inducing a change in bank behavior. However, levels are particularly high in Brazil and Argentina, and Mexico and Uruguay to a lesser extent. The relationship between market concentration and interest rate margins is scarcely ana­ lyzed in Latin America. Recent evidence suggests market share exerts little or no influence on interest rate margins; indeed, lower spreads result from markets that are more competitive and from improvements in efficiency (Chortareas, Garza-Gar­ (p. 1169)

cía, and Girardone, 2012).

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Banking in Latin America: Developments and Prospects (p. 1168)

Table 37.4 Margins, Diversification, Liquidity, and Profitability, %

Net Interest Margin

Non-interest Incometo-Total Income

Liquidity

ROA

Co un try

20 03

20 07

20 10

20 15

20 03

20 07

20 10

20 15

20 03

20 07

20 10

20 15

20 03

20 07

20 10

20 15

Ar­ ge nti­ na

1.9

3.9

4.9

6.8

73. 7

57. 8

61. 8

15. 6

19. 2

34. 5

42. 7

55. 0

– 3.6

1.3

2.7

2.5

Bo­ livi a

4.8

5.1

4.5

5.6

48. 1

45. 0

43. 7

15. 8

10. 7

13. 5

20. 7

17. 3

0.3

2.2

1.5

1.0

Br azil

8.9

7.9

6.3

4.3

30. 5

32. 0

30. 5

18. 1

63. 5

55. 3

55. 6

61. 3

2.0

2.7

1.6

1.1

Chi le

3.6

4.9

4.7

3.5

44. 8

21. 7

34. 3

15. 8

28. 2

15. 1

20. 1

19. 3

1.6

2.0

1.7

1.1

Col om bia

5.1

6.4

6.4

4.9

60. 5

45. 2

39. 4

17. 7

32. 5

19. 4

19. 8

25. 3

2.1

2.3

2.2

1.4

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Banking in Latin America: Developments and Prospects Ec ua dor

7.1

6.0

6.0

6.5

45. 0

45. 4

38. 7

15. 4

37. 8

35. 9

30. 8

23. 8

0.6

1.4

1.4

0.8

Me xi­ co

5.7

8.2

5.6

5.4

40. 9

28. 2

32. 2

14. 4

36. 1

41. 4

48. 6

42. 8

1.5

2.5

1.5

1.2

Par ag ua y

7.6

9.6

7.7

6.1

82. 3

49. 4

55. 9

71. 7

55. 8

39. 8

34. 3

32. 6

– 0.0 1

3.2

3.1

2.0

Pe­ ru

5.2

7.4

7.1

7.1

32. 7

29. 3

34. 0

14. 7

27. 0

21. 8

37. 2

35. 0

1.1

2.7

2.4

1.9

Ur ug ua y

5.6

8.1

5.3

5.5

63. 9

41. 6

28. 9

82. 7

59. 3

52. 1

46. 6

44. 2

– 1.7

2.9

0.7

1.0

Ve nez uel a

16. 4

8.3

5.6

12. 5

23. 3

24. 9

33. 8

13. 6

23. 1

34. 2

28. 7

33. 4

5.2

2.5

1.5

3.5

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Banking in Latin America: Developments and Prospects Chi na

3.3

3.5

2.6

2.7

7.8

12. 2

14. 0

4.0

17. 2

20. 6

15. 6

16. 4

0.7

1.3

1.1

1.0

In­ dia

3.3

3.3

3.1

2.8

39. 3

30. 1

34. 6

22. 3

11. 2

11. 8

8.5

12. 3

1.0

1.0

1.1

0.3

In­ do ne­ sia

5.3

6.1

6.8

5.8

25. 9

21. 2

23. 4

11. 7

34. 4

36. 2

30. 3

14. 9

1.8

1.7

2.2

1.7

Ru ssi a

5.4

5.4

4.3

2.6

46. 6

54. 5

92. 3

37. 1

44. 3

43. 4

51. 1

39. 6

2.4

2.1

0.5

– 0.1

So uth Afr ica

11. 7

3.5

3.0

3.0

30. 9

44. 2

47. 4

5.5

5.4

18. 2

17. 3

22. 9

0.1

1.5

1.0

0.9

Tu rke y

5.5

6.1

4.8

3.5

50. 3

32. 6

30. 8

13. 0

61. 2

20. 7

14. 4

13. 9

2.1

3.0

2.4

1.0

UK

1.9

0.9

2.2

1.4

61. 9

55. 9

46. 0

10. 8

49. 8

49. 9

51. 4

45. 1

1.2

0.7

0.0

0.2

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Banking in Latin America: Developments and Prospects US

3.7

3.1

3.8

3.2

43. 2

40. 8

37. 0

23. 0

18. 5

22. 6

20. 5

21. 5

1.4

0.9

0.7

1.1

Note: Data in italics are for the nearest year to that shown in the column. Liquidity: liquid assets-to-deposits and short-term funding. Source: World Bank, Global Financial Development Database.

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Banking in Latin America: Developments and Prospects Such findings, however, do not generalize across the region: in Mexico, for instance, Mau­ dos and Solis (2011) attribute the strong growth in banking system profitability over the immediate pre-crisis period to monopolistic competition. In Central America, bank inter­ est margins have slightly ticked upwards over the period 1998–2014; the wider margins between loan and deposit rates reflecting the exercise of market power by banks (Birch­ wood, Brei, and Noel, 2017). Tables 37.4 and 37.1 indicate concomitant downward move­ ments in net interest margins and increases in market concentration across the region with some exceptions. There is variation in movements in net interest margins across Latin America with margins trending downwards over time in most countries, with Ar­ gentina a notable exception. Notwithstanding, net interest margins in Latin America are higher than in other emerging markets and developed markets.

37.5 The Effects of Banking Consolidation 37.5.1 Market Structure, Privatization, Foreign Bank Penetration, and Bank Performance The privatization of state-owned banks dramatically altered the market structure of bank­ ing sectors in Latin America. Privatization has transformed the governance structure of domestic banks as new, private owners (domestic and foreign) assumed control of banks. Generally, and across Latin America, state-owned banks had served political and social purposes and they shared certain characteristics: weak loan quality, underperformance, and poor cost control. Indeed, privatization was a cheaper option than restructuring and recapitalization. The outcomes of bank privatization have varied across countries. For Ar­ gentina and Brazil, the evidence suggests that privatized bank performance improved post-privatization (Berger et al., 2005 for Argentina; Nakane and Weintraub, 2005 for Brazil). In stark contrast, the 1991 privatization program in Mexico failed in the mid-1990s with the onset of the Tequila crisis. The crisis revealed deep-seated problems in the banking sector, obscured by weak property rights and ineffective bank regulation, which failed to prevent imprudent behavior by newly privatized banks. Bank privatization failed to the tune of a bailout costing an estimated $65 billion (Haber, 2005). Yet, unlike in Argentina and Brazil, the 1991 Mexican program disbarred foreign banks from entering the auctions. Between February 1995 and December 1998, a post-Tequila second round of restructuring and privatization liberalized the treatment of foreign ownership of domestic banks. This facilitated a large-scale transfer of bank (p. 1170) ownership from domestic to foreign hands: foreign banks held 5 percent of banking sector assets in 1995 that leapt to 82 percent by 2003 (Haber, 2005); in 2013, foreign bank asset share stood at 70.1 per­ cent (Claessens and Van Horen, 2015; see Table 37.1). In 2018, foreign banks owned two of the three largest banks in Mexico. One must be cautious when interpreting the apparent positive outcome of bank privatiza­ tion. The observed post-privatization improvements in bank performance may reflect se­ lection bias. To raise the viability of state-owned banks to prospective buyers, the authori­ ties sanitized bank balance sheets and privatized healthy banks while funding bad banks Page 30 of 60

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Banking in Latin America: Developments and Prospects using public funds (Clarke and Cull, 2000). On Argentina, Berger et al. (2005) report sta­ tistically significant differences in the balance-sheet structures of privatized and non-pri­ vatized state-banks. Brazil adopted similar transfers. The evidence indicates that utiliza­ tion of the bad bank model did influence post-privatization bank performance. Bank privatization assisted foreign bank penetration in Latin America as foreign banks acquired large, domestic banks. Policymakers expected greater foreign bank entry to in­ crease competition, leading in turn to efficiency gains and banking sector recapitaliza­ tion. Foreign bank entry did increase banking sector capitalization in Mexico between 1997 and 2004 by more than $8.8 billion—equivalent to 42 percent of total banking sec­ tor capital in 2004 (Schulz, 2006). Country-level evidence suggests bank efficiencies im­ proved at the same time as foreign bank penetration increased. Arguably, this is too gen­ eral a claim since there are caveats to consider. First, one should distinguish between the performance of existing foreign banks and domestic banks acquired by foreign banks— mainly large banks purchased via cross-border bank M&A. We refer to the latter as for­ eign bank acquisitions. Second, it is difficult to disentangle the effects of foreign bank en­ try from other liberalization effects that could have affected bank efficiency. Finally, many studies use proxy measures of efficiency like the ratio of overhead costs-to-assets; there is limited evidence where econometric estimates of bank efficiency were employed (Berger, 2007). One exception finds inter-country differences in bank cost efficiencies with large banks more efficient than both very small and very large banks. Inefficient banks tended to be small, undercapitalized, relatively unprofitable, less risk averse, facing unstable deposit bases and intermediating less. Country-level factors positively relate to bank-level cost ef­ ficiencies: faster economic growth rates, a denser demand for banking services, and low­ er levels of market power (hence, more competitive) (Carvallo and Kasman, 2005). It is difficult to separate the effects of bank privatization and greater foreign participation on bank condition and performance. Earlier studies find little difference in the perfor­ mances of private-owned domestic banks and foreign-owned banks, though the former did outperform state-owned banks (Crystal, Dages, and Goldberg, 2002). Average loan growth rates were higher at foreign banks compared to domestic banks (in Argentina, Chile, and Colombia), and loan growth stronger at existing foreign banks over acquired foreign banks. In explanation, management at foreign bank acquisitions (p. 1171) focused on restructuring the former domestic banks and integrating operations with the parent (foreign) bank. This infers that foreign acquisitions adopt a defensive strategy toward market share and growth until the integration process is complete. The cautious nature of foreign bank strategies explains why foreign banks, and especially foreign bank acquisi­ tions, achieve better loan quality than domestic banks, although stronger provisioning and higher loan recovery rates lead to weaker profitability at foreign banks. Foreign banks tend to be relatively liquid, rely less on deposit financing, and realize stronger loan growth during episodes of financial difficulty. The available evidence attributes the rela­ tively superior efficiency in intermediation of foreign banks to their skills in evaluating credit risks and allocating resources at a faster pace than domestic-owned banks (Crys­ Page 31 of 60

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Banking in Latin America: Developments and Prospects tal, Dages, and Goldberg, 2002). Saez-Fernandez, Picazo-Tadeo, and Beltran-Esteve (2015) compare the performances of domestic and foreign banks in Latin America and the Caribbean in 2001–13 to determine if efficiency differentials reflect differences in man­ agerial ability and/or restrictions imposed using different technologies. Their evidence shows foreign banks employ superior technologies that realize higher levels of technical efficiency. In Argentina, foreign banks typically entered the market via cross-border M&A rather than de novo entry, and targeted larger and more profitable domestic banks. On average, loan quality, capitalization, and profitability were better at foreign banks than domestic (Clarke, Crivelli, and Cull, 2005). Berger et al. (2005) summarize the effects of gover­ nance changes on bank performance: state-owned banks underperform against both do­ mestic and foreign banks due partly to poor loan quality associated with directed lending and subsidized credit. The privatization of provincial banks realized efficiency gains as the amount of non-performing loans fell and profit efficiencies increased. However, im­ provements in profit efficiency may simply reflect selection bias, since cost efficiencies exhibited little change before and after privatization. M&A activity involving domestic banks and foreign bank entry had little effect on bank performance (Berger et al., 2005). These findings do not apply to Brazil. Foreign banks in Brazil had difficulty in adapting to the peculiarities of the Brazilian banking sector and the dominance of private domestic banks (Paula, 2002). Incidentally, the empirical record is inconclusive on whether foreign banks are more efficient than domestic banks (Guimarães, 2002; Paula, 2002). One study finds foreign banks can realize a good (cost and profit) efficiency performance by either establishing new affiliates or acquiring domestic banks (Tecles and Tabak, 2010). Another study, however, shows state-owned banks to be significantly more cost efficient than both foreign and domestic-owned banks across 2000 to 2007, which confirms predications of the “home field advantage hypothesis” (Staub, Souza, and Tabak, 2010). This is unsurprising in the light of evidence that the operational characteristics and bal­ ance sheets of domestic and foreign banks are similar (Carvalho, 2002). Hence, the ex­ pected benefits of foreign bank entry have been slow to materialize in Brazil, because for­ eign banks witnessed and graduated toward operational characteristics similar to large private domestic banks (Paula and Alves, 2007). (p. 1172)

37.5.2 Market Concentration and Competition Effects

The ongoing consolidation process increased concentration in banking sectors in Latin America. Whereas policymakers expected higher concentration to increase competition and realize bank efficiency gains, it was possible that powerful, larger banks could exploit their market power and not behave more competitively. This alternative scenario sug­ gests that the evolution of highly concentrated market structures could retard the deep­ ening of financial intermediation and the development of efficient banking sectors (Rojas Suarez, 2007). If a non-competitive market structure induces banks into oligopolistic be­

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Banking in Latin America: Developments and Prospects havior, the implication is that further consolidation could incentivize banks to exploit mar­ ket power and not prioritize improving efficiency. It is an empirical matter to establish if bank consolidation (greater market concentration) raises competition and banking sector efficiency, or instead realizes heightened market power for banks. Some degree of market power can check if bank risk-taking and trade­ offs exist between competition and financial stability. One difficulty when considering the relationship between consolidation and competitive conditions is how to measure compe­ tition. Studies commonly employ the H statistic, which is the sum of the elasticities of bank revenue with respect to input prices (Panzar and Rosse, 1987). Using this approach, banks in Latin America operate under monopolistic conditions, consistent with results from industrialized countries and other emerging markets. Some studies focus on the relationship between market concentration and bank efficiency (measured by parametric or non-parametric techniques) in Latin America in a test of the so-called “quiet life” hypothesis. It posits a negative relationship between bank efficiency and market power because greater concentration—due to M&A—leads banks to exploit market power and behave less competitively. In contrast, the “efficiency structure hypoth­ esis” proposes that the expected relationship is positive (due, among other factors, to the possibility for large banks to exploit scale economies). Empirical evidence fails to support conjecture of the quiet life hypothesis in Latin American banking sectors; rather, bank re­ structuring promoted competition and yielded bank efficiency gains under conditions of monopolistic competition (Williams, 2012). Efficiency gains, especially scale efficiencies, positively and significantly affect bank profitability, thereby confirming predications of the efficiency structure hypothesis, most notably in Argentina, Brazil, and Chile (Chortar­ eas, Garza-García, and Girardone, 2011). Evidence shows banks in Latin America are more cost efficient than they are profit efficient; that the bulk of inefficiency derives from the revenue side is indicative of a certain level of market power (Tabak, Fazio, and Ca­ jueiro, 2011). Importantly, increases in consolidation did not weaken competitive conditions (Gelos and Roldós, 2004; Yeyati and Micco, 2007; Yildirim and Philippatos, 2007). Despite the gener­ al finding, some country-level features and some inconsistencies between studies are worth noting. For instance, banking sector competition has increased in Argentina and has remained constant in Mexico from the mid-1990s into the new millennium; competi­ tive conditions in Brazil and Chile are reported to have changed little (Gelos and Roldós, 2004) or weakened (Yildirim and Philippatos, 2007). In general, the literature rejects the notion of collusion between banks; some evi­ dence from Brazil suggests banks possess some degree of market power (Nakane, 2001; Nakane, Alencar, and Kanczuk, 2006). Other Brazilian evidence reveals complexities asso­ ciated with the identification of competition effects. That Brazilian banking operates un­ der conditions of monopolistic competition does not generalize across bank ownership and bank size. While small banks and state-owned banks operate under monopolistic con­ ditions, large banks and foreign banks behave competitively. Belaisch (2003) contends (p. 1173)

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Banking in Latin America: Developments and Prospects such differences indicate markedly different competitive conditions in local markets and the national market. In local markets, private-owned banks are more pro-competitive than state-owned banks, although the latter enter markets which the former do not service (Coelho, de Mello, and Rezende, 2007). Small and large banks in Argentina and Chile also face different competitive conditions (Yildirim and Philippatos, 2007). Evidence from Colombia finds more competition reduces banks’ market power (Barajas, Steiner, and Salazar, 1998). Differently from Brazil and Colombia, evidence from Mexico suggests that efficiency gains may have translated into extraordinary profits for banks, being the result of a re­ duction in competitive rivalry in banking markets. Banks used a cross subsidization strat­ egy, granting loans with very small margins and recuperating this loss by setting higher margins on deposits, which proved very profitable (Maudos and Solis, 2011). During the banking restructuring period (1993–2005), evidence attributes the high net interest mar­ gins to operating costs and market power (Maudos and Solis, 2009). The loss of social welfare attributable to the exercise of market power exceeds welfare gains emanating from improved cost and profit efficiencies. Furthermore, an inverse relationship exists be­ tween market power (in setting the price of loans) and cost efficiency (Solis and Maudos, 2008). Table 37.5 shows indicators of bank capitalization (bank capital-to-total assets), bank sta­ bility (Z score), profitability (ROE—return on equity), and leverage (ratio of assets-to-eq­ uity) for selected years between 2003 and 2015. At first sight, greater competition brought about by the changes in the banking industry in the 1990s has not weakened bank safety. Latin America banking sectors seem sufficiently capitalized with little evi­ dence to suggest a shock to bank capital from the GFC. As of 2015, there is little varia­ tion in capitalization across Latin America, and capitalization has compared favorably with other emerging markets since 2007. The Z score indicator of bank stability is a prod­ uct of bank profitability and leverage. Leverage has increased gradually between 2003 and 2015 in several countries and has fallen in some, with the largest reductions occur­ ring between 2003 and 2007 (in Ecuador and Uruguay). Leverage in Latin America com­ pares favorably with other emerging markets, such as, China, India, Russia, and South Africa as well as the UK in 2015. The strong performance in terms of capital helps to off­ set greater variation in bank profitability (ROE). Bank profitability generally improved be­ tween 2003 and 2007 before falling because of the crisis episode. What is worrying is that bank profitability has not rebounded between 2010 and 2015 although ROE exceeds 10 per cent in all countries except Ecuador. Relatively, profitability in Latin America com­ pares favorably with developed and other emerging markets. (p. 1175) The interval data show the most stable banking sectors, measured by the Z score, are in Mexico (18.3), Pe­ ru (14.0), Paraguay (12.2) and Brazil (11.5) in 2015. The data suggest that the mainte­ nance of stability is due to a strengthening of bank capital positions. Nevertheless, the profitability of banking sectors in Latin America exceeds the industrialized countries where stability would also appear to reflect (supported) capital levels.

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Banking in Latin America: Developments and Prospects (p. 1174)

Table 37.5 Bank Capital, Stability, Profitability, and Leverage

Capital-to-Assets

Z score

ROE

Leverage

Co un try

20 03

20 07

20 10

20 15

20 03

20 07

20 10

20 15

20 03

20 07

20 10

20 15

20 03

20 07

20 10

20 15

Ar­ ge nti­ na

11. 9

13. 1

11. 9

12. 3

3.3

6.6

6.9

7.4

– 32. 5

11. 5

25. 1

21. 8

9.0

8.8

9.2

8.8

Bo­ livi a

12. 1

9.0

8.4

7.7

13. 1

12. 3

10. 6

9.4

2.7

22. 8

17. 0

13. 2

8.4

10. 5

11. 6

12. 8

Br azil

9.6

11. 3

11. 0

8.5

15. 9

15. 1

13. 1

11. 5

19. 5

27. 6

17. 4

13. 1

9.6

10. 4

10. 9

12. 1

Chi le

7.3

7.1

7.1

7.6

8.8

8.8

7.7

7.1

17. 5

23. 5

22. 1

14. 1

11. 0

11. 7

12. 8

12. 8

Col om bia

11. 6

12. 9

10. 3

14. 1

6.5

6.9

7.7

6.2

19. 8

20. 6

16. 8

12. 4

9.6

8.8

7.7

8.9

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Banking in Latin America: Developments and Prospects Ec ua dor

8.8

8.1

8.9

13. 0

4.7

5.1

4.6

5.1

14. 6

19. 9

13. 4

7.4

23. 1

13. 9

9.8

9.2

Me xi­ co

11. 4

9.6

10. 4

10. 4

19. 6

26. 3

20. 4

18. 3

13. 6

18. 0

13. 1

11. 5

9.2

7.2

8.8

9.5

Par ag ua y

9.5

9.7

9.4

7.2

9.9

14. 8

13. 5

12. 2

– 0.0 5

26. 6

29. 8

19. 2

9.3

8.2

9.6

9.5

Pe­ ru

9.3

8.8

9.5

10. 1

14. 8

14. 9

15. 4

14. 0

10. 6

28. 1

23. 7

20. 2

9.7

10. 3

9.7

10. 4

Ur ug ua y

7.2

10. 5

9.5

8.5

1.9

6.7

5.8

5.1

– 28. 5

30. 2

6.7

10. 8

16. 5

10. 6

9.3

10. 9

Ve nez uel a

14. 3

9.4

9.8

10. 5

12. 0

9.4

6.9

6.6

36. 0

19. 0

14. 5

46. 7

6.9

7.5

9.8

13. 5

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Banking in Latin America: Developments and Prospects Chi na

3.8

5.7

6.1

8.4

18. 7

28. 3

25. 5

28. 6

18. 3

18. 9

18. 8

14. 7

25. 1

14. 9

17. 0

14. 3

In­ dia

5.7

6.4

7.1

7.2

7.4

8.4

9.7

9.1

20. 7

16. 5

15. 7

4.3

20. 0

16. 2

14. 3

13. 8

In­ do ne­ sia

10. 4

9.2

10. 7

13. 6

3.8

4.1

4.5

5.2

21. 1

16. 7

20. 9

13. 2

11. 9

9.9

9.5

7.8

Ru ssi a

14. 6

13. 3

12. 9

8.9

8.7

6.8

6.3

4.3

13. 0

15. 7

3.9

– 1.7

5.3

7.5

8.4

27. 6

So uth Afr ica

8.0

8.0

7.0

7.0

21. 8

12. 4

13. 0

13. 9

0.7

25. 5

14. 4

15. 1

6.1

17. 1

15. 1

16. 4

Tu rke y

13. 7

12. 8

12. 3

11. 0

7.5

9.3

9.4

7.2

25. 1

26. 6

19. 4

9.4

11. 8

9.0

8.2

9.4

UK

6.6

5.5

5.4

6.8

18. 0

6.1

6.5

9.8

10. 8

19. 7

– 0.4

3.5

9.3

28. 0

24. 4

15. 7

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Banking in Latin America: Developments and Prospects US

9.2

10. 3

12. 7

11. 7

23. 6

24. 6

26. 7

27. 7

14. 9

8.6

6.0

9.3

10. 8

9.8

9.0

8.8

Note: Data in italics are for the nearest year to that shown in the column. Source: World Bank, Global Financial Development Database.

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Banking in Latin America: Developments and Prospects One should read these data with some care, though. It is true that the 1990s and the 2000s witnessed a widespread effort at modernization of regulatory and supervisory methods and institutions everywhere in Latin America. Nevertheless, in part the data may be hiding one important source of fragility, that is, the dependence of the banking indus­ try, at least in some of the largest economies, on the supply of credit to the government. Public debt securities tend to benefit from zero risk weighting (and thus do not require any capital to cover credit risk) adding one more incentive to banks to accumulate them, instead of private credit. As a result, in countries such as Argentina, Brazil, or Mexico, high capitalization may not necessarily translate into higher defenses against insolvency, but in fact, to higher dependency on Treasury policies. It is clear from the data that banking sectors across the region were appearing to have become more efficient over time by realizing lower cost–income ratios. However, data for 2015 signal possible problems in Uruguay (96.9 percent), Argentina (92.1 percent), (p. 1176) Paraguay (86.5 percent) and Brazil (81.8 percent) with each banking sector expe­ riencing a sharp deterioration in efficiency between 2010 and 2015 (see Table 37.6). Ex­ amining the ratio of overhead cost-to-assets suggests the problem for Brazilian banks re­ lates to income generation since overhead costs are among the lowest in the region. Ar­ gentina fits this pattern whereas worsening cost control is a concern for banks in Paraguay and Uruguay. In 2015, the cost and efficiency performance of banks in Latin America was inferior to banks in other emerging markets, which implies the regulatory authorities should take note.

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Banking in Latin America: Developments and Prospects Table 37.6 Cost Structure and Efficiency Overhead Cost-to-Assets, %

Cost-to-Income, %

2003

2007

2010

2015

2003

2007

2010

2015

Argenti­ na

4.2

4.9

6.2

5.7

92.6

66.6

59.5

92.1

Bolivia

6.0

5.8

4.8

4.2

75.0

69.6

68.0

78.5

Brazil

6.1

5.5

4.1

3.1

62.2

56.4

54.6

81.8

Chile

3.0

2.5

3.1

2.2

54.8

46.9

47.9

56.7

Colombia

7.2

5.8

4.9

3.3

66.5

56.5

54.2

66.5

Ecuador

7.8

6.6

5.7

5.0

75.2

68.0

71.2

79.9

Mexico

4.5

5.0

3.7

3.6

62.0

52.2

51.9

68.0

Paraguay

27.5

9.4

8.6

16.0

95.0

70.4

69.3

86.5

Peru

4.5

4.6

4.3

3.4

66.1

50.4

47.0

53.8

Uruguay

9.6

6.8

5.1

22.6

87.4

59.9

72.8

96.9

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Banking in Latin America: Developments and Prospects Venezuel a

8.5

4.6

3.9

5.2

56.7

56.1

64.0

53.5

China

1.4

1.2

0.9

1.2

43.2

36.3

36.3

49.0

India

2.4

2.2

1.9

2.1

48.7

50.6

45.0

64.8

Indonesia

3.2

3.5

3.7

3.2

52.8

53.2

48.0

58.2

Russia

4.5

6.6

80.0

2.5

54.4

63.0

98.7

67.1

South Africa

11.5

3.2

3.1

2.9

71.7

54.9

57.9

100.7

Turkey

5.7

3.6

2.8

2.1

60.5

43.1

43.1

61.0

UK

2.9

1.1

0.5

1.7

64.1

57.3

56.3

118.0

US

3.3

2.9

2.8

2.5

56.3

61.6

58.2

72.5

Note: Data in italics are for the nearest year to that shown in the column. Source: World Bank, Global Financial Development Database.

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Banking in Latin America: Developments and Prospects In the discussion so far, no attempt has been made to disentangle the impact of foreign bank entry on competition. A priori greater foreign bank penetration should increase competition, and offset potential growth in domestic bank market power resulting from higher concentration. Consistent with expectations, cross-country evidence suggests in­ creased foreign bank penetration raises the level of competition (Yildirim and Philippatos, 2007). An alternative view claims increased concentration produces little effect on com­ petition and financial stability; rather, foreign bank entry causes competitive conditions to weaken (Yeyati and Micco, 2007). Intuitively, foreign banks typically acquire domestic banks under duress and consequently operate with relatively high interest margins. For new foreign owners, the franchise value of high margins, and the time needed to trans­ form the fortunes of their acquisitions, can explain why increased foreign bank penetra­ tion is associated with weaker, rather than stronger competition. While this possibility is inconsistent with policymakers’ objectives, the franchise value of high margins serves to discipline bank risk-taking because of fears of a dissipation of higher levels of bank prof­ itability. In short, although foreign bank entry may weaken competition, it appears to ex­ ert a beneficial effect on banking sector stability (Yeyati and Micco, 2007). Foreign bank entry raises expectations of more competition that conditions how domestic banks behave, thereby constraining their market power (Claessens, Demirgüç-Kunt, and Huizinga, 2001). Evidence suggests this is the case in Latin America: greater foreign bank penetration lowered interest margins and profits at domestic banks (Yildirim and Philippatos, 2007). Individual country studies offer a rich interpretation of events. Evi­ dence from Colombia suggests foreign bank and domestic bank behavior began to evolve differently following the announcement (in 1990) of impending financial liberalization policies (Barajas, Steiner, and Salazar, 2000). This study controlled for other liberalizing reforms that could affect bank behavior; for instance, differentiating foreign bank entry from entry of new domestic firms, and controlling for the opening of the capital account plus improvements made to bank regulation and supervision. Whereas foreign bank entry conditions domestic bank behavior by reducing excess intermediation spreads over mar­ ginal cost, the effect of new domestic entrants on behavior is greater and reduces non-fi­ nancial costs and interest spreads. The Colombian evidence suggests that bank behavior reflects the degree of market power of banking groups; since foreign banks had relatively little market power they were more able to adapt to changes in competitive conditions (Barajas, Steiner, and Salazar, 2000). In Mexico, the lower administrative costs of foreign banks released downward pressure on administrative costs across all banks, which improved bank efficiency (Haber and Musacchio, 2005). Others, for example Schulz (2006), suggest a limited impact of foreign bank entry on bank efficiency because the low level of competitive intensity in the bank­ ing sector abated pressures for banks to improve operational efficiency. Evidence from Argentina and Brazil reports of no significant difference in the behavior of foreign and do­ mestic banks with both types of bank reacting similarly to the macro-institutional environ­ ment (Paula and Alves, 2007).

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Banking in Latin America: Developments and Prospects

37.5.3 Consolidation and the Allocation of Credit The governance changes resulting from bank privatization and foreign bank penetration raised concerns of possible adverse effects on the supply of bank credit. Three concerns found a voice: first, greater foreign bank penetration would affect the stability of bank lending; second, foreign bank entry and/or new private ownership of banks might lead to a reallocation of credit toward certain geographic or product market segments; and third, given the governance changes, would bank credit respond to market signals? Foreign bank penetration has raised foreign banks’ share of bank lending in Latin Ameri­ ca. However, foreign bank lending is concentrated in specific market segments, mostly commercial loans markets (including government and interbank sectors) in Argentina, Colombia, and Mexico (Barajas, Steiner, and Salazar, 2000; Dages, Goldberg, and Kinney, 2002). In these countries, foreign banks limit their exposure to the household and mort­ gage sectors. In Chile, household credit has dominated foreign banks’ loan portfolio in­ creasing from 18.4 percent to 27 percent of total foreign bank loans between 1990–9 and 2000–5 (Betancour, De Gregorio, and Jara, 2006). In Argentina and Brazil, foreign and do­ mestic banks compete in loans markets and share loan portfolio characteristics (Dages, Goldberg, and Kinney, 2002; Paula and Alves, 2007). However, foreign banks in Argentina weight the loan portfolio toward relatively less risky loans (Dages, Goldberg, and Kinney, 2002), which is not the case in Brazil where there is no distinction between interest rates charged by foreign banks and domestic banks, hence the claims that variations in pricing occur within the foreign bank and domestic bank sectors rather than between the two (Carvalho, 2002). Interestingly, the negative impact of the GFC on foreign bank lending to Latin America was cushioned by the specific nature of foreign bank operations in the region. This is one of the reasons why the retrenchment of foreign bank credit to the region was significantly less severe in comparison to other emerging markets. Indeed, the expansion of foreign bank activities in Latin America in the 2000s has largely taken the form of increased do­ mestic currency lending by their local affiliates rather than direct cross-border lending in foreign currencies from headquarters. Furthermore, local affiliates’ funding mostly comes from an expanding domestic deposit base rather than from parent banks or offshore wholesale markets; this feature provided a more stable source of funding during the GFC. Consequently, the resilience of domestic financial systems to external financial shocks has increased (Kamil and Rai, 2010). The effect of bank ownership on credit growth in developing economies, before and after the GFC, explains variation in behaviors. While domestic private banks in both Eastern Europe and Latin America experienced a sharp contraction in lending during the crisis, notable differences in the behavior of foreign and state-owned banks were ob­ served across the regions. In Eastern Europe, loan growth of foreign banks fell more than that of domestic private banks during the crisis, and state-owned banks did not act coun­ tercyclically. However, in Latin America state-owned bank-lending growth exceeded do­ mestic private and foreign-owned banks (Cull and Martínez Pería, 2013). (p. 1178)

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Banking in Latin America: Developments and Prospects Foreign banks are an important source of finance for specific customer segments achiev­ ing higher loan growth (better quality and less volatile) than domestic banks (especially vis-à-vis state-owned banks) (Dages, Goldberg, and Kinney, 2002). Foreign banks—and private domestic banks—are responsive to market signals: in particular, lending is pro­ cyclical and sensitive to movements in GDP and interest rates, which is indicative of transactions-based activities. The finding of higher loan growth and lower volatility at for­ eign banks—even during crisis periods—underscores their role as important stabilizers of bank credit (Dages, Goldberg, and Kinney, 2002). After being granted unrestricted access in 1997, foreign banks came to dominate the Mexican banking sector quicker than they had done in other countries: in 1997, foreign banks supplied 11 percent of bank credit which grew to 83 percent in 2004 (Haber and Musacchio, 2005). During this time, a credit crunch occurred and private sector lending in real terms fell by 23 percent between December 1997 and December 2003 (Haber, 2005). On appearance, foreign bank penetration altered bank lending strategies, but this was not the case because the acquired banks had begun to reduce private lending before acquisition. Prior to the 1991 bank privatizations, the ratio of commercial bank loans-toGDP was 24 percent and rose to 26 percent in 1996; subsequently, it declined to 14 per­ cent in 2003 (Haber, 2005). Furthermore, the behavior of foreign bank acquisitions, pre and post M&A, differed little from domestic banks. In brief, the credit crunch was driven by factors affecting all banks and was unrelated to foreign bank entry. In Argentina, bank privatization and foreign bank entry raised fears of a reallocation of bank lending. Initially, fears arose because the acquirers of privatized provincial banks tended to be small, wholesale banks based in Buenos Aires, which were expected to raise deposits in the provinces and allocate resources more in the Buenos Aires province (Clarke, Crivelli, and Cull, 2005). State-owned bank lending had been geographically di­ versified, though tending to concentrate more in the public sector with fewer manufactur­ ing loans. Other concerns were that the volume of bank credit would decrease post priva­ tization because the transfer of non-performing loans to bad banks meant the size of the privatized provincial banks was smaller than pre-privatization (Berger et al., 2005). Since foreign banks were located mostly in Buenos Aires and financed large-scale manufactur­ ing and utilities firms in that province, commentators questioned foreign bank commit­ ment to diversify lending to the provinces (Berger et al., 2005). Temporarily, privatization and foreign bank entry disrupted credit in the 1990s. Disrup­ tions were most pronounced in provinces that had privatized banks; credit levels fell but quickly returned to pre-privatization levels once privatized banks increased in (p. 1179) size. Privatization did not affect lending by private domestic or foreign banks. For foreign bank acquisitions, lending grew in importance and as a ratio of total assets, with loans growth allocated more toward consumers than manufacturing (Berger et al., 2005). Fears that foreign banks would concentrate their lending in Buenos Aires did not materialize. Foreign banks did enter provincial markets, and did so aggressively in provinces that had privatized their banks. In contrast, the newly privatized banks decreased lending relative to total assets to control risk by raising prudence (Berger et al., 2005). In summary, for­ Page 44 of 60

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Banking in Latin America: Developments and Prospects eign bank penetration did lead to an increase in provincial lending because foreign banks offset changes in the lending of domestic banks (Clarke, Crivelli, and Cull, 2005).

37.5.4 Consolidation and Interest Rate Spreads Finally, we review the effects of foreign bank penetration and market concentration on the evolution of bank interest rate spreads and the process of financial intermediation. We determine the effects by comparing spreads charged by foreign banks and domestic banks with evidence coming from several countries (Argentina, Chile, Colombia, Mexico, and Peru). Foreign banks have operated with lower spreads compared with domestic banks (especially de novo foreign banks), but the main impact of foreign bank penetration has been the inducement for all banks to reduce costs rather than a marked decline in spreads. Concentration, on the other hand, could offset the apparent benefit of foreign bank penetration, since higher concentration could raise operational costs and thereby widen spreads, especially for domestic banks (Martínez Pería and Mody, 2004). The convergence of spreads continues to the present. Spreads are correlated more with loan rates than deposit rates (especially in Argentina and Peru) meaning that a shock that causes spreads to widen will raise lending rates rather than decrease deposit rates. While Brazilian spreads remain the highest in the region, nevertheless, the spread in 2015 was around 14 percentage points below the 2003 level. Oreiro and Paula (2010) report that spreads are particularly affected by risk variables (risk premia, interest rate volatility), output growth and the level of short-term interest rates. Whereas spreads in Paraguay (16.2 percent in 2015) and Peru (13.8 percent) exceed most other countries in the region, these spreads have fallen between 2010 and 2015. In Argentina, Chile, Mexico, and Venezuela, spreads are below 5 percent in 2015.

37.6 Regulatory Developments Post GFC Financial regulation had been in a process of modernization at least since the early 1990s in the most important Latin American economies, all of which had adhered to the Basel Agreement of 1988 and its additional guidelines. By 2008, when the crisis (p. 1180) be­ came international, many of these countries were in the process of implementation of Basel II. Following the GFC, the Basel Committee on Banking Supervision was directed to increase their membership to include the G20 members, instead of the original G10. The same happened with the Financial Stability Forum, transformed into the Financial Stabili­ ty Board. The widened membership of these entities now included the members of the G20 plus three Latin American countries: Argentina, Brazil, and Mexico. The three Latin American countries saw themselves as morally obligated to follow their decisions. Accordingly, they committed to implement Basel III, the set of toughened capi­ tal coefficients defined to deal not only with the risks already defined in Basel II and Basel 2.5, but also to comply with the new rules included in Basel III, such as the liquidity provisions and the leverage ratio. Thus, at least with respect to Argentina, Brazil, and Mexico, the effort to strengthen banking regulation that had contributed to make their Page 45 of 60

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Banking in Latin America: Developments and Prospects banking systems more resilient against crises is to continue at the same pace (sometimes even more quickly) that is followed by developed economies. The Basel Committee (BCBS, 2013) reported in April 2013 that Mexico already put in place Basel III in what refers to capital rules, while Argentina and Brazil had already published the rules they were to adopt by the end of 2013. It is interesting to note that the report shows the three countries ahead of the United States and of the European Union in the speed of imple­ mentation of Basel III. The latest data on risk-weighted capital coefficients provided by the World Bank strength­ en the notion that banks in Latin America suffered generally little from the GFC. Table 37.7 shows that banks from Latin America maintained capital-to-risk-weighted assets over 10 percent in 2015. The data are not particularly volatile and there is no visible break in the years around 2008. The resilience shown by banks in the region is a result of the suc­ cess in maintaining overall macroeconomic stability in the face of adverse shocks coming mostly from the United States first, and then from Europe. However, it is also a measure of the success of these countries in modernizing their financial stability supervisory sys­ tems.

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Banking in Latin America: Developments and Prospects (p. 1181)

Table 37.7 Bank Solvency and Asset Quality Capital-to-Risk-Weighted Assets, %

Non-Performing Loans-to-Total Gross Loans, %

Country

2003

2007

2010

2015

2003

2007

2010

2015

Argenti­ na

14.5

16.9

17.7

13.3

17.7

2.7

2.1

1.7

Bolivia

15.3

12.6

11.9

12.7

16.7

5.6

2.2

1.6

Brazil

18.8

18.8

16.9

16.4

4.1

3.0

3.1

3.3

Chile

14.1

12.2

14.1

12.6

1.6

0.8

2.7

1.9

Colombia

13.0

16.0

17.3

16.9

6.8

3.2

2.9

2.8

Ecuador

12.2

19.2

18.3

20.3

7.9

3.7

3.4

4.4

Mexico

14.2

15.9

16.9

15.0

3.2

2.3

2.0

2.5

Paraguay

20.9

16.8

13.0

16.1

20.6

1.3

1.4

2.6

Peru

13.3

11.7

14.0

14.3

14.8

2.7

3.0

3.9

Uruguay

18.1

17.8

14.2

14.5

14.3

1.1

2.4

1.6

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Banking in Latin America: Developments and Prospects Venezuel a

25.1

12.9

13.2

15.1

7.7

1.2

3.4

0.8

China

2.5

8.4

12.2

13.5

20.4

6.2

1.1

1.7

India

12.7

12.3

15.2

12.7

8.8

2.7

2.4

5.9

Indonesia

22.3

20.2

16.2

21.3

6.8

4.0

2.5

2.4

Russia

19.1

15.5

18.1

12.7

5.0

2.5

8.2

8.3

South Africa

12.4

12.8

14.9

14.2

2.4

1.4

5.8

3.1

Turkey

30.9

18.9

19.0

15.6

11.5

3.3

3.5

3.0

UK

13.0

12.6

15.9

19.6

2.5

0.9

4.0

1.0

US

13.0

12.8

14.8

14.1

1.1

1.4

4.4

1.5

Note: Data in italics are for the nearest year to that shown in the column. Source: World Bank, Global Financial Development Database.

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Banking in Latin America: Developments and Prospects Table 37.7 includes data on non-performing loans as a share of gross loans. A general pic­ ture emerges, namely an intertemporal improvement in asset quality since the early 2000s. The data suggest that the reform processes in Latin American countries, including bank privatization and foreign bank acquisitions, have arrested the formerly high propor­ tions of non-performing loans and significantly reduced them in several countries to lev­ els that are better than those found in other emerging market banking sectors. Neverthe­ less, and contrary to the trend, the subprime crisis adversely affected asset quality in 2008 and 2009, although Latin America appears less scathed compared with other re­ gions. Indeed, Latin American banking sectors managed to shake off the impact of the cri­ sis quicker than other emerging markets. The GFC did not make a marked impact on bank asset quality and the data suggests the hypothesis that loan management improved in the whole region in the period, either by bank managers or by bank supervisors or both. As a caveat, there is a mild deterioration in quality in some countries between 2010 and 2015. However, asset quality in banking sectors in Latin America is superior to other emerging markets in 2015.

37.7 Latin American Development Banks: Some New Developments or an Impasse? Development banks were a common feature of Latin American economies during the Im­ port-Substitution-Industrialization (ISI) period. They were believed to be a key instrument to guarantee that credit would be available for industrial investment at interest rates compatible with the risks involved in such activities. All the major Latin American economies created their own national development banks, particularly after the end of World War II. Other countries joined in efforts to create multinational institutions dedicat­ ed to finance investment, of which the Corporacion Andina de Fomento (CAF), created in 1970 and still in operation, is the most durable and best-known case. Nineteen countries own CAF—seventeen of Latin America and the Caribbean, and Spain and Portugal—as well as 13 private banks in the region. It aims at promoting a (p. 1182) sustainable devel­ opment model through credit operations, non-reimbursable resources, and support in the technical and financial structuring of projects in the public and private sectors of Latin America. Development banks were deeply affected by the financial liberalization wave that swept the region in the 1980s and 1990s, under the context of the implementation of Washing­ ton Consensus policies. They disappeared from countries such as Argentina and Mexico. Some were transformed into financial agencies specialized in supporting specific sectors and activities like small to medium-sized enterprises (SMEs). Surviving institutions, such as, notably, the largest in the region, the National Economic and Social Development Bank (BNDES) in Brazil, had their mission redefined to operate as investment banks or as instruments to facilitate privatization processes in other sectors. Following the discontin­ uation of active industrial policies in the region, surviving development banks’ credit poli­ cies were reoriented to give support to the development of national private capital mar­ Page 49 of 60

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Banking in Latin America: Developments and Prospects kets in the cases where this was possible. Development banks also survived in Colombia and Chile. The new millennium witnessed a dramatic change to Latin American politics. With the major exception of Mexico, governments in some of the most important countries in the area shifted to the political left. Brazil, Argentina, Venezuela, Uruguay, Bolivia, and Ecuador, all elected leaders arguing the need to change development standards, to accel­ erate industrial growth in tandem with income redistribution and to give new responsibil­ ities for governments in the process. Even Chile, which was governed by a left-center coalition for most of the post-Pinochet period, moved, if slightly, to the left. There was not much in common among all these experiences besides the rhetoric of change. Lula da Silva’s administration in Brazil remained largely committed to the free market policies of his predecessor, just adding to it a wider social security intervention to improve the lives of the very poor. Chile and Uruguay remained moderate in their eco­ nomic policy choices. Venezuela embarked on a policy, the viability of which depended di­ rectly on oil prices remaining high, with disastrous consequences. The change in the political scenario did not affect financial markets in Latin America. Fi­ nancial liberalization and the privatization of state financial institutions did not proceed but neither were they rolled back. The general orientation to support the development and differentiation of local capital markets was maintained in the largest economies. Cap­ ital controls remained an instrument-of-last-resort to manage balance of payments prob­ lems, except, as it is well known, in the case of Argentina after the 2001 crash and, again, by the mid-2010s, and in Venezuela when economic disorganization was accentuated, af­ ter the death of Hugo Chavez. One institution that changed its ways in the period was Brazil’s BNDES. Timidly, at first, and more intensely in the aftermath of the 2008 international financial crisis, the bank’s loans were rapidly expanded as part of an overall state-institutions-led, credit-expansion strategy implemented in 2009 to reverse the contraction of the Brazilian economy. The bank’s balance sheet was expanded significantly by the growth of loans for working capi­ tal. After the emergency was successfully contained, with the economy recovering no­ tably in 2010, a new emphasis was given to active industrial policies by the (p. 1183) gov­ ernment, which maintained the momentum of BNDES’ expansion. Between 2012 and 2014, loan disbursement from BNDES ranged from $76 billion to nearly $85 billion. In comparison, loans from the InterAmerican Development Bank (IADB) ranged from just under $7 billion to $10.6 billion (Zeidan and Filho, 2017). The new industrial policy strategy centered on the notion of national champions, inspired by the experience of the East Asian economies who successfully transited from an under­ development position to the status of advanced economies. The bank was to concentrate its loans on those firms and sectors that had, or were judged capable of reaching, a strong position in international markets. The government was not supposed to choose the sectors to be favored, as much as to support the expansion of those businesses that were Page 50 of 60

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Banking in Latin America: Developments and Prospects already successfully reaching international scale. Support was to take the form of making available loans at favored rates for expansion projects. The national champions’ policy was politically controversial since its inception. When Brazil was engulfed by a large-scale corruption scandal by the end of 2015, which is still unfolding, it was inevitable that directing favored loans to specific borrowers would be seen as highly suspect, hurting the public image of BNDES. No evidence whatsoever emerged that bank staff and its decision processes were vitiated in any way. The national champions’ policy was selected at higher levels of government. Nevertheless, in the over­ all climate of suspicion that was installed in the country, it was inevitable that the bank would pay a heavy price for its role as enforcer of a policy widely considered, at that point, to be corrupt. After these events, the bank’s role was dramatically downsized. Credits were curtailed, and part of its capital reserves were returned to the Treasury. Loan disbursements in 2015 and 2016 stood at $39.2 billion and $24.3 billion, respectively (Zeidan and Filho, 2017).6 Besides, its more important policy instruments, such as the charge of favored long-term interest rates for investment projects in which social returns surpassed private returns, were also affected, cutting the importance of financial subsidies to investment. The implications for the overall economy of Brazil (and, given the size of the country) for the region, should be obvious when one remembers that BNDES was responsible in re­ cent years for about 10 percent of total investment in the country. There is no way to know how permanent such a policy shift is. Brazilian society has been living in turmoil since the corruption scandals and the political crisis began in 2015. The economy is in disarray, public finances are completely disorganized, the political system gives no sign of having the ability to steer the country out of this situation. Some recent downsizing of development banks, however, is observable in other cases, such as, Colom­ bia and Chile, although the reduction pales in comparison to Brazil. In contrast, (p. 1184) loan disbursements by the development bank in Peru have increased to $12.4 billion in 2016 (Zeidan and Filho, 2017). In sum, the BNDES story is impressive, given the sheer volume of resources it handled and its longevity (it was founded in 1952). The founding of new multilateral institutions reflects the rise of China; for instance, the Asian Infrastructure Investment Bank (AIIB), and the BRICS New Development Bank (NDB) controlled by some big emerging economies of the group led by China, but also including Brazil, India, Russia and South Africa. They illustrate an increasing importance given to multilateralism and, at the same time the importance given to the creation of new multilateral financial institutions, the governance of which is independent from the traditional powers, the US, Western Europe and Japan (see Baumann, 2017), that ultimately control even the old Inter-American De­ velopment Bank (IADB). On the other hand, given the dire straits in which countries like Argentina, Brazil, and Venezuela find themselves, the idea of Banco del Sur, launched at the time of Lula da Silva in Brazil and Chavez in Venezuela, is as good as dead (if it was ever feasible). Page 51 of 60

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Banking in Latin America: Developments and Prospects Nevertheless, new attention is also increasingly focusing on modernizing the functions of such institutions, national or multilateral, to cope with the extraordinary technical changes that have reshaped national economies as well as the relations between them. A new emphasis on innovation, flexible production processes and global integration de­ mands deep changes in the modus operandi of existing institutions. Of course, naming ob­ jectives is incomparably easier than defining goals and methods to reach them but, in­ creasingly, efforts are dedicated to the issue (de Olloqui, 2013).

37.8 Conclusion The last three decades have witnessed deep changes in the operation of the banking sec­ tor everywhere, but without a doubt, these changes have been particularly strong in Latin America. In these years, financial repression was eliminated or drastically attenuated from Mexico to the Southern Cone. The role of state-owned banks was streamlined either by privatization or by increasing specialization in the provision of financial support to spe­ cial groups of borrowers, such as, medium and small firms, as in the case of Mexico. In a few countries, however, and most notably in Argentina and Brazil, a large sector of stateowned banks survived the financial liberalization process and went on to become leaders in their domestic banking sectors. A common feature of the financial liberalization process in the whole region has been the increasing presence of foreign banks in domestic markets. Led by US and Spanish banks, foreign institutions have aggressively taken advantage of the relaxation of restrictions on the operation of foreign banks in virtually the whole continent. Liberalization, privatization, and foreign bank entry combined with larger macroeconom­ ic policy changes and strategies to generate a process of consolidation in the banking sec­ tor of all countries in the region. Consolidation was actively supported by local (p. 1185) government policies aimed at taking advantage of possible economies of scale and scope in the production of banking services. Nevertheless, the results of these efforts are still to appear more clearly, although there is some evidence of efficiency improvements in bank operations in the region. In the major countries of Latin America, banks faced important difficulties in adapting to the new context of financial deregulation and liberalization. Serious banking sector crises took place in Chile, which pioneered the liberalization process, Argentina, also in the ear­ ly stages of liberalization, and Mexico. In Brazil, banks suffered strong pressures result­ ing from the joint impact of deregulation and price stabilization processes in the mid-1990s, forcing the government to create a special crisis-resolution program. Argenti­ na suffered another banking crisis in 2001, connected to the balance of payments crisis that put an end to the Convertibility Plan. Interest rates are currently market-determined everywhere except for Venezuela, where controls still subsist. Privatization advanced strongly everywhere, except in Brazil and Argentina, where the leading banks (Banco do Brasil and Caixa Economica Federal in Brazil, and Banco de la Nation Argentina, in Ar­ gentina) were kept in the hands of the federal government. Directed credit was reduced Page 52 of 60

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Banking in Latin America: Developments and Prospects or eliminated across the region, again with the partial exception of Brazil, where a feder­ al development bank (BNDES) had been the main provider of long-term credit, but since 2017 there has been a shift in the policy orientation of BNDES toward a more reduced and focused role in the economy. The results of the process have been relatively disappointing, given the high expectations that surrounded the liberalization process in the late 1980s. The jury is still out, of course, given the relatively short time during which these changes have been in place and the turbulence that characterized some periods in the 1990s. There is some evidence of improvement in many cases, but still not enough to generate enthusiasm. Banking crises and stresses, however, have not led to reversals in the financial liberalization process so far. On the contrary, most countries in the area have been investing in building regulatory and supervisory institutions while adhering to modern regulatory paradigms, such as the Basel accords. If the assumptions underlying the process of financial liberal­ ization are in fact true, better results should begin to show in the short term in the form of lower cost of capital, wider access to finance, and better allocation of resources while, of course, maintaining a reasonable degree of financial stability. It is a tall order, but fi­ nancial liberalization promises no less.

References Ahumada, A. and Marshall, J. (2001). “The Banking Industry in Chile: Competition, Con­ solidation and Systemic Stability,” BIS Papers No. 4, August. Avalos, M. and Trillo, F. (2006). “Competencia Bancaria en Mexico,” UN CEPAL, August. Barajas, A., Steiner, R., and Salazar, N. (1998). “Interest Spreads in Banking: Costs, Fi­ nancial Taxation, Market Power, and Loan Quality in the Colombian Case 1974–96,” IMF Working Paper No. WP/98/110. Barajas, A., Steiner, R., and Salazar, N. (2000). “The Impact of Liberalization and Foreign Investment in Colombia’s Financial Sector,” Journal of Development Economics, 63, 157– 96. Baumann, R. (2017). “Os Novos Bancos de Desenvolvimento: Independencia Con­ flitiva ou Parcerias Estrategicas,” (The New Development Banks: Conflictual Indepen­ dence or Strategic Partnerships), The Brazilian Journal of Political Economy, 37(2, April– June), 287–303. (p. 1186)

BCBS (Basel Committee on Banking Supervision) (2013). Report to G20 Finance Minis­ ters and Central Bank Governors on Monitoring Implementation of Basel III Regulatory Reform, April. BCRA (Banco Central de la República Argentina) (2012). Financial Stability Report, Octo­ ber. Belaisch, A. (2003). “Do Brazilian Banks Compete?” IMF Working Paper No. WP/03/113. Page 53 of 60

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Banking in Latin America: Developments and Prospects Berger, A.N. (2007). “International Comparisons of Bank Efficiency,” New York University Salomon Center, Financial Markets, Institutions and Instruments, 16(3), 119–44. Berger, A.N., Clarke, G.R.G., Cull, R., Klapper, L., and Udell, G.F. (2005). “Corporate Gov­ ernance and Bank Performance: A Joint Analysis of the Static, Selection, and Dynamic Ef­ fects of Domestic, Foreign, and State Ownership,” Journal of Banking and Finance, 29, 2179–221. Betancour, C., De Gregorio, J., and Jara, A. (2006). “Improving the Banking System: The Chilean Experience,” BIS Papers No. 28, August. Birchwood, A., Brei, M., and Noel, D. (2017). “Interest Margins and Bank Regulation in Central America and the Caribbean,” Journal of Banking and Finance, 85, 56–68. BIS (2008). “Monetary and Financial Stability Implications of Capital Flows in Latin America and the Caribbean,” BIS Papers No. 43, November. Buch, C.M. and DeLong, G.L. (2001). “Cross-border Bank Mergers: What Lures the Rare Animal?” Kiel Institute of World Economics Working Paper No. 1070. Cardias Williams, F. and Williams, J. (2008). “Does Ownership Explain Bank M&A? The Case of Domestic Banks and Foreign Banks in Brazil,” in P. Arestis and L. F. Paula (eds.), Financial Liberalization and Economic Performance in Emerging Countries (Basingstoke: Palgrave Macmillan), 194–215. Carvalho, F.C. (1998). “The Real Stabilization Plan and the Banking Sector in Brazil,” Ban­ ca Nazionale del Lavoro Quarterly Review, 206, 291–36. Carvalho, F.C. (2000). “New Competitive Strategies of Foreign Banks in Large Emerging Economies: The Case of Brazil,” Banca Nazionale del Lavoro Quarterly Review, 213, 135– 70. Carvalho, F.C. (2002). “The Recent Expansion of Foreign Banks in Brazil: First Results,” Latin American Business Review, 3(4), 93–119. Carvalho, F.C. (2008). “Financial Liberalization in Brazil and Argentina,” in P. Arestis and L. F. Paula (eds.), Financial Liberalization and Economic Performance in Emerging Coun­ tries (Basingstoke: Palgrave Macmillan), 121–41. Carvallo, O. and Kasman, A. (2005). “Cost Efficiency in the Latin American and Caribbean Banking Systems,” Journal of International Financial Markets, Institutions and Money, 15, 55–72. CGFS (Committee on the Global Financial System) (2004). “Foreign Direct Investment in the Financial Sector of Emerging Market Economies,” Report Submitted by a Working Group Established by the CGFS, Basel, BIS, March.

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Banking in Latin America: Developments and Prospects Chortareas, G., Garza-García, J.G., and Girardone, C. (2011). “Banking Sector Perfor­ mance in Latin America: Market Power versus Efficiency,” Review of Development Eco­ nomics, 15, 307–25. Chortareas, G., Garza-García, J.G., and Girardone, C. (2012). “Competition, Efficiency and Interest Rate Margins in Latin American Banking,” International Review of Financial Analysis, 24, 93–103. Claessens, S. and Van Horen, N. (2014). “Foreign Banks: Trends and Impact,” Journal of Money, Credit and Banking, 46(1), 295–326. Claessens, S. and Van Horen, N. (2015). “The Impact of the Global Financial Cri­ sis on Banking Globalization,” IMF Economic Review, 63(4), 868–918. (p. 1187)

Claessens, S., Demirgüç-Kunt, A., and Huizinga, H. (2001). “How Does Foreign Bank En­ try Affect Domestic Banking Markets?” Journal of Banking and Finance, 25, 891–911. Clarke, G.R.G. and Cull, R. (2000). “Why Privatize? The Case of Argentina’s Public Provin­ cial Banks,” World Development, 27, 865–86. Clarke, G.R.G., Crivelli, J.M., and Cull, R. (2005). “The Direct and Indirect Impact of Bank Privatization and Foreign Entry on Access to Credit in Argentina’s Provinces,” Journal of Banking and Finance, 29, 5–29. Coelho, C.A., de Mello, J.M.P., and Rezende, L. (2007). “Are Public Banks Pro-competi­ tive?” Evidence from Concentrated Local Markets in Brazil, PUC-RJ Texto para Discussão No. 551. Crystal, J.S., Dages, B.G., and Goldberg, L. (2002). “Has Foreign Bank Entry Led to Sounder Banks in Latin America?” Current Issues in Economics and Finance, 8(1), 1–6. Cull, R. and Martínez Pería, M.S. (2013). “Bank Ownership and Lending Patterns During the 2008–2009 Financial Crisis: Evidence from Latin America and Eastern Europe,” Jour­ nal of Banking and Finance, 37, 4861–78. Dages, B.G., Goldberg, L., and Kinney, D. (2002). “Foreign and Domestic Bank Participa­ tion in Emerging Markets: Lessons from Mexico and Argentina,” FRBNY Economic Policy Review, September, 17–36. De la Torre, A. (2000). “Resolving Bank Failures in Argentina: Recent Developments and Issues,” World Bank Policy Research Working Paper Series No. 2295. de Olloqui, F. (ed.) (2013). Public Development Banks: Toward a New Paradigm? (Washington, DC: Interamerican Development Bank). De Vries, M.G. (1987). Balance of Payments Adjustment, 1945 to 1986: The IMF Experi­ ence (Washington, DC: IMF).

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Banking in Latin America: Developments and Prospects Domanski, D. (2005). “Foreign Banks in Emerging Market Economies: Changing Players, Changing Issues,” BIS Quarterly Review, December, 69–81. ECLatin AmericaC (Economic Commission for Latin American and Caribbean) (2000). Foreign Investment in Latin America and the Caribbean—1999 Report (Santiago: ECLatin AmericaC). Fanelli, J.M. (2003). Estrategias para la Reconstrucción Monetaria y Financiera de la Ar­ gentina (Buenos Aires: Siglo XXI). Focarelli, D. and Pozzolo, A.F. (2001). “The Patterns of Cross-Border Bank Mergers and Shareholdings in OECD Countries,” Journal of Banking and Finance, 25, 2305–37. Foxley, A. (1983). Latin American Experiments with Neo-Conservative Economics (Berkeley, CA: University of California Press). Fry, M. (1995). Money, Interest, and Banking in Economic Development, 2nd edn (Balti­ more, MD: The Johns Hopkins University Press). Gelos, R.G. (2006). “Banking Spreads in Latin America,” IMF Working Paper No. WP06/44. Gelos, R.G. and Roldós, J. (2004). “Consolidation and Market Structure in Emerging Mar­ ket Banking Systems,” Emerging Markets Review, 5, 39–59. Gerschenkron, A. (1962). Economic Backwardness in Historical Perspective (Cambridge, MA: The Belknap Press of Harvard University Press). Guimarães, P. (2002). “How Does Foreign Entry Affect Domestic Banking Market? The Brazilian Case,” Latin American Business Review, 3(4), 121–40. Haber, S. (2005). “Mexico’s Experiments with Bank Privatization and Liberalization, 1991–2003,” Journal of Banking and Finance, 29, 2325–53. Haber, S. and Musacchio, A. (2005). “Foreign Banks and the Mexican Economy, 1997–2004,” Stanford Center for International Development Working Paper. (p. 1188)

Hawkins, J. and Mihaljek, D. (2001). “The Banking Industry in the Emerging Markets Economies: Competition, Consolidation and Systemic Stability,” BIS Papers No. 4, August. Hernandez-Murillo, R. (2007). “Experiments in Financial Liberalization: The Mexican Banking Sector,” Federal Reserve Bank of St Louis Review, 89(5), 415–32. Honohan, P. (2007). “Cross-Country Variation in Household Access to Financial Services,” Paper Prepared for World Bank Conference on Access to Finance, March 15–16. IADB (Inter-American Development Bank) (2005). Unlocking Credit: The Quest for Deep and Stable Bank Lending (Washington, DC: IADB).

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Banking in Latin America: Developments and Prospects IMF (International Monetary Fund) (2007). Global Financial Stability Report (Washington, DC: IMF). IMF (2016). “Financial Integration in Latin America,” IMF Policy Papers, March. Jeanneau, S. (2007). “Banking Systems: Characteristics and Structural Changes,” BIS Pa­ pers No. 33, 3–16, February. Kamil, H. and Rai, K. (2010). “The Global Credit Crunch and Foreign Banks’ Lending to Emerging Markets: Why Did Latin American Fare Better?” IMF Working Paper No. WP/ 10/102, April. Martínez Pería, M.S. and Mody, A. (2004). “How Foreign Participation and Market Con­ centration Impact Bank Spreads: Evidence from Latin America,” Journal of Money, Credit and Banking, 36(3), 511–37. Maudos, J. and Solis, L. (2009). “The Determinants of Net Interest Income in the Mexican Banking System: An Integrated Model,” Journal of Banking and Finance, 33, 1920–31. Maudos, J. and Solis, L. (2011). “Deregulation, Liberalization and Consolidation of the Mexican Banking System: Effects on Competition,” Journal of International Money and Fi­ nance, 302, 337–53. Nakane, M.I. (2001). “A Test of Competition in Brazilian Banking,” Banco Central do Brasil Working Paper Series No. 12. Nakane, M.I. and Weintraub, D.B. (2005). “Bank Privatization and Productivity: Evidence for Brazil,” Journal of Banking and Finance, 29, 2259–89. Nakane, M.I., Alencar, L.S., and Kanczuk, F. (2006). “Demand for Bank Services and Mar­ ket Power in Brazilian Banking,” Banco Central do Brasil Working Paper Series No. 107, June. O’Connell, A. (2005). “The Recent Crisis—and Recovery—of the Argentine Economy: Some Elements and Background,” in G. Epstein (ed.), Financialization and the World Economy (Cheltenham: Edward Elgar). Oreiro, J.L. and Paula, L.F. (2010). “Macroeconomic Determinants of Bank Spread in Latin America: A Recent Analysis with Special Focus on Brazil,” International Review of Applied Economics, 24(5), 573–90. Panzar, J.C. and Rosse, J.N. (1987). “Testing for Monopoly Equilibrium,” Journal of Indus­ trial Economics, 35, 443–56. Paula, L.F. (2002). “Expansion Strategies of European Banks to Brazil and Their Impacts on the Brazilian Banking Sector,” Latin American Business Review, 3(4), 59–91. Paula, L.F. (2011). Financial Liberalization and Economic Performance: Brazil at the Crossroads (London and New York: Routledge). Page 57 of 60

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Banking in Latin America: Developments and Prospects Paula, L.F. and Alves, Jr., A.J. (2007). “The Determinants and Effects of Foreign Bank En­ try in Argentina and Brazil: A Comparative Analysis,” Investigación Económica, 66(259), 63–102. Ray, R. (2018). “China–Latin America Economic Bulletin 2018 Edition,” Global Development Policy Center Discussion Paper, 2018–1. (p. 1189)

Rojas Suarez, L. (2007). “The Provision of Banking Services in Latin America: Obstacles and Recommendations,” Center for Global Development Working Paper No. 124, June. Saez-Fernandez, F.J., Picazo-Tadeo, A., and Beltran-Esteve, M. (2015). “Assessing the Per­ formance of the Latin American and Caribbean Banking Industry: Are Domestic and For­ eign Banks So Different?” Cogent Economics & Finance, 3, 1–17. Schulz, H. (2006). Foreign Banks in Mexico: New Conquistadors or Agents of Change? (Philadelphia: PA: University of Pennsylvania). Sebastián, M. and Hernansanz, C. (2000). “The Spanish Banks Strategy in Latin Ameri­ ca,” SUERF Working Paper No. 9. Singh, A., Belaisch, A., Collyns, C., de Masi, P., Krieger, R., Meredith, G., and Rennhack, R. (2005). “Stabilization and Reform in Latin America: A Macroeconomic Perspective on the Experience Since the Early 1990s,” IMF Occasional Paper No. 238. Solis, L. and Maudos, J. (2008). “The Social Costs of Bank Market Power: Evidence from Mexico,” Journal of Comparative Economics, 36, 467–88. Stallings, B. and Studart, R. (2006). Finance for Development: Latin America in Compara­ tive Perspective (Washington, DC: The Brookings Institution). Staub, R., Souza, G.S., and Tabak, B. (2010). “Evolution of Bank Efficiency in Brazil: A DEA Approach,” European Journal of Operational Research, 202, 204–13. Studart, R. and Hermann, J. (n.d.). “Sistemas Financeiros Argentino e Brasileiro,” manu­ script. Tabak, B.M., Fazio, D.M., and Cajueiro, D.O. (2011). “Profit, Cost and Scale Efficiency for Latin American Banks: Concentration–Performance Relationship,” Banco Central do Brasil Working Paper Series No. 244, May. Tecles, P. and Tabak, B. (2010). “Determinants of Bank Efficiency: The Case of Brazil,” Banco Central do Brasil Working Paper Series No. 210, May. Williams, J. (2012). “Efficiency and Market Power in Latin American Banking,” Journal of Financial Stability, 8, 263–76. Yeyati, E.L. and Micco, A. (2007). “Concentration and Foreign Penetration in Latin Ameri­ can Banking Sectors: Impact on Competition and Risk,” Journal of Banking and Finance, 31, 1633–47. Page 58 of 60

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Banking in Latin America: Developments and Prospects Yildirim, H.S. and Philippatos, G.C. (2007). “Restructuring, Consolidation and Competi­ tion in Latin American Banking Markets,” Journal of Banking and Finance, 31, 629–39. Zeidan, R. and Filho, I.E.C. (2017). “Can Latin America’s Development Banks Be Fixed?” Americas Quarterly, available at: http://www.americasquarterly.org/content/canlatin-americas-development-banks-be-fixed.

Notes: (1) Higher growth rates did occur although at the cost of the emergence of some impor­ tant disequilibria. (2) In 1995 a modification increased the limits of foreign participation established under the NAFTA agreement (initially foreign banks could not buy domestic banks whose mar­ ket share exceeded 1.5 percent). In December 1998, the Mexican Congress approved a further modification allowing foreign investment in domestic banks to reach 100 percent. Subsequently, foreign banks acquired the largest banking institutions (Bancomer, Ba­ namex, and Serfin) (Maudos and Solis, 2011). (3) Estimations of the ratio of non-performing loans-to-total loans reached 52.6 percent by December 1996 (Hernandez-Murillo, 2007, p. 421). (4) The term for universal banks is “multiple banks” in Brazil. (5) Decisions concerning financial liberalization in Argentina since the late 1980s are list­ ed (in Portuguese) in Studart and Hermann (n.d.) and are reproduced and discussed in Carvalho (2008). For an overview of the process, see O’Connell (2005). (6) In 2017, there was a new shift in BNDES’s strategy, with the change in its loans’ inter­ est rate, from “long-term interest rate—TJLP,” fixed by the National Monetary Council of Brazil (according to its inflation target more a premium risk), to “long-term rate—TLP,” adjusted by the headline index of prices (IPCA) and more the real interest rate of the NTN (the Note of National Treasury, a federal public bond) of five years. The main objec­ tive of this change is to move the BNDES interest rate closer to private market interest rates and, consequently, to reduce its share in long-term financing in Brazil.

Fernando J. Cardim De Carvalho

Fernando J. Cardim De Carvalho is Professor of Economics at the Institute of Eco­ nomics, Federal University of Rio de Janeiro (Brazil) and Director of the Money and Finance Study Group headquartered at the same university. A former chairman of the Brazilian Association of Graduate Schools in Economics (ANPEC), his research inter­ ests are Keynesian macroeconomics, international monetary economics, and financial systems. Luiz Fernando De Paula

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Banking in Latin America: Developments and Prospects Luiz Fernando De Paula is Professor of Economics at the State University of Rio de Janeiro (Brazil), joint appointment between the Faculty of Economics (FCE) and Insti­ tute of Social and Political Studies (IESP), and CNPq Researcher. He is currently a co-editor of the Brazilian Keynesian Review. He is author of the book Financial Liber­ alization and Economic Performance: Brazil at the Crossroads (Routledge, 2011) and co-editor of the book Financial Liberalization and Economic Performance in Emerg­ ing Countries (Palgrave Macmillan, 2008). A former chairman of the Brazilian Keyne­ sian Association, his research interests include banking, financial systems, Keynesian macroeconomics, and economic policies related to emerging economies. Jonathan Williams

Jonathan Williams is a Professor of Banking and Finance at Bangor University, Wales, where he is Head of Bangor Business School and Co-Director of the Institute of Euro­ pean Finance. His early research focused on the performance of European banks un­ der their organizational models. Subsequently, he has examined on banking sector developments in emerging market economies, such as bank privatization and compe­ tition. His most recent research is concentrated on executive compensation in bank­ ing, the characteristics of bank directors, and their effects on firm performance out­ comes, including the impact of corporate culture in banking.

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Banking in Australia and New Zealand—Geographic Proximity, Market Con­ centration, and Banking Integration

Banking in Australia and New Zealand—Geographic Proximity, Market Concentration, and Banking Integra­ tion   Fariborz Moshirian and Eliza Wu The Oxford Handbook of Banking (3rd edn) Edited by Allen N. Berger, Philip Molyneux, and John O. S. Wilson Print Publication Date: Oct 2019 Subject: Economics and Finance, Financial Economics Online Publication Date: Nov 2019 DOI: 10.1093/oxfordhb/9780198824633.013.38

Abstract and Keywords This chapter focuses on the Australian and New Zealand (NZ) banking industry. Aus­ tralian and New Zealand banks have undergone significant growth and challenges in the past decade. Australian banks weathered the Great Recession from 2008 and still record­ ed strong profits and minimal losses while other global banks failed internationally. To un­ derstand why this might be, we examine the composition of the closely integrated bank­ ing sectors in Australia and NZ, their respective performance, capital levels, and some defining regulatory reforms that have particularly shaped the Australian banking system since the 2008 Global Financial Crisis. Keywords: banking competition, banking integration, financial resilience, Financial System Inquiry, Four Pillars Policy, government guarantee, market structure,

38.1 Introduction THIS chapter focuses on Australia’s and New Zealand’s banking systems, which are not only geographically proximate and very similar in market structure but strikingly also highly integrated in the provision of financial services across the Oceania region. We ex­ amine their combined economic importance, composition, strong performance, resilience, and some of their defining characteristics and regulatory reforms. There are a number of reasons why an analysis of the banking industry in these two largest countries in the Oceania region may be of particular interest. First and most important of all, these bank­ ing industries were unique in remaining relatively unscathed by the Great Recession, which started in 2008, when global banks around the world were suffering significant fi­ nancial losses. Second, the high degree of geographical proximity and banking integra­ tion across the Tasman Sea between the two economies of Australia and New Zealand of­ fer interesting perspectives on the benefits and potential costs of having jointly integrat­ ed and concentrated banking sectors in small open economies. Third, Australia and New Zealand were the last two countries in the group of Organisation for Economic and Coop­ Page 1 of 34

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Banking in Australia and New Zealand—Geographic Proximity, Market Con­ centration, and Banking Integration eration Development (OECD) members to be without any form of explicit depositor pro­ tection or guarantees of bank liabilities prior to the 2008 Great (p. 1191) Recession, so this provides a unique case on the effectiveness of implementing financial safety nets in times of financial turmoil. This chapter is organized as follows. In this section, we provide an overview of the size and significance of the Australian and New Zealand banking Industry. In section 38.2, we discuss the degree of competition in the industry. Sections 38.3 and 38.4 examine the breakdown of the main sources and uses of funds for Australian and NZ banks. Section 38.5 discusses the performance of the banking industry. Section 38.6 discusses the level of government support for the banking sector and section 38.7 highlights the recent regu­ latory reforms before conclusions are offered.

38.2 Size and Significance of the Australian and NZ Banking Industries The significance and importance of the Australian and NZ banking industries to the oper­ ation of their respective financial system and economy cannot be overstated. Authorised Deposit-taking Institutions (ADIs) in Australia collectively hold around 55 percent of the total assets of Australian financial institutions (as at the September quarter 2017) and, hence, constitute the largest part of the Australian financial system. The total value of banking assets held stands at 147 percent of GDP in NZ and 136 percent in Australia (see Table 38.1). This ratio is very high in both Australia and NZ by global standards (with the world average being 55 percent) indicating that the banking systems in Australia and NZ are highly developed and account for a significant portion of national wealth in the two countries. It should also be noted that the proportion of bank asset holdings relative to GDP in Australia and NZ rivals those in both the UK (135 percent) and Japan (166 per­ cent). Moreover, in Australia the financial services industry (which includes ADIs) is high­ ly productive and contributed 9.3 percent to gross domestic product in the aggregate economy, according to the most recent annual data provided by the OECD up to 2017. This can be compared to an OECD average of 5.8 percent for financial service industries in developed countries. This level of contribution by the financial sector in the Australian economy is striking as it exceeds even the contributions made by the financial service sectors in the largest financial centers in the world, like those in the UK (7.1 percent), the US (7.6 percent) and the Eurozone (4.5 percent). In NZ, by contrast, the financial ser­ vices industry contributed 6.3 percent to its GDP. While the financial services sector is relatively less important in NZ than in Australia and other comparable economies like the US and the UK, it still exceeded the value-added contribution by other primary industries such as Agriculture, Fisheries and Forestry.1 The importance of the banking industry in both Australia and NZ becomes even more apparent when we analyze the size of the customer base. In Australia, there are ap­ proximately 20 million people over the age of 15. The top four major banks in Australia and NZ are the Commonwealth Bank of Australia (CBA), Westpac Banking Corporation (p. 1192)

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Banking in Australia and New Zealand—Geographic Proximity, Market Con­ centration, and Banking Integration (Westpac), the National Australia Bank (NAB) and Australia and New Zealand Banking Group (ANZ). The Commonwealth Bank and Westpac have customers within that demo­ graphic (persons over 15 years of age) totaling 17 and 15 million people, or 85 percent and 75 percent of the population, respectively.2 Although a proportion of their customers are international, these figures nonetheless demonstrate how far-reaching the banking in­ dustry is within the broader Australian society in providing financial services for individu­ als, corporations, and the government sector. Banks provide a wide range of financial products and services to Australian financial consumers and businesses, and cross-selling of wealth management, insurance, and loan products has become widespread within the banking industry. Bank lending is a key source of external financing for small to mediumsized enterprises (SMEs) and agricultural businesses in both Australia and NZ.

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Banking in Australia and New Zealand—Geographic Proximity, Market Concentration, and Banking Integration Table 38.1 Size and Importance of the Financial Services Industry in Australia and New Zealand

Total Bank Assets* as % of GDP(b

NZ

AUS(a)

US

UK

Japan

Eurozone

World

147%

136%

60.2%

135%

166%

103%

55%

6.3%

9.3%

7.6%

7.1%

4.2%

4.5%

5.8%***

)

Value Added Ac­ tivity(c)** *Depository **Financial ***Figure

institutions only.

services contribution to national GDP.

only based on OECD countries.

Note: (a) The Big Four Banks also comprise 44 percent of the total market capitalization of the ASX200 stock index. Sources: (b) https://fred.stlouisfed.org. (c) https://data.oecd.org/natincome/value-added-by-activity.htm.

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Banking in Australia and New Zealand—Geographic Proximity, Market Con­ centration, and Banking Integration

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Banking in Australia and New Zealand—Geographic Proximity, Market Con­ centration, and Banking Integration

38.3 Market Competition Table 38.2 Overall Industry Concentration and Sectoral Concentration Overall Industry Concentration AUS Big Four

Other Domestic Banks

Other (For­ eign)

Loan Vol­ ume in AUS(a)

79%

11%

10%

Loan Vol­ ume in NZ(b),*, **

86%

8%

6%

Sectoral Concentration Loan Sector Concen­ tration by Market

AUS Big Four

Other Do­ mestic ADIs

Foreign ADIs

Personal

81.4%

11.5%

7.1%

Government

63.5%

0.3%

36.2%

NFCs

72.1%

6.2%

21.7%

FCs

76%

3.4%

20.6%

Housing: Owner-occu­ pied

80.9%

11.7%

7.4%

Housing: Investment

85.5%

11.4%

3.2%

Share

*

Consistent with the metric used by the RBA and incorporates loans and advances on DI’s books. **

In NZ, we aggregate across ANZ, Westpac, ASB (owned by CBA), BNZ (owned by NAB).

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Banking in Australia and New Zealand—Geographic Proximity, Market Con­ centration, and Banking Integration Sources: (a) http://www.apra.gov.au. (b) https://www.rbnz.govt.nz/fi­ nancial-stability/overview-of-the-new-zealand-financial-system/thebanking-system. The Australian and NZ banking industry is not only highly concentrated but also signifi­ cantly interconnected. However, the high degree of concentration in the Australian and NZ banking systems are not isolated on the global scale. Both Australia and NZ have the same few large banks operating with significant market power. Within the Australian and NZ banking industry, the aforementioned largest four banks (the Big Four) (p. 1193) com­ prise 79 percent3 in Australia and 86 percent in NZ of total loan volumes, respectively (see Table 38.2). The Australian Big Four banks also hold around three-quarters of all as­ sets held by Australian ADIs. This is one of the highest concentrations of banking market power within a developed banking system—it is more than twice the banking concentra­ tion in the United States and the United Kingdom. However, it is on a par with other smaller advanced economies such as Canada (85 percent) and Sweden (82 percent), which also have similar degrees of banking sector concentration. Other domestic banks, foreign branch banks and credit unions and building societies (mutuals) account for a small proportion of the total assets within the banking sector. There is significant unidi­ rectional banking integration across the two geographically proximate banking industries with the Australian Big Four dominating also the NZ banking industry, with only a meager 8 percent of total loans extended by domestic NZ banks and cooperatives and another 6 percent of the total loans contributed by foreign banks. In contrast, NZ banks have very little presence in the larger Australian banking industry. Both the Australian and New Zealand banking systems are dominated by large Australian banks—the Big Four banks from Australia dominate retail banking, and most of these same institutions also feature prominently in the provision of funds and (p. 1194) wealth management as well as general insurance. Over time, there has also been significant con­ solidation among the largest banks and the formation of large financial conglomerates, which have become increasingly more dominant, posing challenges for financial stability with the loss of diversification potential across financial services. A declining number of smaller banks operate alongside these major financial institutions. Australia’s smaller financial institutions (such as some regional and customer-owned banks (mutuals) and foreign-owned banks) achieve comparatively high market shares in targeted markets—for example, consumers in their home state, employees in a particular profession, or dual nationals from their base country. Focusing on such groups allows these smaller players to overcome the disadvantages of potentially limited scale, higher funding costs, or in the case of foreign-owned banks, limited public-facing branches with­ in the Australian and NZ banking scene. The Productivity Commission (2018) in Australia reports that the banking industry is an “established oligopoly with a tail of smaller providers.” Their assessment is that “Price competition in the banking system is limited. Although institutions claim that they com­ pete in loan markets by discounting, such behaviour is not indicative of a competitive Page 7 of 34

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Banking in Australia and New Zealand—Geographic Proximity, Market Con­ centration, and Banking Integration market when price obfuscation is common and discounts are specific to groups of customers” (Productivity Commission, 2018, p. 38). Furthermore, the Commission’s view is that the smaller banks and non-bank financial institutions “are not a significant com­ petitive constraint on the major banks’ market power” (ibid.). Heard, Menezes, and Rambaldi (2017) examined the locational decisions made by the four largest Australian banks with regards to where they established or maintained branch- and automated teller machine (ATM)-level presence within the domestic banking sector between 2002 and 2013. Their findings reveal important evidence on banking com­ petition in Australia. Their analysis suggests that there is much persistence in banks’ lo­ cational choices as past presence is the most important factor for explaining current pres­ ence. Moreover, they find that the four largest banks tend to co-locate branches but the location of other (smaller) banks generally differs from the location of the four largest banks, suggesting that the smaller banks strategically do not compete directly with the four largest banks. The authors highlight that there has been limited competition be­ tween large banks and smaller banks within the Australian banking market, both before and after the 2007–8 Global Financial Crisis. Given the historical developments and market structure of the Australian and NZ banking industries, the high degree of concentration has climbed steadily over time but a unique policy exists called the “Four Pillars Policy” that prevents the top four banks from amalga­ mating within Australia. In both countries, the degree of market concentration within the banking system tends to be pro-cyclical. This means that in times when the economy is in an upturn, the excess credit growth that follows is produced at a greater rate by the few major banks. Paralleled with this expansion in credit growth is an increase in the top four banks’ collective market share. The Australian housing sector, for example—which has seen staggering house price growth of over 100 percent (particularly in Sydney and Mel­ bourne) since the Great Recession—is experiencing a credit bubble dominated by the country’s major banks. In NZ, there has also developed a (p. 1195) housing price bubble. Total bank credit extended by the Big Four banks in Australia now account for the bulk of all housing loans (80.9 percent in the owner-occupied segment and 85.5 percent of the loan volumes in the investment segment). Similarly, most of the personal loans (81.4 per­ cent) taken out in Australia are also provided by the Big Four banks. The remaining loans are provided by other domestic deposit-taking institutions and foreign banks. The Big Four banks are also dominant in government loans, financing approximately two-thirds of all government borrowing needs with the other third coming from foreign banks. The high degree of bank market power in the Australian and NZ banking industries has allowed Australasian financial institutions to be increasingly more efficient. Over the past decade, the number of ADIs has decreased from 217 (as at the end of the September quarter 2007) to 147 (as at the end of the September quarter 2017), a decline of almost a third of the ADIs that previously existed. This drastic decline in the number of ADIs has occurred due to the decline and changing operations of credit unions, building societies (mutuals) and regional banks that were previously specialized and dominant within their respective Australian states. A consolidation of the banking sector has also occurred over Page 8 of 34

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Banking in Australia and New Zealand—Geographic Proximity, Market Con­ centration, and Banking Integration time with the four major banks acquiring significant regional banks to gain rapid increas­ es in market share in order to improve their competitiveness through achieving greater economies of scale. The Four Pillars Policy only prevents the top four major banks from acquiring each other but not the smaller competitors. For instance, in 2008 the Common­ wealth Bank of Australia acquired BankWest, which was focused in Western Australia, while Westpac Bank acquired St George Bank, based in New South Wales. The significant degree of concentration in the banking sector may pose increasing fragili­ ty in the banking system. However, the findings of Delis, Kokas, and Ongena (2017) high­ light that bank market power can also be beneficial as it allows firms that would other­ wise not get access to bank credit (the SMEs and riskier firms within a country) to bor­ row from banks with greater market power and capacity to achieve loan portfolio diversi­ fication. Delis, Kokas, and Ongena (2017) posit that banks with more market power also have superior screening and monitoring ability, which helps to enhance the performance of the firms that receive bank credit. Hence, having a few banks with significant market power allows a larger number of smaller and/or riskier business enterprises with good in­ vestment ideas to be financed, which improves their performance and is ultimately bene­ ficial for the real economy.

38.4 Balance Sheets—Sources of Funding One of the most striking differences between the Australian and NZ banking industries from their global counterparts is the low percentage of funding sourced from deposits (see Table 38.3). Deposit accounts in Australia and NZ currently comprise 60 percent and 61 percent of their respective banks’ funding composition. This level is rela­ tively low when compared to other banking industries internationally, such as those in the (p. 1196)

US (73 percent) and Japan (72 percent). Australian and NZ banks are more similar to UK banks in their funding structures. This is possibly due to the lack of an explicit deposit in­ surance scheme being in place prior to the 2007–8 Global Financial Crisis, unlike the es­ tablished formal arrangements for deposit insurance funds in countries like Japan and the US. In contrast, Australian and NZ banks operated under an implicit arrangement with depositor preference whereby, in the event of a bank failure, depositors would be given priority to claim their losses over other debt holders wherever possible. As a consequence of not having any explicit financial safety nets in place, there is a greater reliance on mar­ ket-based wholesale funding alternatives, such as the listing of certificates of deposit (CDs) in the money market and offshore funding markets (via both short- and long-term debt issuance), an avenue employed greatly by the major Australian banks as local fund­ ing markets are relatively small and the pool of funds available is typically more expen­ sive compared to that available internationally due to limited diversification opportunities for local fund providers.4 For this reason, traditionally both Australian and NZ banks have been heavily reliant on external debt funding by international standards. Total wholesale debt funding constitutes 32 and 30 percent of all funding sources for Australian and NZ banks, respectively, while the use of wholesale (p. 1197) debt funding is much more limited in countries like the US (13 percent), Japan (21 percent), the UK (24 percent), and across Page 9 of 34

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Banking in Australia and New Zealand—Geographic Proximity, Market Con­ centration, and Banking Integration most of Europe (23 percent). However, while Australian banks resort more to short-term debt funding (that contributes 20 percent of their total funding as opposed to only 8 per­ cent in NZ), NZ banks utilize more longer-term debt funding (with this funding source contributing 22 percent to their total funding compared with 12 percent for Australian banks). This arguably exposes Australian banks to a greater re-pricing risk than for their NZ counterparts, which tend to be relatively more conservative in their risk management practices and business models employed. There is also a myriad of structural (and statistical) factors behind this discrepancy in funding composition across different economies. Demand for credit by Australian house­ holds in the mid-2000s increased concurrently with a decline in the level of savings with­ in the economy, causing deposit growth to flatten and even decline. This was the result of an increasing lending volume in real-estate loans which was accompanied by gradual shifts in asset allocation by households—a trend sparked a decade prior with the intro­ duction of compulsory superannuation5—and saw households store a smaller proportion of their wealth in financial assets, such as deposit accounts with banks.6 Consequently, in the years running up to the 2007–8 GFC, banks’ deposit growth could not match the growth in household credit. Australian banking institutions sought to account for the dif­ ferential in the supply of funds through wholesale funding markets via foreign debt secu­ rity issuance. Other factors explaining the historically low intake of deposit funding in Australia’s and NZ’s banking industry include the size and structure of the industry as well as statistical differences in the classification and measurement of certain deposits held at banks (see Stewart, Robertson, and Heath, 2013; Gertler, Kiyotaki, and Prestipino, 2016).

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Banking in Australia and New Zealand—Geographic Proximity, Market Concentration, and Banking Integration Table 38.3 Bank Funding Sources in Australia and New Zealand, and Globally Bank Funding Sources in Australia and New Zealand Demand Deposits

Short-Term Debt

Long-Term Debt

Equity

AUS(a)

60%

20%

12%

8%

NZ(b)

61%

8%*

22%

8%**

Bank Funding Sources Globally (c) Region

Consumer Deposit Ratio

Wholesale Funding Ratio

Eurozone

41%

23%

Japan

72%

21%

UK

59%

24%

US

73%

13%

*Short-term **Equity

debt included any liabilities classified as a derivative instrument.

includes common and preference shares and retained earnings less reserves.

Sources: (a) https://www.rba.gov.au/chart-pack. (b) https://www.rbnz.govt.nz/statistics/s10-banks-balance-sheet. (c) https://www.rba.gov.au/publications/fsr/2012/sep/pdf/0912.pdf. Page 11 of 34

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Banking in Australia and New Zealand—Geographic Proximity, Market Con­ centration, and Banking Integration

38.5 Balance Sheets—Uses of Funding 38.5.1 Asset Composition of Banks in Australia and NZ and Globally Domestic Australian and NZ authorized deposit-taking institutions are heavily concentrat­ ed in housing loans (residential mortgage lending) by global standards.7 In Australia, (p. 1198) housing loans comprise 42 percent of loan portfolios, while in NZ banks are even more concentrated and allocate 45 percent of their total assets toward housing loans (see Figure 38.1). These concentrations in housing loans are relatively higher than the hold­ ings of US deposit-taking institutions and are almost three times the concentrations seen in Eurozone deposit-taking institutions. Another distinctive feature of the NZ loan books is that they are also highly concentrated in term loans with 35 percent of the aggregate assets of NZ deposit-taking institutions comprising term loans, exceeding the levels ob­ served in the Eurozone (25 percent), the US (21 percent) and Australia (20 percent). This is likely due to the limited capacity of NZ businesses to borrow for longer terms in exter­ nal capital markets as the country is relatively small with few large listed companies. In both Australia and NZ, banks remain the key source of external financing for SMEs and the agricultural sector. In Australia, more than two-thirds of businesses with one to four employees, and almost three-quarters of businesses with five to nineteen employees, ap­ proached banks for debt financing during 2015–16. Moreover, over 90 percent of rural debt is held by banks in Australia and New Zealand as at 30 June 2017.8 Within housing loans (the mortgage sector), banks in the Australian banking sector are funding more property investments than those in NZ, with 41.1 percent of all loans in owner occupied loans versus 25.6 percent for investment property purchases in Australia, and a lesser 40.3 percent compared to 18 percent in New Zealand (see Table 38.4). (p. 1199) This has been largely driven by rising property prices in Australian capital cities like Sydney and Melbourne in recent years.

Figure 38.1 Asset Composition of Banks in Australia, NZ, and Globally.

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Banking in Australia and New Zealand—Geographic Proximity, Market Con­ centration, and Banking Integration In contrast, foreign banks located across the Tasman Sea are much less active in mort­ gage lending. Foreign banks in Australia and NZ are more concentrated in corporate lending (Non-Financial Corporations (NFCs)) than in housing loans, with 55 percent of their portfolios allocated to NFCs and only 27.3 percent in housing loans. This is likely due to the market dominance of local lenders in retail banking and household/consumer finance. Consequently, foreign banks have, over time, become more specialized and com­ petitive in corporate lending (to NFCs). Lending to Finance Companies (FCs) is on a small scale in both Australia (4.3 percent) and New Zealand (2 percent).

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Banking in Australia and New Zealand—Geographic Proximity, Market Con­ centration, and Banking Integration Table 38.4 Sector Concentration by Bank Type in Australia and Loan Type in all Australian and New Zealand Banks Sector Concentration by Bank Type in Australia(a) AUS Big Four

Other Domestic

Foreign

Personal

4.4%

5.1%

2.7%

Government

0.2%

0%

0.8%

NFCs

25.8%

18%

55%

FCs

4.2%

1.5%

8%

Housing: Owner occupied

42%

49.8%

27.3%

Housing: Invest­

23.5%

25.6%

6.2%

ment Sector Concentration by Loan Type in all Australian and New Zealand Banks (b) % of Total Loans in AUS

% of Total Loans in NZ

Personal

4.3%

2.6%

Government

0.2%

0.6%

NFCs

28.3%

38.4%*

FCs

4.3%

2%

Housing: Owner occu­ pied

41.1%

40.3%

Housing: In­ vestment

21.8%

16%

*

Agriculture contributes 14.1% of total loans.

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Banking in Australia and New Zealand—Geographic Proximity, Market Con­ centration, and Banking Integration Sources: (a) Australian data sourced from: http://www.apra.gov.au. (b) NZ data sourced from: https://www.rbnz.govt.nz/statistics/.

38.5.2 Growing Reliance on Mortgages Since the 1990s, Australian banks have been heavily concentrated in residential mort­ gage lending. The gradual shift toward housing loans began in the early 1990s as busi­ ness loan portfolios suffered significant losses during the 1993 recession. Subsequently in (p. 1200) the remainder of the 1990s, the Australian corporate sector went through a peri­ od of deleveraging and reduced a significant amount of debt on their balance sheets. The late 1990s also coincided with the introduction of Basel I capital requirements, which gave a lower risk weighting to residential loans for regulatory purposes and contributed to a reduction in the proportion of business lending in Australian banks’ loan portfolios from 62 percent in 1985 to 48 percent in 1995. At the same time, residential loan ap­ provals rose from 16 percent in 1991 to comprise 46 percent of banks’ loan portfolios by 1995 and have since remained a relatively stable portion of banks’ loan portfolios.9 The Australian banking industry is unique in that Australian mortgages are dominated by variable interest rate loans (about 80 percent of total loans). The variable interest rates move closely with the Reserve Bank of Australia’s target cash rate used to effect mone­ tary policy but are largely set at the bank lenders’ discretion. This offers borrowers greater flexibility when making prepayments. As mortgage interest payments are not tax deductible in Australia, variable rates allow borrowers to make additional prepayments when rates are low, which allows the borrower to build up a repayment buffer against tougher economic conditions. In the decade since the GFC there has been a marked in­ crease in the spread between the cash rate and the advertised lending rate on household mortgages. The rising value of residential mortgages outstanding in the Australian and NZ banking industries, along with historically high housing prices relative to average income levels in major capital cities, are creating uncertainty as there are concerns that this could be in­ dicative of the development of a housing credit bubble. Australian and New Zealand house prices (particularly on the east coast in Australia and in Auckland in NZ) have more than doubled since the GFC, causing the value of housing loan approvals to increase by almost 70 percent from around 16 billion AUD in 2009 to A$27bn in 2017. Strong demand for property with a growing population in major cities in both Australia and New Zealand, combined with geographic and regulatory constraints on land release and housing supply, a historically low cash rate with near zero interest rates worldwide, and growing household debt relative to low income levels (105 percent of GDP in 2009 to 122 percent in 2017), are creating increasingly concentrated loan portfolios skewed to­ ward residential real estate loans.

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Banking in Australia and New Zealand—Geographic Proximity, Market Con­ centration, and Banking Integration

38.6 Efficiency and Profitability The operations of Australian and New Zealand banks are highly efficient and have only become more so since banking deregulation took place in the 1980s. Avkiran (2000) and (p. 1201) Sathye (2001) find that Australian domestic banks have been more efficient than their foreign competitors. They empirically investigate the x-efficiency (technical and al­ locative) in Australian banks using non-parametric techniques to compute standard effi­ ciency scores. Banks in Australia were typically less efficient overall compared with the banks in European countries and in the US. Their earlier results indicate that the ineffi­ ciency in Australian banks was largely attributable to the wasting of inputs (technical in­ efficiency) rather than choosing the incorrect input combinations (allocative inefficiency). Sturm and Williams (2004) also considered the impact of foreign bank entry on banking efficiency in Australia during the post-deregulation period 1988–2001. They found that major Australian banks have consistently used their size and dominance as an effective barrier to entry to new foreign bank entrants. Competition emanating from diversity in bank types has enabled further efficiency improvements. Sturm and Williams (2008) find further evidence to suggest that banks from more financially sophisticated nations and those that have operated in Australia for a longer timeframe are more efficient within Australia. Overall, foreign banks benefit from an early mover advantage into the Aus­ tralian and New Zealand banking industry. Similarly, Lu et al. (forthcoming) recently examined the cost and profit efficiency of banks in New Zealand and find that foreign banks in New Zealand are typically more efficient than domestic banks but the Australian-owned banks in New Zealand operate more effi­ ciently than foreign-owned banks from other countries, suggesting that there are signifi­ cant economic benefits from the high degree of banking market integration across Aus­ tralian and New Zealand banking markets. Their results build on Tripe and To’s (2002) previous findings that the performance of foreign-owned banks in New Zealand depends (similar to that for foreign entrants in Australia), among other factors, on the length of time that they have been operating in the host country. Smaller deposit-taking institutions, like credit unions and building societies, populate a regulated sub-sector of the Australian financial system. These mutuals have had to adapt to significant changes in market competition post banking deregulation and have re­ mained competitive by diversifying their interest and non-interest income sources and embracing technological changes and keeping costs low through achieving scale efficien­ cies (Worthington, 2000; Esho, Kofman, and Sharpe, 2005). However, their objectives, ownership structures and cultures remain different to commercial banks and Worthington (2004) finds that most of the consolidation in this sector has occurred through “friendly mergers” with the perceived compatibility in associational bond and membership being an important driver. McAlvey, Sibbald, and Tripe (2010) also find similar drivers of credit union mergers in New Zealand. Brown and Davis (2009) discuss the challenges for mutu­ al financial institutions in Australia to meeting minimum capital requirements since the formal adoption of the Basel risk-weighted regulatory framework. Using a sample of the Page 16 of 34

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Banking in Australia and New Zealand—Geographic Proximity, Market Con­ centration, and Banking Integration largest Australian credit unions, they provide empirical evidence to show that Australian credit unions shifted to using shorter-term profit targets in managing their capital buffers above those binding regulatory minimums since the Basel rules were first introduced into the Australian banking sector in 1992. (p. 1202)

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Banking in Australia and New Zealand—Geographic Proximity, Market Concentration, and Banking Integration Table 38.5 Cost-to-Income Ratios Cost-to-Income Ratios(a)

C-I* *Includes **Four

NZ

AUS

US

UK

Japan

Euro­ zone(b)

Egypt (lowest)

Brazil (high­ est)

42%

53%(c),**

59%

77%

63%

58%

28%

98%

all financial institutions with assets greater than US $10 Billion.

major Australian banks recorded a Cost-to-Income (C-I) Ratio of 43% in 2017.

Sources: (a) https://marketintelligence.spglobal.com/our-thinking/ideas/cost-to-income-ratios-of-banks-worldwide. (b) https://www.ecb.europa.eu/pub/pdf/other/reportonfinancialstructures201610.en.pdf. (c) https://home.kpmg.com/ au/en/home/insights/2017/11/major-australian-banks-full-year-2017-snapshot.html.

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Banking in Australia and New Zealand—Geographic Proximity, Market Con­ centration, and Banking Integration Indeed, at present Australian and NZ banks are highly operationally efficient by global standards.10 On average, the Australian and NZ banks have a cost-to-income (C-I) ratio that is slightly lower than banking sectors in other developed economies like the US, Japan and in the Eurozone (see Table 38.5). The C-I ratio for Australian banks is 53 per­ cent and for NZ banks it is 42 percent which is much closer to the efficiency of the four major banks (C-I ratio of 43 percent) that dominate both markets. Elsewhere, the C-I ra­ tios are 58 percent for European banks, 59 percent for US banks, 63 percent for Japanese banks, and even 77 percent for UK banks (on average). This indicates that there are dif­ ferences in the operating activities and lending portfolios of Australian and NZ banks rel­ ative to other banks internationally. First, the Big Four and their NZ subsidiaries have his­ torically focused on traditional commercial banking activities. In comparison, “universal” banks situated in the United States and continental Europe (specifically Switzerland and Germany) have additional arms in investment banking and wealth management services. These activities have higher levels of staff remuneration relative to commercial banking operations which, on average, increases personnel (employee-related) expenses for the fi­ nancial institutions. Second, lending concentration in certain segments can also help ex­ plain the differential in cost-to-income ratios. Household lending for example, is more ho­ mogeneous than Commercial and Industrial (C&I) loans with respect to loan applicants, and are thus more likely to benefit from technological developments and scale economies created in processing and monitoring loans. This helps to avoid the excess costs associat­ ed with relationship-based lending activities. Australian and NZ banks have 42 percent and 45 percent, respectively, of their assets concentrated in housing, both owner occupi­ er and investment, compared with a smaller 16 percent within the Eurozone (as dis­ cussed above) and this can account for much of the cost efficiencies achieved relative to other banks internationally. (p. 1203)

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Banking in Australia and New Zealand—Geographic Proximity, Market Concentration, and Banking Integration Table 38.6 Profitability NZ

AUS

US

UK

Japan

Eurozone

World

ROE(a)

14%

12.3%

9.6%

3.5%

6%

6.9%

10.2%

NIM(b)

2.1%

1.7%

3.2%

1.4%

1%

1.8%

3.6%

Sources: (a) https://fred.stlouisfed.org. (b) https://fred.stlouisfed.org.

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Banking in Australia and New Zealand—Geographic Proximity, Market Con­ centration, and Banking Integration Due to their efficient operations and business models, the Australian and NZ banks are al­ so more profitable relative to global standards.11 The return on equity (ROE) for both the Australian and NZ banking industry has consistently been above 10 percent with the four major banks’ ROE being around 15 percent in recent years (see Table 38.6). In these two banking sectors, average ROE has been 14 percent in NZ and a slightly lower 12.3 per­ cent in Australia. ROE, is a measure of profit, expressed as a percentage of shareholders’ equity. It shows how much profit a corporation (like a bank) generates with the funds in­ vested by its shareholders. The high profitability indicated by these ROE figures in the banking industry has been the result of strong economic growth over the past two decades in both Australia and New Zealand as well as low Cost-to-Income ratios achieved by the banks. The Australian and NZ banking sectors have not faced an economic down­ turn for the longest period of time compared to international counterparts in the US, UK, and Europe and this has supported growing profitability enjoyed by bank shareholders. Australian and New Zealand banks currently have higher returns on equity than banks in many other major developed markets. Those returns are about twice as high or more than the returns of Japanese, European, and UK banks. The returns earned by US banks are only a few points below the Australian and New Zealand levels. Interestingly, banks in the smaller banking industry in NZ enjoy greater profits from their traditional lending activities as the net interest margins experienced at 2.1 percent is one of the highest outside of the US. Australian banks have slightly lower net interest margins at 1.7 percent compared with NZ banks and are more similar in terms of the interest rate spreads charged on their traditional lending businesses when compared to European and UK banks (at 1.8 and 1.4 percent, respectively). This suggests that the banking industry is fairly competitive in the lending business, despite the high concentration within the sector. As we have seen, the Australian and NZ banking sectors perform extremely well overall relative to global markets—this fact becomes even more obvious when considering the performance of the four major banks that operate in the Oceania region. The C-I ratio for Australia’s Big Four banks has fallen roughly 20 percent over the previous two decades to 43.4 percent in 2017. This means that on a global scale, the C-I ratio of the Big Four has been at the bottom end for the past decade—a key contributor to (p. 1204) consistent prof­ itability (measured by the ROE). This reduction reflects growing competitive advantages in commercial banking operations. Technological developments in the space of loan ap­ provals (specifically the processing of residential mortgages using more hard than soft in­ formation) allow banks to streamline these products to their customers. This has allowed the banks to reconfigure the operating model of local branches and at the same time cut back on the size of their costly branch networks. Traditional transaction activities are in­ creasingly being pooled through net banking and mobile phone applications, which has allowed local bank branches to focus on product sales and cross-selling to customers, thereby increasing income for the institution relative to the costs incurred.12

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Banking in Australia and New Zealand—Geographic Proximity, Market Con­ centration, and Banking Integration

38.7 Explicit and Implicit Government Support for Banks During the Global Financial Crisis of 2007–8, governments in a large number of countries around the world strengthened deposit protection arrangements and introduced explicit guarantees for financial institutions’ liabilities (see Demirgüç-Kunt, Kane, and Laeven, 2014). Australian and NZ banking systems are unique in that they were the two last OECD countries that did not have explicit deposit insurance on bank deposits or other forms of bank debt in place prior to the GFC. Prior to the GFC, the two banking systems relied on depositor preference, in which it is understood that all deposits have a higher ranking than the claims of ordinary unsecured, non-preferred creditors. However when explicit deposit insurance schemes and wholesale funding guarantee schemes were implemented en masse in advanced economies in response to the extreme­ ly difficult funding conditions experienced during the GFC, Australian and NZ financial regulators quickly followed suit. They implemented protection schemes that were de­ signed to promote financial system stability and to encourage the ongoing provision of credit by supporting confidence in the financial sector and reducing actual and perceived risks, thereby assisting financial institutions to access deposit and wholesale funding (at a reasonable cost) during a time of considerable financial turbulence. In Australia, two ex­ plicit protections were implemented for the first time—the Financial Claims Scheme (also known as the Australian Government Deposit Guarantee) was introduced first to protect retail depositors to the value of 1 million AUD and Australian Government Guarantee Scheme protected large deposits and wholesale debt funding. During the period between 12 October 2008 and 31 March 2010, the Australian Govern­ ment implemented the Guarantee Scheme for Large Deposits and Wholesale Funding (Australian Government Guarantee Scheme hereafter) to offer increased depositor pro­ tection and guarantee arrangements for financial institutions’ wholesale (p. 1205) debt. The Australian Government Guarantee Scheme was announced in October 2008 and com­ menced on 28 November in that year. Under this scheme, eligible ADIs were able to offer government-guaranteed deposits greater than 1 million AUD, and government-guaran­ teed wholesale debt funding with maturity out to five years in exchange for a risk-based fee (see Luong et al. (2019) for details of the scheme). It was designed to provide protec­ tion for large deposits greater than 1 million AUD and banks’ wholesale debt funding to maintain continual confidence in the financial system. It was introduced in response to the evaporation of liquidity in the global financial system at the height of the 2008 Great Recession. The scheme was implemented to restore financial system stability in Australia and to encourage the ongoing provision of credit by supporting confidence and assisting ADIs to access wholesale funding from international credit markets at a reasonable cost during the time of considerable turbulence and liquidity shortage. The scheme also en­ sured that Australian institutions were not placed at a disadvantage, compared to their international competitors, who could access similar government guarantees on bank debt. The scheme was administered by the national central bank (the Reserve Bank of Page 22 of 34

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Banking in Australia and New Zealand—Geographic Proximity, Market Con­ centration, and Banking Integration Australia) for the federal government. Eligible ADIs were able to apply to have their eligi­ ble wholesale funding securities guaranteed under the scheme. The scheme was volun­ tary and subject to an approval process and the payment of a monthly fee by the ADI on the amounts guaranteed. Following improvements in funding and market conditions, the Australian government closed the wholesale funding guarantee to new borrowings on March 31, 2010. Outstanding large deposits and wholesale funds of approximately 160 billion AUD with up to five years of maturity remained at the time of the removal of the government guarantee. In the context of the Financial Claims Scheme introduced in Australia for retail deposits during the GFC, Yan et al. (2014) showed that market deposit rates and deposit growth for ADIs became much less sensitive to bank fundamentals once the scheme was in place, meaning that market discipline had been weakened to some extent by the introduction of a formal explicit deposit protection arrangement. Yan et al. (2014, 2015) find that the introduction of the explicit domestic deposit insur­ ance scheme lowered the perceived risks for Australian financial institutions and this, in turn, led to a reduction in market discipline by depositors for protected banks and mutu­ als (building societies and credit unions). They find this to be reflected in the lower inter­ est rates demanded by depositors resulting in a major reduction in funding costs for fi­ nancial institutions after the introduction of the Financial Claims Scheme. Luong et al. (2019) closely examine the effects of the Australian Government Guarantee Scheme and find that the introduction of the wholesale funding guarantee was effective in helping larger ADIs to secure wholesale debt funding at reasonable costs during the GFC and as intended, it supported consumer confidence by lowering actual and perceived bank risks within the financial system. They find that the Australian Government Guaran­ tee Scheme led to a significant reduction in bank funding costs for those ADIs that volun­ tarily paid to adopt the government guarantee for their longer-term liabilities (with a ma­ turity up to five years). Moreover, they find that larger banks continued to enjoy lower funding costs even after the subsequent removal of (p. 1206) the government guarantee scheme. This suggests that the effects of the Australian Government Guarantee Scheme may continue to persist in the form of an implicit subsidy for an extended period, even well beyond the closure of the Australian Government Guarantee Scheme, given the precedence with having an explicit government guarantee on bank liabilities. This can continue to help banks to maintain better access to off-shore funding markets. However, despite the significant reduction in banks’ funding costs, the authors do not find evidence to suggest that the government guarantee increased risk-taking in banks that voluntarily paid for the guarantee. Consistent with this revelation, Bollen et al. (2015) also found a significant reduction in both systematic and systemic risks in Australian banks with the introduction of the government guarantee scheme during the GFC. Corroborating with the cross-country study of Anginer, Demirgüç-Kunt, and Zhu (2014), the empirical evi­ dence indicates that the warranted introduction of explicit protection at the height of the GFC was beneficial as it effectively reduced bank risk (especially systemic risk) and

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Banking in Australia and New Zealand—Geographic Proximity, Market Con­ centration, and Banking Integration served to maintain confidence in the banking system without creating moral hazard prob­ lems, unlike in normal times. Overall, the explicit protection offered by the government through the Financial Claims Scheme and the Australian Government Guarantee Scheme strengthened the overall sta­ bility of the Australian financial system by ensuring that financial institutions continued to have access to capital market funding during the most intense phase of the crisis and banks continued to extend credit to support investment throughout the economy. Howev­ er, it remains that there is a perception that the four major banks dominant in the Aus­ tralian and NZ banking industries are too big and too systemically important to fail and they continue to enjoy some implicit subsidies in funding costs that help to maintain their competitive advantages relative to smaller domestic financial institutions. The empirical evidence clearly indicates that the large Australian banks can borrow more cheaply be­ cause their lenders expect them to receive government support during financial crises and this perception has continued since government support was officially extended at the height of the 2007–8 Global Financial Crisis. Furthermore, the Productivity Commis­ sion (2018) argues that by “incorporating perceived government support in their relative ratings of Australia’s banks, rating agencies further embed the major banks’ ‘too big to fail’ status” (p. 38).

38.8 Resilience of the Australian and New Zealand Banking Systems 38.8.1 Capital Requirements

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Banking in Australia and New Zealand—Geographic Proximity, Market Concentration, and Banking Integration Table 38.7 Capital Requirements

CET1 Ratio *for

AUS

NZ

US***

UK

Eurozone

9.5%*

7%**,(a)

10%(b)

9.875%****

7.875%*****

Banks listed as a D-SIB, CET1 ratios 1% higher.

**equal

to the minimum level recommended in Basel III.

***D-SIB

listed. 2019 target.

****Comprised

of 4.5%CET1 + 1.5% Pillar 2 (discretion) + 1.875% CCB + 1% CCCB.

*****Comprised

of 4.5%CET1 + 1.5% Pillar 2 (discretion) + 1.875% CCB.

Sources: (a) https://www.rbnz.govt.nz/regulation-and-supervision/banks/prudential-requirements/information-relat­ ing-to-the-capital-adequacy-framework-in-new-zealand. (b) https://www.forbes.com/sites/greatspeculations/ 2017/03/10/how-the-largest-u-s-banks-have-strengthened-their-core-capital-ratios-since-2012/#f5bc4e7445ac.

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Banking in Australia and New Zealand—Geographic Proximity, Market Con­ centration, and Banking Integration The Australian Prudential Regulation Authority (APRA) enforces the capital adequacy re­ quirements of all Australian banks. In 2013, APRA implemented Basel III and (p. 1207) in­ creased the requirements for both the quality and quantity of regulatory capital. As a re­ sult, the composition of Tier 1 and Tier 2 capital has also changed. Tier 1 capital must be at least 6 percent (of risk-weighted assets), of which 4.5 percent must be from common equity. The combination of Tier 1 and Tier 2 capital must be at least 8 percent of riskweighted assets. Regarding the capital buffer levels, APRA requires all locally incorporat­ ed ADIs to hold a capital buffer consisting of three components: a capital conservation buffer, a countercyclical capital buffer and an additional buffer (1 percent of risk-weight­ ed assets) for domestically systemically important banks (D-SIBs) like the “top four” ma­ jor Australian banks, constituting a common equity tier 1 (CET1) ratio of 9.5 for most banks and 10.5 for the largest banks (see Table 38.7). In the NZ banking industry, banks are well capitalized relative to the local prudential cap­ ital requirements (CET1 ratio of 7 percent) with the four largest banks reporting a higher weighted average CET1 ratio of 10.5 percent. However, this level of capitalization places NZ banks in the bottom quartile of banks globally as the world’s major banks reported a median CET1 ratio of 12.1 percent as at February 2017. This does not suggest that the capital framework in NZ is inadequate but, rather, it reflects the different approaches and timing in implementing the new capital requirements under Basel III to accommodate for idiosyncrasies within a country’s financial system. In December 2015, for example, the APRA estimated that after factoring differences in risk-weight exposure measurements across economies, the major Australian banks would record a CET1 ratio 3.5 percent higher under an internationally uniform prudential methodology.13,14 Bui, Scheule, and Wu (2017) recently examined the financial resilience of the Aus­ tralasian banking industry. The authors conducted simulations to assess the (p. 1208) con­ sequences of banks having higher capital buffers (above the minimum regulatory require­ ments) on financial system resilience, banks’ cost of debt, and credit supply and found that in spite of its high level of concentration, the Australasian banking system has a strong ability to withstand or recover from losses, should they occur in the near future. The authors examined the likely unconditional losses to the Australian financial system at the aggregate level using systemic metrics such as the Value-at-Risk (VaR), conditional VaR (CoVaR), and also Expected Shortfall (ES) under varying levels of capital buffers. They find that a moderate increase in bank capital buffers of around 2 to 3 percent would be sufficient to maintain system-wide resilience, even after taking economic downturns into consideration. Their findings affirm that higher capital buffers are associated with lower system-wide losses. Banks that hold capital buffers in excess of the regulatory re­ quirement are able to absorb losses more sufficiently, and hence, are less likely to pass the losses onto the whole system. Furthermore, while banks benefit from paying a lower cost of debt when they have a higher capital buffer, lending volumes are reduced, indicat­ ing that credit supply may be hampered if bank capital levels are raised too high for banks in the financial system.

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Banking in Australia and New Zealand—Geographic Proximity, Market Con­ centration, and Banking Integration Cummings and Durrani (2016) analyzed the loan loss provisioning (LLP) practices of Aus­ tralian banks and found evidence that Australian banks are prudent in mitigating the im­ pact of external credit market conditions under the Basel regulatory framework in their provision of credit supply, and actively increase their provisions in anticipation of future lending growth by allocating their earnings and capital buffers to pre-fund future credit losses. Brown, Do, and Trevarthen (2017) provide further evidence to show that the Australian banking sector is highly resilient as, during the 2007–8 Global Financial Crisis, globally active international banks retrenched home and stopped lending to the Australian mar­ ket. However, with limited global operations, the major Australian banks were able to ab­ sorb and manage the liquidity shock. This subsequently resulted in these domestic banks carrying a significantly greater proportion of revolving credit facilities in their syndicated loan portfolios after 2008. Domestic banks’ willingness and ability to deal with the disrup­ tion in credit supply and to hold a greater proportion of high liquidity risk revolvers were largely supported by the increasing levels of their transaction deposits. This was particu­ larly encouraged by the introduction of explicit deposit insurance and government guar­ antees for bank liabilities (Luong et al., 2019).

38.8.2 Recent Banking Regulatory Reforms There have been major episodes of banking deregulation, financial system inquiries (FSI), and subsequent regulatory reforms based on recommendations emanating from the FSIs that have shaped the Australasian banking industry. There is now much more political at­ tention on Australian banks and their activities with the introduction of a new bank levy and the launch of a Royal Banking Commission. The most recent FSI took place in 2014, post the Great Recession. The key recommendations emanating from (p. 1209) the 2014 FSI related to the capital standards for Australian banks as, like in the rest of the world, there is an ongoing debate concerning the appropriate size of capital requirements for banks to mitigate system-wide losses, and the economic tradeoff associated with raising more capital. From a macro-prudential perspective, raising the level and quality of capital in the banking system is the traditional regulatory approach to ensure that there is effec­ tive loss-absorbing capacity. Thakor (2014) shows theoretically that higher capital is asso­ ciated with higher lending, higher liquidity creation and banks’ value as well as their sur­ vival likelihood during the crises. In the aftermath of the Great Recession suffered in the rest of the world, an extensive Fi­ nancial System Inquiry was conducted and reported in 2014 by the Australian Govern­ ment (Australian Treasury, 2014) to provide recommendations to enhance the financial re­ silience of the Australian financial system and banks became a key focus, given the weak­ nesses shown in the global banking sector, especially with regards to their loss absorp­ tion capacity. The inquiry identified that Australian banks were not as strongly capitalized as they ought to be and recommended that banks increase their capital requirements to the levels of the top quartile of all banks in the world to improve their loss absorption ca­ pacities. Following that recommendation, banks had to engage in large equity capital Page 27 of 34

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Banking in Australia and New Zealand—Geographic Proximity, Market Con­ centration, and Banking Integration raisings to shore up their regulatory capital levels to world-class standards. This has made Australian banks and the financial system as a whole even better capitalized to weather any future economic shocks in years to come. Overall, the new higher capital requirements coming from the FSI in Australia, and as part of the additional Basel III capital and liquidity arrangements, do impose extra con­ straints on banks’ balance sheets. Based on scenario analysis, Cummings and Wright (2016) showed that the higher capital requirements recommended by the FSI would flow on to result in only a modest increase in the borrowing costs faced by bank customers (in the order of 20 basis points annually for a 5 percentage point increase in the ratio of equi­ ty capital to bank assets). The Prudential Regulator, APRA’s more conservative approach relative to other banking systems around the world should also help to lower the cost of funds for banks based on the recent findings of Bui, Scheule, and Wu (2017) on the trade­ offs associated with higher capital requirements for Australian banks. However, exces­ sively high capital requirements may instead force banks to curb their lending and re­ duce credit supply throughout the economy. On balance, using more capital funding and holding more liquidity is likely to enhance the stability of the financial system and give more confidence to wholesale investors, creditors, and depositors, as reflected in lower risk premia required by these providers of funds to banks in the highly integrated Aus­ tralian and New Zealand banking industries. During 2017, the Australian Federal Government introduced a major bank levy on the five largest banks in the country (the Big Four plus the Macquarie Bank). This bank levy was designed to contain excessive risks in domestic systemically important banks, and to help to raise new revenue to augment depleted government coffers following taxpayer-funded support for banks that took place during the financial crisis. More specifically, the objec­ tives of the bank levy are to ensure that large banks in Australia contribute to the govern­ ment budget in the short and long term; make a fair contribution given the (p. 1210) risks that they pose to the financial system and wider economy; and operate on a more level competitive playing field with smaller banks. The bank levy is expected to raise 6.2 billion AUD over the first four years of its operation. Chronopoulos, Sobiech, and Wilson (forthcoming) have recently examined the impact on shareholders from the Australian Federal Government’s introduction of this bank levy. They perform an event study using abnormal daily stock prices for a small sample of com­ mercial banks operating and listed in Australia that were both affected and not affected by the new bank levy around the announcement of the bank levy on May 9, 2017. The re­ sults of their event study analysis indicate a material loss of shareholder value following the announcement of the bank levy for the large Australian banks that were directly af­ fected by this policy decision. The cumulative abnormal returns for the banks liable to pay the new bank levy suggest a decline in value of the order of 5.2 percent, which is both statistically and economically significant. This indicates that market expectations re­ garding the effects of the sudden introduction of a bank levy on large Australian banks are detrimental for shareholder value.

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Banking in Australia and New Zealand—Geographic Proximity, Market Con­ centration, and Banking Integration In late 2017, following repeated banking scandals involving the major banks over a num­ ber of years, the Australian Federal Government established the Royal Commission into Misconduct in the Banking, Superannuation, and Financial Services Industry and appoint­ ed the Honorable Kenneth Madison Hayne AC QC as the Commissioner for this major in­ quiry.15 The Royal Banking Commission started investigating the extent of misconduct in the Australian financial services sector in early 2018 and identified in its September 2018 Interim Report some fundamental issues in the provision of consumer financial services and perverse remuneration structures that existed within the financial services industry. The judiciary inquiry has publicly revealed that the large financial institutions in Australia have abused their oligopolistic powers and have breached laws when issuing home loans, credit cards, and other consumer loans and financial products. Public trust in the Aus­ tralian financial services industry has been compromised through the repeated revela­ tions of malpractice across a broad range of financial products and services offered by the industry. Banks have become too focused on cross-selling financial products, not just to those customers who did not need them, but even to customers who were no longer liv­ ing; their greed has been publicly condemned, as have their sales-driven profit-maximiza­ tion strategies. It has also been highlighted in the judicial inquiry that when misconduct by the banks has been revealed in the past, it either went unpunished or the conse­ quences did not meet the seriousness of what had been done. The responsible financial regulators rarely, if ever, took full enforcement action and went to court to seek public de­ nunciation of, and punishment for, misconduct and the penalties they settled for were nearly always much more trivial than what they could properly have asked a court of jus­ tice to impose upon the banks. On February 4, 2019, Commissioner Kenneth Hayne deliv­ ered his final report on the banking and financial services industry and made a number of referrals to the financial regulators, the Australian Securities and Investments Commis­ sion (ASIC) and APRA, to further (p. 1211) investigate and take appropriate action over cases of misconduct identified. Critically, he also provided seventy-six recommendations to overhaul the financial sector and, in particular, highlighted the need to end conflicted remuneration within the Australian financial services industry.

38.9 Conclusions The Australian and New Zealand banking systems are highly integrated with all “top four” Australian banks having significant investments and operations within the relatively smaller New Zealand banking sector. The two most prominent banking industries in the Oceania region are highly interconnected and this naturally results in similar banking market structures and regulatory supervision frameworks for banks to operate under. Australian and NZ banks were resilient throughout the Great Recession that started in 2008 and they have displayed relatively stronger financial performance compared to banking industries in other developed economies, which suffered economic downturns and credit losses that weighed heavily on US and European banks through the recent Great Recession and European Sovereign debt crisis. They were remarkably resilient to the liquidity shortages that engulfed the rest of the world during the 2007–8 global finan­ Page 29 of 34

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Banking in Australia and New Zealand—Geographic Proximity, Market Con­ centration, and Banking Integration cial crisis period. They have also absorbed the higher capital requirements that have been prescribed by banking regulators post-crisis relatively well. The Australian banking system has always been well capitalized and increasingly more so with recent recommendations for higher capital requirements emanating from the 2014 Financial System Inquiry that encouraged banks to become among the strongest of all the banks in the world. Despite the significant level of market concentration, both the Aus­ tralian and NZ banking industries remain two of the most stable banking systems in the developed world, and are well supported and closely supervised by financial regulators within a sound regulatory framework. However, the recent Royal Banking Commission in Australia has identified some fundamental issues in the provision of consumer financial services, and public trust in the Australian financial services industry has been compro­ mised through repeated revelations of malpractice across a broad range of financial prod­ ucts and services offered by the industry. This has renewed interest in boosting competi­ tion within the banking sector in order to improve upon financial consumer outcomes.

References Anginer, D., Demirgüç-Kunt, A., and Zhu, M. (2014). “How Does Deposit Insurance Affect Bank Risk? Evidence from the Recent Crisis,” Journal of Banking and Finance, 48, 312– 21. Australian Treasury (2014). “Financial System Inquiry: Final Report,” Commonwealth of Australia, Canberra. Avkiran, N.K. (2000). “Rising Productivity of Australian Trading Banks Under Deregulation,” Journal of Economics and Finance, 24, 122–40. (p. 1212)

Bollen, B., Skully, M., Tripe, D., and Wei, X. (2015). “The Global Financial Crisis and Its Impact on Australian Bank Risk,” International Review of Finance, 15, 89–111. Brown, C. and Davis, K. (2009). “Capital Management in Mutual Financial Institutions,” Journal of Banking and Finance, 33, 443–55. Brown, C., Do, V., and Trevarthen, O. (2017). “Liquidity Shock Management: Lessons from Australian Banks,” Australian Journal of Management, 42, 637–52. Bui, C., Scheule, H., and Wu, E. (2017). “The Value of Bank Capital Buffers in Maintaining Financial System Resilience,” Journal of Financial Stability, 33, 23–40. Chronopoulos, D.K., Sobiech, A., and Wilson, J. (forthcoming). “The Australian Bank Levy: Do Shareholders Pay?” Finance Research Letters. Cummings, J. and Wright, S. (2016). “Effect of Higher Capital Requirements on the Fund­ ing Costs of Australian Banks,” Australian Economic Review, 49, 44–53.

Page 30 of 34

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Banking in Australia and New Zealand—Geographic Proximity, Market Con­ centration, and Banking Integration Cummings, J.R. and Durrani, K.J. (2016). “Effect of the Basel Accord Capital Require­ ments on the Loan–Loss Provisioning Practices of Australian Banks,” Journal of Banking & Finance, 67, 23–36. Delis, M., Kokas, S., and Ongena, S. (2017). “Bank Market Power and Firm Performance,” Review of Finance, 21, 299–326. Demirgüç-Kunt, A., Kane, E., and Laeven, L. (2014). “Deposit Insurance Database,” IMF Working Paper No. WP/14/118, July. Esho, N., Kofman, P., and Sharpe, I. (2005). “Diversification, Fee Income, and Credit Union Risk,” Journal of Financial Services Research, 27, 259–81. Gertler, M., Kiyotaki, N., and Prestipino, A. (2016). “Anticipating Banking Panics,” Ameri­ can Economic Review, 106, 554–9. Heard, C., Menezes, F., and Rambaldi, A. (2017). “The Dynamics of Bank Location Deci­ sions in Australia,” Australian Journal of Management, 43, 241–62. Lu, Y.F., Gan, C., Hu, B., Toh, M.Y., and Cohen, D. (forthcoming). “Bank Efficiency in New Zealand: A Stochastic Frontier Approach,” New Zealand Economic Papers. Luong, T.M., Pieters, R., Scheule, H., and Wu, E. (2019). “The Impact of Government Guarantees on Banks’ Wholesale Funding Costs and Lending Behavior: Evidence from a Natural Experiment,” Pacific-Basin Finance Journal, in press. McAlvey, L., Sibbald, A., and Tripe, D. (2010). “New Zealand Credit Union Mergers,” An­ nals of Public and Cooperative Economics, 81, 423–44. Productivity Commission (2018). “Competition in the Australian Financial System,” Aus­ tralian Government Productivity Commission Inquiry Report Overview and Recommenda­ tions, No. 89, June. Sathye, M. (2001). “X-Efficiency in Australian Banks,” Journal of Banking and Finance, 25, 613–30. Stewart C., Robertson, B., and Heath, A. (2013). “Trends in the Funding and Lending Be­ haviour of Australian Banks,” Research Discussion Paper 2013–15, Reserve Bank of Aus­ tralia, Sydney. Sturm, J.-E. and Williams, B. (2004). “Foreign Bank Entry, Deregulation and Bank Efficien­ cy: Lessons from the Australian Experience,” Journal of Banking and Finance, 28, 1775– 99. Sturm, J.-E. and Williams, B. (2008). “Characteristics Determining the Efficiency of For­ eign Banks in Australia,” Journal of Banking and Finance, 32, 2346–60. Thakor, A. (2014). “Bank Capital and Financial Stability: An Economic Trade-Off or a Faustian Bargain?” Annual Review of Financial Economics, 6, 185–223. Page 31 of 34

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Banking in Australia and New Zealand—Geographic Proximity, Market Con­ centration, and Banking Integration Tripe, D. and To, H.M. (2002). “Factors Influencing the Performance of ForeignOwned Banks in New Zealand,” Journal of International Financial Markets, Institutions and Money, 12, 341–57. (p. 1213)

Worthington, A. (2000). “Technical Efficiency and Technological Change in Australian Building Societies,” Abacus, 36, 180–97. Worthington, A. (2004). “Determinants of Merger and Acquisition Activity in Australian Cooperative Deposit-taking Institutions,” Journal of Business Research, 57, 47–57. Yan, X., Skully, M., Avram, K., and Vu, T. (2014). “Market Discipline and Deposit Guaran­ tee: Evidence from Australian Banks,” International Review of Finance, 14, 431–57. Yan, X., Skully, M.T., Avram, K., and Vu, T. (2015). “Credit Unions, Market Discipline, and the Australian Deposit Guarantee,” Monash University Working Paper.

Notes: (1) Information sourced from: http://archive.stats.govt.nz/browse_for_stats/ economic_indicators/NationalAccounts/Contribution-to-gdp.aspx. (2) Information sourced from: https://financialservices.royalcommission.gov.au. (3) Sourced from: https://financialservices.royalcommission.gov.au/publications/Docu­ ments/some-features-of-the-australian-banking-industry-background-paper-1.pdf. (4) Information sourced from: https://www.rba.gov.au; https:// financialservices.royalcommission.gov.au/publications/Documents/some-features-of-theaustralian-banking-industry-background-paper-1.pdf. (5) It is important to note however that the shift in preferences was counteracted to an ex­ tent by the asset allocation of Australian superannuation companies (pension funds). A high percentage of their portfolios are allocated to deposit accounts. (6) Information sourced from: https://www.rba.gov.au/publications/rdp/2013/pdf/ rdp2013-15.pdf. (7) Data on asset composition for Australian ADIs is sourced from: http://www.apra.gov.au/ publications/quarterly-authorised-deposit-taking-institution-property-exposures; NZ ADIs is sourced from: https://www.rbnz.govt.nz/statistics/s10-banks-balance-sheet; US ADIs is sourced from: https://www.federalreserve.gov/releases/H8/current/h8.pdf; and Eurozone ADIs is sourced from: http://sdw.ecb.europa.eu/reports.do?node=10000029. (8) Sourced from: https://financialservices.royalcommission.gov.au/publications/Docu­ ments/some-features-of-the-australian-banking-industry-background-paper-1.pdf. (9) See http://www.apra.gov.au/Speeches/Documents/1508-ABE-Lunchtime-Briefing-Bank­ ing-on-housing-26August2015.pdf; https://www.rba.gov.au/publications/rdp/2013/pdf/ Page 32 of 34

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Banking in Australia and New Zealand—Geographic Proximity, Market Con­ centration, and Banking Integration rdp2013-15.pdf; https://www.rba.gov.au/speeches/2010/sp-ag-300310.html; https:// www.rba.gov.au/chart-pack/household-sector.html. (10) Data sourced from: http://www.rba.gov.au/publications/fsr/2014/sep/pdf/0914.pdf. (11) Caveat: A precise international comparison cannot be made, mainly due to differ­ ences in accounting standards employed by banks around the world. (12) Sourced from: http://www.rba.gov.au/publications/fsr/2014/sep/pdf/0914.pdf. (13) Sourced from: https://www.rbnz.govt.nz/research-and-publications/speeches/2017/ speech-2017-03-07. (14) RBNZ conducted a similar study and found an increase in CET1 ratios of 1 to 2 per­ cent. (15) See details at: https://financialservices.royalcommission.gov.au.

Fariborz Moshirian

Fariborz Moshirian is the Director of the Institute of Global Finance (IGF) in the UNSW Business School, Sydney. The IGF conducts collaborative research on Sys­ temic risk, Financial innovation and Global financial stability with NYU, UCLA and has had joint work with the Asian Development Bank, the International Monetary Fund, the World Bank, PwC and a number of world-class research centers. He was the Bertil Danielsson Professor of Finance for 2006 (sponsored by the Stockholm School of Economics and Nordea Bank). He is a consultant to the Asian Development Bank. He served as the Head of School of Banking and Finance at UNSW for over four years. He has published a number of influential research works on global finan­ cial stability, interconnectedness, governance, systemic risk, and the financial and so­ cial challenges of the twenty-first century in leading finance journals including the Journal of Finance, Journal of Financial Economics, Journal of Financial and Quanti­ tative Analysis, Journal of Financial Markets, and the Journal of Banking and Fi­ nance. Eliza Wu

Eliza Wu is an Associate Professor in Finance at the University of Sydney Business School. She has a joint honours degree in Economics and Econometrics and a Ph.D in Finance from the University of New South Wales (UNSW). Her research is focused on financial integration, the impact of financial regulations, credit risk and corporate governance. She has published over fifty international academic journal articles and book chapters. She was an Associate Editor of the Journal of Banking and Finance from 2013–2019 and serves as an Associate Editor for the Journal of Financial Stabil­ ity amongst other journals. Outside of academia, she has worked at the Reserve Bank of Australia and at the Bank for International Settlements’ (BIS) Representative Of­ fice for Asia and the Pacific. She has also worked as a teaching fellow at the Universi­ Page 33 of 34

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Banking in Australia and New Zealand—Geographic Proximity, Market Con­ centration, and Banking Integration ty of Cambridge in Banking and Finance, a research fellow at the Hong Kong Insti­ tute for Monetary Research, and undertaken consulting and policy work for the BIS.

Page 34 of 34

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Index

Index   The Oxford Handbook of Banking (3rd edn) Edited by Allen N. Berger, Philip Molyneux, and John O. S. Wilson Print Publication Date: Oct 2019 Subject: Economics and Finance Online Publication Date: Nov 2019

(p. 1214)

(p. 1215)

Index

Note: Boxes, Figures and Tables are indicated by an italic “b”, “f ”, “t” and notes are indi­ cated by “n” following the page numbers. A ABCP, see asset-backed commercial paper (ABCP) ABN Amro bank 361 ABS, see asset-backed securities (ABSs) ABSA bank 1089 access to financial services, see financial inclusion Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) 361, 380 accounting principles and practices 114 accounting systems 48–9 Act on Provision of Trust Business by Financial Institutions (1943), Japan 1044 Action Program Concerning Enhancement of Relationship Banking Functions (2003 and 2004), Japan 1056, 1057 Additional Credit Claims framework, Europe 456 adjustable rate mortgages (ARMs) 165, 471, 478–9, 479f, 481, 489f Adrian, Tobias 20, 530–65 adverse selection and asset selection 511–13 and contagion 860 driving liquidity dry-ups 610–11 information disclosure 615, 802 and joint liability lending 407–9 and shadow banking 546 Africa 1076–109 agent banking 1098–9 bank-and branch-level evidence 1087–9 banking concentration 1083 banking losses 890 benchmarking banking systems 1085–6 branching 1097–9 Page 1 of 74

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Index characteristics 1077 competition 1083 credit registries 1096 credit unions 332 creditor rights 1096 cross-border entry 1106–8 data available 1078–9 deposits to GDP 1079–80, 1080f efficiency 1082–3, 1087 enterprise access to finance 1089–91, 1090f exchange rate pegs 582 financial development 1079–85, 1080f financial inclusion 1080, 1082, 1082f, 1086, 1091–6, 1092f, 1093t, 1094f, 1095f, 1099–100 financial innovation 1096–7 financial stability 1083–4 foreign-owned banks 1089, 1106–8 gender gap 1092–6, 1094f, 1095f global financial crisis 1083, 1084 household access to finance 1091–6, 1092f, 1093t, 1094f, 1095f income gap 1092–6, 1094f, 1095f labor force gap 1094f, 1095f liquid liabilities to GDP 1079–80, 1080f long-term finance challenge 1104–6 maturity distribution 1083 microfinance 418 microinsurance 1100 mobile banking 1102t, 1103–4 mobile money accounts 1092 mortgages 1083 new challenges 1104–8 overcoming barriers to financial inclusion 1096–104 (p. 1216)

overhead costs 1088, 1088t personal identification 1100 population density 1086 private credit to GDP 1079–80, 1080f, 1081f, 1085–6, 1085f privatization 1089 profitability 1082–3 property registration 1096 rainfall insurance 1100 regulatory reforms 1107–8 short-term loans 1083, 1084f technological innovation 1101–4 agency problems in shadow banking 549–50 agent banking 1098–9 aggregate shocks, and systemic risk 862–3 AIG 626, 903, 986 Alibaba 558 Page 2 of 74

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Index Alipay 558 Allen, Franklin 16, 39–57 Allen, Linda 17, 153–77 Allen and Gale framework 43–4, 45, 607, 608, 859–60, 862, 863, 865 Allende, President Salvador 1158 Almost Ideal Demand System 237 Amanah (demand deposits) 370 American International Group, see AIG amortization 471, 479–80 Ancient Rome and Greece 953–4, 970 Anginer, Deniz 22, 685–703 Anglo-Irish Bank 901 Anzen credit cooperative 1059 Argentina ATMs 1166 bank failures 921, 923 bank insolvencies 890 bank runs 892, 899 banking crises 895 credit 1164 cross-border entry 1178 currencies 582 deposit insurance 696 efficiency 1175 financial inclusion 1166 financial liberalization 1160–1 foreign-owned banks 1156, 1161, 1171 global financial crisis 1162 privatization 1161, 1169 Argentine Central Bank 1162 ARMs, see adjustable rate mortgages (ARMs) artificial intelligence (AI) 268–9 ASF, see available stable funding (ASF) Ashcraft, Adam B. 20, 530–65 Ashikaga Bank 1060 Asia East Asian crisis 51, 865, 891 financial inclusion 1092f financing structure 40–1 G-SIBs 104 interest margins 1167 interest rates 1167 mergers and acquisitions 931, 933f, 934f Asian Infrastructure Investment Bank (AIIB) 1184 asset commonality, and contagion 49–50 asset management, and financial stability risks 562–3 asset purchase program (APP) 1019 asset quality review (AQR) 1023 Page 3 of 74

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Index asset relief interventions, response to global financial crisis 639 asset transformation role 64–8, see also maturity transformation asset-backed commercial paper (ABCP) and bank runs 547 evolution 509 guarantees 519 securitization 72, 154–5 and shadow banking 535, 539 asset-backed securities (ABSs) benefits and risks to investors 522–3 evolution 506–7 growth in demand 503–4 issuance 507, 508t, 517–18 OTD model 198 securitization 154–5, 503, 517–18 and shadow banking 535, 546–7 asset-backed securities purchase program (ABSPP) 1019 asset-based lending (ABL) 437, 1057 asymmetric information banking problems 853–4, 860 coordination games 46 and corporate complexity 115 and financial instability 579–80 and information sharing 802 (p. 1217)

and moral hazard 523 and securitization 511–12, 548–9 and systemic risk 853–4 ATMs, see automated teller machines (ATMs) Australia 1190–211 authorized deposit-taking Institutions (ADIs) 1191, 1195, 1205 bank assets 1191, 1192t, 1197–9, 1198f bank failures 921 bank levy 1209–10 banking concentration 1192–5, 1193t capital buffers 1207–8 capital requirements 1206–8, 1207t, 1209 competition 1192–5 debt funding 1196–7 deposit insurance 691, 1205 deposits 1195–6 efficiency 1200–4 financial services 1191 financial system inquiries (FSI) 1208–9 Four Pillars Policy 1194–5 funding sources 1195–7, 1196t funding uses 1197–200 global financial crisis 1204–6 Page 4 of 74

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Index house price bubble 1194–5, 1200 loans 1199, 1199t malpractice and misconduct 1210–11 mortgages, residential 1197–200 profitability 1200–4 regulatory reforms 1208–11 resilience of the banking system 1206–11 size and significance of banking 1191–2, 1192t tax subsidies 340 Australia and New Zealand Banking Group (ANZ) 1192 Australian Federal Government 1209–10 Australian Government Guarantee Scheme 1204–6 Australian Prudential Regulation Authority (APRA) 1206–7, 1209, 1210 Australian Securities and Investments Commission (ASIC) 1210 Austria 334 authorized deposit-taking Institutions (ADIs) 1191, 1195, 1205 automated clearinghouse (ACH) 265–6, 285, 289t, 292, 982 automated teller machines (ATMs) 297–8, 982, 1166, 1194 automobile loans 270, 437, 981 available stable funding (ASF) 211 Azerbaijan 1147 B back end ratio 472 bad loans 661, 1132, 1136, 1141 Bagehot (Walter) recommendation 589–90, 603, 609, 898–9, 900 bail-ins 630–2, 656–76, 857, see also total loss-absorbing capacity (TLAC) alternatives 674–5 BHCs 632, 657, 663 bonds 175n frameworks and experience 657–61 market discipline 752–3, 754–6 meeting of objectives 666–70 objectives 656–7 and other instruments 670–3 overall consequences 673–4 regulation 1023–4 social costs and benefits 663–4, 669, 673 theoretical motivation 661–5 theoretical research 663–5 bailouts 630–55, 675–6 alternatives 674–5 and banking crises 888–90, 895 central banks 624, 625–6 costs 634 experiences 635–41 funds distributed 652 G-SIBs 95–6 incentive distortions 634 Page 5 of 74

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Index meeting of objectives 645–54 objectives 632–5 overall consequences 655 role of LOLR 603–4 social costs and benefits 631, 644, 652, 655, 663–4, 674 sovereign debt crisis 2–3 and systemic risk 856 theoretical motivation 641–4 balance sheets 370–2, 370t, 371t, 708t Banca Eutiria 1024 Banca Marche 1024 (p. 1218) Banca Monte dei Paschi di Siena SpA (BMPS) 660 Banca Popolare di Vicenza 660 BancAlliance 439 Banco Azteca 418 Banco de Espirito Santo 670 Banco de la Nación 1161 Banco de la Provincia de Buenos Ayres 1161 Banco del Sur 1184 Banco Espirito Santo (BES) 660, 1024 Banco Internacional do Funchal (BANIF) 661 Banco Popular 661 Banco Santander 661 Bancorp 996 Bangladesh 360, 406, 414, 417 bank assets Australia 1191, 1197–9, 1198f China 1115–16 Europe 1002, 1006 European Union (EU) 1010t Eurozone 1007, 1009t, 1010t global 39–40, 40f, 1198f Islamic banking 362 Japan 1034 New Zealand 1191, 1197–9, 1198f risk 8, 1021 UK 1191 bank branching, see branching bank capital, see capital bank consolidation Brazil 1162 Chile 1162 and hard information 444 Latin America 1154–7, 1162–3, 1169–71, 1177–9 and relationship banking 68–70 and small business lending 433, 446–51 US 991–4 bank culture Page 6 of 74

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Index and corporate governance 144–7 research studies 14–15 risk-taking 85–6 bank failures 910–24 and contagion 612–13, 918–19 and contagion versus fundamentals as causes of 911–13 and deposit insurance 693 economic consequences 692–3 in the global financial crisis 903, 910 Great Depression 913–17 Iceland 899 Ireland 899 Islamic banking 376, 379–80 Japan 1059–60 late 20th century 922–3 management and fraud 887–8 payments 312–13 pre-depression era 919–22 role of LOLR 603 US 897, 915–17, 919–21 bank holding companies (BHCs) bail-ins 632, 657, 663 bailouts 644, 666 Basel III 205 capital requirements 725t credit enhancements 515 forecasting 747 leverage ratios 727t liquidity requirements 212 ownership 255 performance 253–4 stress tests 728 supervision 749 Bank Insurance Fund 986 Bank Itaú 1155, 1157 bank levy 1209–10 Bank of Africa 1089 Bank of America 636, 993, 996 Bank of Brazil 1162 Bank of China 103, 116, 1116 Bank of Communications 1116 Bank of Cyprus 659 Bank of East Asia 1116 Bank of England 123, 328, 729, 899n Bank of Japan (BoJ) 587, 590, 1053, 1057 Bank of Montreal 919–20 Bank of New York 636 Bank of Portugal 660 Page 7 of 74

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Index Bank of US 914–15 bank performance 229–56, see also performance measurement China 1117–18, 1117t and competition 779t, 780–1 EU 1004–16 (p. 1219)

Europe 1004–16 Latin America 1169–71 non-structural approaches 252–5 structural approaches 246–52 transition countries 1145 Bank Recovery and Resolution Directive (BRRD), EU 3, 632, 658, 659, 668, 746, 753–5, 1023 bank restructuring and banking crises 898–9 Latin America 1154, 1155–7 transition countries 1136 bank runs and banking crises 44–7, 892–4 and contagion 918–19 and contagion versus fundamentals as causes of 911–13 and deposit insurance 686–7 distinguished from banking panic 858 and liquidity 78, 184n and liquidity shortages 687–8 market discipline 741–2 maturity transformation 606, 692 shadow banking 547 and systemic risk 608, 858 bank size and financial crises 455 historical trends 341–4 and local outcomes 351 post-crisis regulatory reforms 1012 and relationship banking 454–5 and small business lending 447–50 bank-borrower relationship 65–70, 197, 1056 Bankers Trust 158 Bankhaus Herstatt 312–13 banking decade following global financial crisis 1–28 emerging research themes 4–16 and the real economy 953–71 Banking Act (1933), US, see Glass-Steagall Act (1933), US Banking Act (2009), UK 753 banking and financial crises 44–51, see also sovereign debt crisis (2009–11); subprime crisis (2007) around the world 885–905 and bank runs 78 Page 8 of 74

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Index and bank size 455 and banking panics 44, 892–3 and business cycles 873 and contagion 47–51, 612, 893–4 costs 895–6 and credit booms 872–3 and debt 871 diverse origins 887–92 dynamic regulation 904–5 early history 886–7 East Asian crisis 51, 865, 891 and financial liberalization 889 and government policies 890 impact 47 information disclosure during 614–16 Japanese banking crisis 1058–62 and LOLR 898–900 macro boom and bust 890–2 Malaysian banking crisis 889 management and fraud 887–90 Mexican Tequila crisis 888 and monetary policy 623–5 and mortgages 491–4 1920s and 1930s 913–16 and regime changes 888–9 response and prevention 897–900 Savings and Loans crisis 609 and small business lending 454–5 sudden and fast-moving 892–4 and systemic risk 847–8, 863 theories to explain 44–7 Banking Code (2010), Netherlands 132 banking competition, see competition banking complexity, see Global Systemically Important Banks (G-SIBs) banking concentration Africa 1083 Australia 1192–5, 1193t Canada 1193 Eurozone 1007 Latin America 1155, 1156t, 1172–7 New Zealand 1192–5, 1193t Sweden 1193 transition countries 1137, 1144 Banking Co-partnership Act (1826), UK 328 banking globalization, see cross-border entry Banking Law (1981), Japan 1039 (p. 1220) banking nationalism 1141 banking panics 614 Page 9 of 74

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Index and banking crises 44, 892–3 Chicago banking panic 911, 915–16 and contagion 867 and contagion versus fundamentals as causes of 911–12 distinguished from bank run 858 Great Depression 913–17 role of LOLR 603–4 Banking Reform Act (2014), UK 1020 bankruptcy as alternative to bailouts 674–5 market discipline 753 social costs and benefits 674–5 and success of bail-ins 649 BankWest 1195 Barclays 103, 104, 328 Barings Bank 156, 888 Basel Committee on Banking Supervision (BCBS) 81n, 127–9, 708, 751–2, 753, 897, 904–5, 1180 Basel I capital requirements 194–5, 202, 708 market discipline 756, 758 risk-weighted assets (RWA) 718, 718t Basel II capital requirements 195, 202, 203f market discipline 82–4, 756–8 Pillar 3 751, 756–9 quality of capital 715–16 risk-weighted assets (RWA) 709, 718–19, 719t three pillars 751, 897 Basel II.5 reforms 719 Basel III and banking crises 898 capital distribution 731–2, 732f capital requirements 8, 84, 161, 202–7, 203f, 210, 709, 721–9, 1020–1 End Game reforms 720, 726 implementation 1, 3 Latin America 1180 liquidity creation 183 liquidity requirements 210 market discipline 756–9 mortgages 490 Pillar 3 756–9, 759t quality of capital 716, 717t, 729, 730–1, 731f quantitative impact 729–32 quantity of capital 716–17, 717t, 729, 730f re-regulation 987–8 risk weights 720, 905 shadow banking 550 three pillars 751–2, 897 Page 10 of 74

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Index BCCI 888 Bear Sterns 50, 81n, 156, 903, 986, 993 Beck, Thorsten 27, 1076–109 behavioral economics, and decision-making 814, 820, 821, 822 Belarus 1147 Belgium 10, 296, 334, 1006 Bergengren, Roy F. 332 Berger, Allen N. 1–28, 431–59 Bernanke, Ben 587, 633 BHCs, see bank holding companies (BHCs) biases cognitive 825–7 and decision-making 820–1, 825–30, 838–9 forecasting 764–5, 765t and systemic risk 852 Big Data mining (data analytics) 70 Bitcoin 13, 267, 274–5, 302, 996 Black, Lamont K. 20, 431–59 Blank, Michael 25, 953–71 Bliss, Robert R. 23, 736–68 blockchain technology 13, 263, 267–8, 274–5, 301–2 BNP Paribas 104, 117 boards of directors and corporate governance 132–3, 141–2, 147–8 diversity 142–4 independence 145 BOJ-NET payment transfers 286 Bolivia 592, 696, 1155, 1164 bonds 743, 746, 763–4 bonuses cash 137f EU bonus cap 14, 132, 137–8, 1021–2 and global financial crisis 901 and risk-taking 136–8 boom and bust, and banking crises 890–2 Boone (2008) Competition Indicator 784–5 (p. 1221) Boot, Arnoud W.A. 17, 62–87 Boot-Thakor model 42, 348 borrowing benefits and risks of securitization 520–2 consumer decision-making 816–18 Boubakri, Narjess 19, 359–99 Bouwman, Christa 18, 181–216 branching Africa 1097–9 and banking competition 794 commercial banks 982f and deregulation 983 Page 11 of 74

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Index Europe 1006 Latin America 1166 productive 982 Brazil ATMs 1166 bailouts 890 bank consolidation 1162 bank stability 1175 banking concentration 1155 competition 1173 credit 1164 development banks 1182–4 efficiency 1176 financial inclusion 1166 financial intermediation 1164 financial liberalization 1159–60, 1161 foreign direct investment (FDI) 1155 foreign-owned banks 1156, 1161, 1171 global financial crisis 1162 interest rates 1166, 1179 mergers and acquisitions 1157 private credit 1164 privatization 1169 regional banks 1155 textiles industry 964 Breuer, Peter 20, 530–65 Brexit 1025 BRICS New Development Bank (NDB) 1184 bridge bank structure 659, 660, 997, 1060 Brunei 361, 362 Bryant model 184, 605–6 BTG Pactual 1155 Buch, Claudia M. 25, 928–46 Buffett, Warren 162 Bulgaria 291, 1135, 1141 Bulte, Erwin 19, 404–25 Bundesbank 582, 583 business cycles and banking crises 44–6 and credit 871 and debt 873 and financial stability 579–80 business services after global financial crisis 988–91 offered by MFIs 421–4, 422f, 423t business strategies after global financial crisis 988f performance measurement 253–4 Page 12 of 74

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Index US 988–91 buyer of last resort (BOLR) 622–3 C Caldwell and Co. 915 Calomiris, Charles 24–5, 910–24 CAMELS supervisory rating system 215 Canada 292, 294, 332, 696, 919–20, 1193 Cape Verde 1079 capital balance sheet 708t China 1117 definition 707–8 distribution 731–2, 732f and financial stability 495–6 human 405–6, 421–2, 424 injections of in response to global financial crisis 639, 640t Latin America 1173, 1174t quality 715–16, 717t, 729, 730–1, 731f quantity 716–17, 717t, 729, 730f research studies 8–9 tier 1 202, 715–16, 717, 717t tier 2 715, 717t capital asset pricing model (CAPM) 157–8 capital conservation buffers (CCBs) Australia 1207–8 and capital requirements 721–3, 721t, 723t countercyclical 204t, 722, 723t research studies 8 capital market funding and bank lending 70–3 and relationship banking 73 Capital Purchase Program (CPP) 615, 636 (p. 1222) capital ratios 193, 194f, 195, 984 capital requirements after the global financial crisis 707–33 Australia 1206–8, 1207t, 1209 and banking crises 897 Basel II 202–7, 203f Basel III 161, 203f, 715–20, 721–9, 729–32 and deposit insurance 701 Eurozone 1207t higher bank 710–11 history 708–9 and liquidity creation 190–6, 207–10 and liquidity requirements 214–15 literature review 709–15 lower bank 711–13 New Zealand 1207–8, 1207t Page 13 of 74

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Index optimal bank 713–15 regulation 84, 202–10, 1020–1 research studies 8 sectoral 496 and shadow banking 210 UK 1207t US 1207t Capital Requirements Directive II (CRD II), EU 516 Capital Requirements Directive IV (CRD IV), EU 1, 8, 14, 1020–2 capital strategies, performance measurement 252–3 capital structure and corporate governance 134–5 performance measurement 243–4 Caprio, Gerard 24, 885–906 Caribbean 582 Carletti, Elena 16, 39–57 Carmassi, Jacopo 17, 95–129 Carvalho, Fernando J. Cardim de 27, 1152–85 cash bonuses 136–8, 137f and negative interest rates 294–6 and tax evasion 291 use of 289–90, 289t, 292–3 vault 191, 192f cash cards, use of 293–4 cash reserve requirements 190–3, 192f, 196 Casu, Barbara 20, 503–26 CATFIN systemic risk indicator 174, 616, 672 causality debate 954–6 Cavallo, Finance Minister Domingo 1161 Cayman Islands 114 CBCs, see commercial bank clearinghouses (CBCs) CDOs, see collateralized debt obligations (CDOs) CDSs, see credit default swaps (CDSs) CEE, see Central Eastern Europe (CEE) Central America 1154–5, 1169 Central Bank of Brazil 1160, 1161 central banks 573–95, see also lender of last resort (LOLR) and bailouts 624, 625–6 and deposit insurance 687–8 financial stability policy 589–95 governance 581–2 independence 579, 581–2 interest rates 619f as lender of last resort 79–80, 589–90 and liquidity provision 79, 617 monetary policy 579, 582–9 science 573–81 Page 14 of 74

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Index total assets 618f transition countries 1134 Central Eastern Europe (CEE) 1132–50 bank lending 1144–5 banking sector structure 1143 financial inclusion 1148 financial intermediation 1142 CEO compensation, see executive pay Cetorelli, Nicola 20, 25, 530–65, 953–71 CHAPS payment transfers 286 Charles Schwab Corporation 352, 996 charter value 252, 642, 662 Chase Bank 361 Chavez, Hugo 1182, 1184 checks (cheques) 288, 289t, 291–2, 982 Chen, Ruiyuan (Ryan) 19, 359–99 Chicago banking panic (1932) 911, 915–16 Chicago Board of Trade (CBOT) 163 Chicago Board Options Exchange (CBOE), Volatility Index (VIX) 646 Chicago Mercantile Exchange (CME) 163 Chile ATMs 1166 bank consolidation 1162 cross-border entry 1177 deposit insurance 696 (p. 1223)

financial inclusion 1164, 1166 financial intermediation 1164 financial liberalization 1158–9 foreign direct investment (FDI) 1155 foreign-owned banks 1156–7 interest rates 1166 private credit 1164 China 1113–29 bailouts 889 bank assets 1115–16 bank claims on non-bank financial institutions 557, 557f, 558–9 bank performance 1117–18, 1117t capital 1117 credit booms 1115f credit intermediation 556–9 economic growth 1113 efficiency 1116–17 financial assets 1113, 1114f, 1115, 1116f financial inclusion 1126–9 financial intermediation 1122 financial sector size 1113, 1114f FinTech 1115 Page 15 of 74

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Index foreign-owned banks 1116–17 global financial crisis 1121 G-SIBs 103 and Latin America 1153, 1155 local government funding 1121, 1123–4 MMFs 558 mobile banking 1127, 1128 non-bank credit intermediation (NBCI) 556f online banking 1127, 1129 regulatory arbitrage 558 regulatory constraints 1119–21 shadow banking 533, 1118–25, 1119f, 1123 SIVs 155 structure and performance of financial sector 1115–18 traditional banking 1115 unbanked population 1127–8, 1128f wealth management products (WMPs) 155, 1118–20, 1119f, 1121, 1123, 1125 China Construction Bank 1116 CHIPS payment transfers 286, 307–9, 312–13 Citi 156 CItibank 361 Citibank Budapest 1135 Citigroup 636, 903, 986, 993, 1116 city banks 1040–1 clearing houses 688 CLS Bank, see Continuous Linked Settlement (CLS) Bank CoCos, see contingent convertible bonds (CoCos) Codetermination Act, Germany 148 collars (option positions) 165 collateralized debt obligations (CDOs) 167–8, 507, 508t, 509 collateralized loan obligations (CLOs) 513 Colombia ATMs 1166 banking concentration 1155 branching 1166 cross-border entry 1176 financial inclusion 1166 financial intermediation 1164 regional banks 1154–5 combined loan-to-value (CLTV) ratio 472 commercial and industrial (C&I) loans 648 commercial bank clearinghouses (CBCs) 614 Commercial Bank of Africa (CBA) 1103 commercial banks, see also community banks bank ratios 990t composition by size 343t consolidation 991–4, 994t defining features 322b, 326–7 Page 16 of 74

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Index deregulation 983–4 deregulation and industry consolidation 345 distribution 992f entry and exits 346–7, 347f, 349–50 and global financial crisis 984–7 historical origins 327–8 historical trends 341–4, 342f joint-stock liability 325 mortgage market share 348–50 numbers 977, 982f, 993f performance 229–31 profitability 1011 ratios 984f services 979 today 328 versus universal in Japan 1052 (p. 1224) commercial loans 647 commercial paper (CP) 154–5, 200, 535, 978, 981–2, 1034 commercial real estate (CRE) bonds 549 commercial real estate (CRE) loans 437, 647–8 Commodity Futures Trading Commission (CFTC) 162 Commonwealth Bank of Australia (CBA) 1192, 1195 community banks accessibility and social implications 350–3 competition 346 composition by size 343t current challenges 353–4 decline 992 defining features 321, 322b, 326 deregulation and industry consolidation 344–6 dominance 980 entry and exits 346–8, 347f, 352 financial and technological innovations 348–50, 353–4 historical trends 341–4, 342f institution types 326–35 local specialization 335–40 mergers and acquisitions 344–6, 345f regulation 350 resilience 325–6 services 980 transformation in market structure 341–50 Community Development Capital Initiative (CDCI) 636 Compartamos, Mexico 413 compensation in banking 135–40 competition 776–805 Africa 1083 Australia 1192–5 and bank strategy 788–94, 796–7 Page 17 of 74

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Index Brazil 1173 and capital market funding 73 and community banks 346 and conduct 788–94 definition 776 and deposit insurance 694 and deregulation 801 effects of cross-border entry 940–2 Europe 800, 1014–16 and financial stability 797–801 and industries 960–3 and information sharing 802–5 Japan 1046–7 Latin America 1172–3 market structure and conduct 788–94, 795–6 measurement 777–88 and microfinance 415 New Zealand 1192–5 in providing payment services 300–1 and regulation 794–801 and relationship banking 68–70 role in real economy 959–60 and small business lending 433–4, 451–3 and success of bailouts 651, 654 competition-fragility hypothesis 797–8, 799, 1016 competition-stability view 798, 799, 1016 complaints 300 Composite Indicator of Systemic Stress (CISS), ECB 869 Comprehensive Assessment, Europe 641 Comprehensive Capital Analysis and Review (CCAR) 456, 638, 728 concentration, see banking concentration Conditional Value at Risk (CoVaR) 11, 173, 315, 616, 645, 868–9 conduct and competition 788–96 and complaints 300 misconduct 145, 1210–11 and regulation 796 conflicts of interest 76 conforming loan limit 485 conjectural-variations method 778, 785–6, 790–1, 795 consolidation, see bank consolidation Constant Net Asset Value (CNAV) MMFs 550–1 constant-money-growth rule 583 Consumer Financial Protection Bureau (CFPB) 15, 987 consumer protection 15 consumers, financial decisions 814–34 (p. 1225) contagion and bank failures 612–13, 911–13, 918–19 Page 18 of 74

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Index and banking crises 893–4 domino effect perspective 612–13 empirical evidence 867–70 and financial crises 47–51 and financial innovation 48–9 versus fundamentals as causes of bank failures 911–13 and global financial crisis 50–1 illiquidity 175, 612 illiquidity view 613–14 information disclosure 614–16 and lender of last resort 611–17 and liquidity shocks 48–9, 607–9, 859, 870 measuring links between financial institutions 616–17 microeconomic studies 918–19 and systemic crises 611–17 and systemic risk 850, 858–62 Continental Illinois bank 868, 893 contingent convertible bonds (CoCos) 175n, 670–3 Continuous Linked Settlement (CLS) Bank 286, 312–13 contract terms flexibility 66–7 intertemporal smoothing 66 and success of bailouts 650 and systemic risk 853 contracts co-signing 408 microcredit 419–20 contractual saving 818 Convertibility Plan (Cavallo Plan), Argentina 1161 Cooperative Bank of Peloponnese 659 cooperative banks 328–31 defining features 322b, 328–9 historical origins 329 today 329, 330t, 331 Corpbanca 1155 Corporacion Andina de Fomento (CAF) 1181–2 corporate complexity, see Global Systemically Important Banks (G-SIBs) corporate debt 166, 521 corporate governance 131–48 and bank culture 144–7 and bank performance 246–7 of banks 131–3, 147–8 boards of directors 132–3, 141–2, 147–8 difference between banks and non-banking institutions 131–3, 134–5 Islamic banking 380 policy implications 147–8 research studies 14–15 role of banks 53–4 Page 19 of 74

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Index shareholder-orientated 141–2 corporate sector purchase program (CSPP) 1019 corporate social responsibility (CSR) 382 costs of banking crises 895–6 payments 296–7 cost-to-income ratios 1202–3, 1202t countercyclical capital buffers (CCyBs) 204t, 722, 723t Countrywide Financial Corporation 482 CoVaR, see Conditional Value at Risk (CoVaR) covered bond purchase program (CBPP) 1019 CRAs, see credit rating agencies (CRAs) credit costs 1167 daylight 310–11 and decision-making 816–18 Latin America 1163–4, 1167, 1177–9 transition countries 1138 US 980 credit booms 492–6, 864–6, 871–3, 1113–14, 1115f credit bubbles 593–4 credit cards costs 296–7, 300 and decision-making 823 increase 982 interchange fees 298–9 loans 270 rationality of use 831–4 reasons for 292 and securitization of debt 506 security 301 use of 285, 289t (p. 1226) credit cooperatives 1044–5 credit crunches global 894, 901–3 Japan 1061–2, 1063–5 Latin America 1178 Spain 873 credit default swaps (CDSs) 165–9, 743–4, 746–7 credit derivatives 166–9, 517 credit enhancements 515–16, 517f, 541 Credit Guarantee Corporation Law, Japan 1058 credit guarantee corporations (CGCs) 1058 credit guarantees 455–6, 542 credit intermediation chain 536f China 556–9, 1122 financial innovation 537–9 Page 20 of 74

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Index and shadow banking 536f, 537 Crédit Lyonnais 888 Crédit Mobilier 328 credit rating agencies (CRAs) and banks 75–7 and global financial crisis 900–1 problems 549, 553–4 regulatory reforms 552 role in financial systems 64 and securitization 513, 525 Credit Rating Agency Reform Act (2006), US 77 credit registries 802–5, 872, 1096 public 803–4 credit reporting 348–9 credit risk 155–6 contagion 48–9 Islamic banking 379 management 489–90 measurement 160–1 and risk-weighted assets (RWA) 718–19, 720 success of bailouts 647 credit scores financial innovation 348–9 model 161 for mortgages 473f past reaction to 995 small business (SBCS) 266–7, 1057 credit shocks 5–7 credit spreads 763–4 Credit Suisse 103, 1012 credit supply research studies 6–7 and residential mortgages 494 success of bailouts 647–50, 653–4 and systemic risk 857 Credit Union National Extension Bureau 332 credit unions, see also community banks and competition 991–2 composition by size 343t defining features 322b, 331–2 deregulation and industry consolidation 344–6 entry and exits 346–7 expansion 353 historical origins 332 historical trends 341–4, 342f and mortgages 350 numbers 993f tax subsidies 340, 350 Page 21 of 74

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Index today 332–3 CreditMetrics 161 creditors, and corporate governance 131, 134–5, 147–8 crises, see banking and financial crises; sovereign debt crisis (2009–11); subprime crisis (2007) crisis management 855, 875, 903, 1017–18 crisis management group (CMG) 121–2 Croatia 1140, 1143 cross-border entry 924–46 Africa 1106–8 and banking globalization 929–35 changing patterns in complexity 934–5 determinants of through acquisitions 935–40 effects on efficiency and competition 940–2 effects on risk 942–4 Latin America 1176–8 Mexico 1176–7 through mergers and acquisitions 929–34 cross-border payments 302 cryptocurrencies 13, 263, 267, 274–5, 301–2, 996–7 (p. 1227) Cull, Robert 27, 1076–109 culture, see bank culture Cyprus 3, 658–9, 667, 668, 669, 697, 903, 1003 Cyprus Popular Bank (Laiki Bank) 659 Czech Republic 1143, 1148 Czechoslovakia 1135 D data and data-processing and competition 70 on corporate complexity 127–9 daylight credit 310–11 daylight overdrafts 309–10 de Bandt, Olivier 24, 847–75 de Larosière Report 1018 de novo banks 1136 debit cards costs 296–7 increase 982 interchange fees 298–9 reasons for 292 security 301 use of 272–3, 285, 289t, 290 debt and banking crises 871 corporate 166, 521 government 51 inside debt 140 rationality of 831 yields 745–7 Page 22 of 74

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Index debt instruments in Islamic banking 367, 368–9, 368t debt-based compensation 140 decision-making biases 838–9 cognitive biases 825–7 consumers’ financial 814–34 extensiveness of decision processes 815–19 fast and frugal heuristics 837–8 financial 816–18 framing 821 heuristics and biases 820–1 for household durables 816–18 and hyperbolic discounting 823–5 investment and borrowing 816–18 market environments 838–9 and mental accounting 822–3 prospect theory 821–2 rationality 819 rationality of credit card use 831–4 savings 818–19 Degryse, Hans 23, 776–805 delegated monitoring role of banks 42, 53–4 DeLong, Gayle L. 25, 928–46 Delta CoVaR 173 demand deposits Amanah 370 and banking crises 892–3 and liquidity 688 and maturity transformation 686 Demirgüç-Kunt, Asli 22, 685–703 Democratic Republic of the Congo (DRC) 1090 Denmark 334, 582, 693 deposit funding 1143, 1144t, 1146t deposit insurance 685–703 Australia 1205 and bank failures 693, 922–3 and bank runs 686–7 countries with 689–92, 689f, 690f, 692f coverage limits 698–9 covering bank liabilities 691, 691f design and the institutional environment 698–702 economic benefits 692–4 economic costs 694–8 economic rationale 686–8 and guarantees 135 history of adoption and changes 688–92 increasing integration of banks and financial markets 85 and moral hazard 688, 694–8, 699 Page 23 of 74

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Index regulation 701 risk-based pricing 699–701, 700f supervision 701 and withdrawal risk 184 Deposit Insurance Corporation, Japan 1053, 1060 deposit markets 791–3 Depository Institutions Deregulation and Monetary Control Act (DIDMCA) (1980), US 191, 335, 346, 983 Depository Trust and Clearing Corporation 313 (p. 1228) deposits Australia 1195–6 demand 370, 686, 688, 892–3 Latin America 1164 New Zealand 1195–6 deregulation and banking competition 801 and commercial banks 983–4 and community banks 339–40, 344–6 and entrepreneurship 961–3 Europe 1004–11 increasing integration of banks and financial markets 83–4 real economy 956–7 US 5, 983–4 derivatives, and risk-taking 162–9 Desjardins, Alphonse 332 Deutsche Bank 103, 104, 300, 758 Development Bank of Japan 1046 development banks 1181–4 Dexia bank 638 DeYoung, Robert 25–6, 977–98 Dhan Foundation 414 diabolic loop link 620 Diamond model 42 Diamond-Dybvig model 47, 78–9, 184, 186–7, 213, 547, 605–6, 607, 610, 687–8, 695, 911 digital currencies 292–4 direct market discipline 739, 740 disclosure information 614–16 and Pillar 3 757–9, 759t discount brokerage 995–6 discount windows and bank failures 916–17 and global financial crisis 985–6 lending 308, 604 and liquidity 10, 182, 185 and regulation 189 response to financial crises 637 stigma 615 Page 24 of 74

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Index discounting, and decision-making 823–5 discrete choice models 787, 872 discretionary saving 818–19 distributed ledger technology 267–8 diversification boards of directors 142–4 and contagion 50 Europe 1012 G-SIBs 104, 105t and risk-taking 232–5, 232f Dodd-Frank Act Stress Test (DFAST) 728 Dodd-Frank Wall Street Reform and Consumer Protection Act (2010) (DFA) bail-ins 657 capital requirements 8, 210 compensation 14 credit rating agencies 77 financial markets integration 84 implementation 3 market discipline 752, 753 regulatory changes 456–7 repeal of certain provisions 674 re-regulation 987 resolution authorities 123–4 resolving large banks 997–8 securitization 516 Dominican Republic 887–8 domino effect perspective 612–13 Donaldson, Piacentino and Thakor model 182, 185–7, 193, 207, 213 Dow Jones CDX (DJ CDX) 167 Draghi, Mario 6, 622 Dubai Islamic Bank 360 Dun and Bradstreet 349 Dybvig, see Diamond-Dybvig model dynamic incentives, joint liability lending 410, 413, 415 dynamic model of bank runs 46 dynamic provisioning 6, 457, 496 E E*Trade 996 earnings quality in Islamic banking 381–2 Eastern Europe 1132–50, see also Central Eastern Europe (CEE) bailouts 641 credit unions 332 global financial crisis 1178 information sharing 802 (p. 1229)

interest rates 1167 non-performing loans 889 relationship banking 351 Page 25 of 74

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Index retail banking 1005 ECB, see European Central Bank (ECB) Ecobank 1089 ECOFIN Council 3 econometrics, and market discipline 763 economic activity, see real economy Economic and Monetary Union (EMU) 1002 economic behavior 815–30 economic costs of banking crises 895–6 economic growth credit booms 1113–14 and Islamic banking 386–8 Economic Growth, Regulatory Relief and Consumer Protection Act (2018), US 457 economic role of banks 64–8 economies, importance of banks 39–41 economies of scale Australia 1195 and bank competition 938 and bank consolidation 991 and bank performance 247–52 financial institutions 247–52 impact 433 importance 1011–12 Japan 1047–8 large banks 437, 449, 981, 1011–12 Latin America 1162, 1185 risk-taking 232–5 shadow banking 535 economies of scope and bank competition 794–5 and cross-border entry 940 Europe 1005, 1012–13 financial institutions 247–9, 254 Japan 1048 Latin America 1185 Ecuador 582, 1155, 1164, 1166 Edge Act (1919), US 113 efficiency Africa 1082–3, 1087 Australia 1200–4 China 1116–17 effects of cross-border entry 940–2 Europe 1011–14 Islamic banking 372–6, 373t Japan 1047–52 Latin America 1170–2, 1175–7, 1175t Mexico 1173 New Zealand 1200–4 Page 26 of 74

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Index and success of bailouts 650 efficiency structure hypothesis 779–81, 1172 efficient markets hypothesis 740 El Salvador 582 electronic payments 303, 982 Elliehausen, Gregory 23, 814–40 Emergency Economic Stabilization Act (2008), US 635–6 emergency liquidity assistance (ELA) conditions for provision 609–10 and financial crises 608 and global financial crisis 603–4 and LOLR 620, 859 and systemic risk 855, 875 Emigrant Savings Bank of New York 918 employment Europe 1006 and success of bailouts 649 endowment effect 826 enhanced supplementary leverage ratio (eSLR) 725–6 Enron 76, 76n enterprise access to finance 1089–91, 1090f entrepreneurship and bank competition 961–3 and Islamic banking 388 equipment lending 437 equity, and banks 74–5 Equity Bank 1086, 1088–9, 1097–8 equity instruments in Islamic banking 367, 368t equity prices, and monitoring 748–9 equity-based compensation 138–40 Estonia 1142, 1143, 1144 Ethiopia 1092, 1099–100 euro (currency) 622, 1000 Euro Area, see Eurozone Euro crisis, see sovereign debt crisis (2009–11) Euro1 payment transfer 286 (p. 1230) Europe 1000–26, 1190–211 bail-ins 632 bailouts 631, 635–8, 640t, 652–4 bank assets 1006 banking reform 964 banking union 1004, 1018, 1022–5, 1141 cash use 290–1, 292 checks (cheques) 288–9, 292 commercial banks 326 competition 800, 1014–16 cooperative banks 329, 330t, 331 credit unions 332 Page 27 of 74

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Index deregulation 1004–11 diversification 1012 efficiency 1011–14 employment in banking 1006 financial inclusion 1092f funding sources 1197 global financial crisis 638, 901, 1016–19 government support 1017 industries 964 integration 1004–11, 1007f joint stock banks 328 large banks 1011–12 leverage 134 mergers and acquisitions 1005, 1007, 1011 MMFs 551 new regulatory architecture 1019–25 numbers of banks 1006 payment services 286 post-crisis business models 1012 post-crisis regulatory reforms 1012 profitability 1011–14, 1015t risk 1014–16 savings banks 334 securitization 509–11, 510f, 552 SEPA initiative 298 small business lending 431, 454, 456, 458 sovereign debt crisis., see sovereign debt crisis (2009–11) stress tests 729 structure and performance of banking 1004–16 universal banking model 1001 European Banking Authority (EBA) 1018, 1022 European banking union 1004, 1018, 1022–5, 1141 European Central Bank (ECB) bail-ins 658 bailouts 3 and banking union 1004, 1018, 1022–3, 1141 establishment 1000 LOLR policy 622–3 long-term refinancing operations (LTROs) 10 outright monetary transactions (OMT) 6 research studies 6 response to sovereign debt crisis 1018–19 supervisory role 590 total assets 618f European Commission 1002 response to global financial crisis 638–9, 641, 1002, 1017 European Company Statute 1005 European deposit insurance scheme (EDIS) 1004, 1025 Page 28 of 74

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Index European Economic Community (EEC) 1000 European Financial Stability Facility (EFSF) 3, 639, 1003 European Insurance and Occupational Pensions Authority (EIOPA) 1018 European Securities and Markets Authority (ESMA) 1018 European System of Financial Supervisors (ESFS) 1018 European Systemic Risk Board (ESRB) 81, 550, 1018 European Systemic Risk Council (ESRC) 1018 European Union (EU) bail-ins 658–61, 666–70 bailouts 638–41, 640t bank assets 1002, 1010t Bank Recovery and Resolution Directive (BRRD) 3, 632, 658, 659, 668, 746, 753–5, 1023 banking integration 1001 banking structure 1004–16 banking supervision 1001 Basel II 196 bonus cap 14, 132, 137–8 capital requirements 205 Capital Requirements Directive II (CRD II) 516 (p. 1231)

Capital Requirements Directive IV (CRD IV) 1, 8, 14, 1020–2 competition 803 Council of Finance 1018 deposit insurance 690, 694 expansion 1000–1 FinTech 12 First Banking Directive (77/780/EEC) (1977) 1001, 1004 government support to banks 1002–3 house prices 492–3, 493f large banks 1007, 1010t market discipline 754–5 mortgage credit tools 495 numbers of banks 1008t Payment Services Directive 2 (PSD2) 269, 300 Recovery and Resolution Directive (2014), EU 1020 regulatory reforms 753–4 Second Banking Directive (89/646/EEC) (1989) 964, 1001–2, 1011 single market 328 single resolution mechanism (SRM) 1004 single supervisory mechanism (SSM) 1004 White Paper on The Completion of the Internal Market 1001 Eurozone bank assets 1002, 1007, 1009t, 1010t banking concentration 1007 capital requirements 1207t economies of scale 249–50 expansion 1001 financial services 1191 Page 29 of 74

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Index financing structure 39–41, 40f household assets 40–1, 41f implementing LOLR policy 621–3 large banks 1010t liquidity creation 620 low interest rates 592 non-financial corporations 41, 41f numbers of banks 1007, 1008t pension schemes 40 risk-sharing 43 shadow-banking 533 sovereign debt crisis., see sovereign debt crisis (2009–11) evergreening 1065–6 exchange rates 582–3 executive pay, see also bonuses compensation 136–40 regulation 1020–1 and risk-taking 135–40 exposure at default (EAD) 489 extreme-value theory (EVT) 868 F failures, see bank failures Fair, Isaac and Co. (FICO), see FICO (Fair, Isaac and Company) scores Fair Credit Reporting Act (1970), US 348 Faisal Islamic Bank of Egypt 360 Faisal Islamic Bank of Sudan 360 fake warehouse receipts 185–6 Fannie Mae 485, 490, 505, 903, 986–7 Fast Pay payment transfer 308 fast payments 24/7 302–3 Federal Credit Union Act (1934), US 332, 341 Federal Deposit Insurance Corporation (FDIC) 84, 123–5, 327, 347, 637, 657, 689, 986, 997–8 Federal Deposit Insurance Corporation Improvement Act (FDICIA) (1991), US 195 Federal Deposit Transaction Account Guarantee Program (TAGP) 637 federal funds market 185 Federal Home Loan Bank (FHLB) 349, 551, 637 Federal Home Loan Mortgage Corporation (FHLMC), see Freddie Mac Federal National Mortgage Association (FNMA), see Fannie Mae Federal Reserve automated clearinghouse (ACH) 982 banking panics 604 cash reserve requirements 190–3 and commercial banks 984 discount window., see discount windows establishment 288 forward guidance 588 global financial crisis 50–1, 637, 985–6, 987 independence 582 Page 30 of 74

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Index liquidity creation 620, 621t (p. 1232)

liquidity provision 80 and living wills 124–5, 657 as LOLR 185, 190 monetary policy 591 Regulation Q 980, 983 stress tests 728–9 supervisory role 590 systemic risk 308–9 term auction facility (TAF) 10 total assets 618f Federal Reserve Act (1914), US 135 Fedwire payment transfer 286, 306 fiat currency 892 FICO (Fair, Isaac and Company) scores 271, 348, 438, 443, 549, 981, 995 Fidelity 996 Filene, Edward 332 Final Report of the High-level Expert Group on Reforming the Structure of the EU Banking Sec­ tor, see Liikanen Report, EU Financial Access Survey database (FAS) 16 Financial Accounting Standards Board (FASB), US 539 financial assets banks’ share 977 China 1113, 1114f, 1115, 1116f distribution 977–9, 978t Japan 1034, 1035t, 1037f, 1039, 1040f residential mortgages 483–8 Financial CHOICE Act (under consideration), US 674 Financial Claims Scheme (Australian Government Deposit Guarantee) 1204, 1205–6 financial contagion, see contagion financial crises, see banking and financial crises; global financial crisis (2007–9) financial development Africa 1078–96, 1080f Islamic banking 386–8 financial education intervention studies 834, 836–8 financial fragility hypothesis 850–2 financial imbalances 850 financial inclusion Africa 1080, 1082, 1082f, 1086, 1091–6, 1092f, 1093t, 1094f, 1095f, 1096–104 China 1126–9 Islamic banking 388 Kenya 1088–9 Latin America 1163–9 and payments 303–4 research studies 15–16 transition countries 1145, 1147–50 financial innovation Page 31 of 74

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Index Africa 1096–7 and community banks 348–50 and contagion 48–9 definition and determinants 263–5 organizational forms 275–8 processes 265–9 products 269–75 shadow banking 531, 537–9 and technological innovation 262–79 US 980–3 financial institutions increasing integration with banks 62–87 measuring links between 616–17 performance 229–56 risk sharing 45 Financial Institutions Recovery and Reform Act (1989), US 349 financial intermediaries, see also shadow banking Great Recession 966–70 growth rate 534f market discipline 762–3 private information 172 role 530 and shadow-banking 533f share of assets 977–9, 978t financial intermediation Latin America 1164 theory 65 transition countries 1142–3 financial liberalization Argentina 1160–1 and banking crises 889 Brazil 1161 Latin America 1158–60 (p. 1233) financial literacy behavioral studies 837–8 effects on behavior 835–7 and microfinance 421 research studies 15, 834–5 financial markets different economies 39–41, 40f increasing integration with banks 62–87 and liquidity provision 79 market discipline 82–5 and risk sharing 45, 80 financial services 1191 Financial Services Action Plan, Europe 1005 Financial Services Agency (FSA), Japan 1053, 1060 Financial Services Authority, UK 614 Page 32 of 74

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Index financial stability Africa 1083–4 and asset management 562–3 and business cycles 579–80 and competition 797–801 and credit intermediation 556–9 and FinTech 564–5 Islamic banking 376–80 market discipline 736–8 and mortgages 491–6 and payments 314–15 prime brokerage 563–4 and regulation 797–801 and securitization 524 shadow banking 542–4 and structured leverage finance 559–61 Financial Stability Board, G20 96–7, 118, 120, 122–3, 127–9, 531–3, 549–50, 753, 1180 Financial Stability Oversight Council (FSOC), US 81 financial stability policy 589–95 and financial supervision 590–1 and liquidity provision 589–90 and monetary policy 591–5 financial statement lending 437 financial sustainability perspective 425 financial system inquiries (FSI) 1208–9 financial systems bank-based versus market-based 52–3, 69 causality debate in real economy 954–6 composition of liabilities of financial business 537–9, 538f residential mortgages as a vulnerability 491–4 role of banks 39–57 role of credit rating agencies 64 financing, and competition 801 financing structure of different economies 39–41, 40f Finca DRC 1098 Finland 329 FinTech China 1115 definition 438 development 263 and efficiency 1013 financial stability risks 564–5 and future of banking 995–7 investment 354 marketplace lenders 277–8 and mortgages 278 and payment services 300 process innovations 267–9 Page 33 of 74

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Index product innovations 274–5 research studies 12–14 US 995–7 FinTech lending 354, 438–9, 442–3 fire sales 861, 869–70 First Banking Directive (77/780/EEC) (1977) 1001, 1004 fiscal costs of banking crises 895–6 Fiscal Investment Loan Program (FILP), Japan 1045 fiscal policy 856 fixed rate mortgages 471, 478–9, 479f fixed-asset lending 437 fixed-for-floating rate swaps 165 Flannery, Mark J. 23, 736–68 Fobaproa, Mexico 1159 Ford 167 forecasting biases 764–5, 765t market discipline 747–8 foreclosure (mortgages) 473–5, 474f, 481–3 foreign bank entry, see cross-border entry foreign direct investment (FDI) 1155 (p. 1234) foreign-owned banks Africa 1089, 1106–8 Argentina 1156, 1161, 1171 Brazil 1156, 1161, 1171 Chile 1156–7, 1177 China 1116–17 and competition 796–7 Japan 1044 Kazakhstan 1137 Latin America 1154–7, 1156t Mexico 1155, 1156, 1161–2, 1169–70 Russia 1137 and small business lending 451 Soviet Union 1137 transition countries 1135–9, 1143, 1144–5 Fortis bank 638 forwards (financial futures) 163–4 fragile banks 78–80 Frame, W. Scott 18, 262–79 framing, and decision-making 821 France bank assets 1002 banking reform 964 checks (cheques) 292 credit and debit cards 292 guarantees 1017 joint stock banks 328 Page 34 of 74

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Index recapitalizations 1017 savings banks 334 fraud, and banking crises 887–90 Freddie Mac 485, 490, 505, 903, 986–7 Freixas, Parigi and Rochet model 47–8, 608, 609–10 Freixas, Xavier 21–2, 602–26 Friedman, Milton 575, 913–15, 918 Friedman-Phelps natural rate hypothesis 576 fundamentals, versus contagion as causes of bank failures 911–13 funding fragilities, and shadow banking 547 funding sources Australia 1195–7, 1196t global 1195–7, 1196t New Zealand 1195–7, 1196t securitization 71 funding uses Australia 1197–200 New Zealand 1197–200 Fungáčová, Zuzana 27, 1132–50 future of banking 995–8 futures 162, 163–4, 165n G G20 (Group of 20 Heads of State), and G-SIBs 96–7, 100, 118–19 Garn-St.Germain Act (1982), US 191, 335, 346, 983 gender, and board of directors 143–4 gender gap Africa 1092–6, 1094f, 1095f transition countries 1147–8 General Motors 166, 167 Germany bailouts 639, 641, 653, 654 banking concentration 1007 banks and growth 52 cooperative banks 329 credit and debit cards 292 cross-border entry 936 deposit insurance 691, 696 employment in banking 1006 guarantees 1017 Hausbank system 54 joint stock banks 328 monitoring role of banks 54 recapitalizations 1017 savings banks 334–5 Ghana 1100 Gharar (speculation) 359, 365–6, 376 Ginnie Mae 485, 505 giro transactions 285, 287–9, 290–1, 292, 297, 305 Page 35 of 74

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Index Glass-Steagall Act (1933), US 84, 113, 339, 980, 984 global finan cial crisis (2007–9) Africa 1083, 1084 Argentina 1162 Australia 1204–6 and bailouts 95–6, 635–8 and bank failures 903, 910 Brazil 1162 China 1121 and commercial banks 328 and contagion 50–1 and credit booms 872–3 (p. 1235)

Croatia 1140 a decade after the 2–4 effects 51 and emergency liquidity assistance (ELA) 603–4 Europe 1016–19 Hungary 1139–40 and Islamic banking 377–80, 378t Japan 1062–3 Latin America 1153, 1162–3 and mortgage policies 495 New Zealand 1204–6 reasons 51 regulation 904–5 role of LOLR 625–6 Russia 1140 and securitization 72, 900–2 and small business lending 434, 453–8 and systemic risk 176–7, 850 transition countries 1138–40 Ukraine 1140 US 635–8, 900–4, 984–7 views on systemic crisis 611–12 Global Financial Inclusion Database (World Bank) 16, 304 global games theory 46, 48, 860 global investment banks 994t global systemically important banks (G-SIBs) accounting principles and practices 114 after the global financial crisis 99–113 asymmetric information 115 bail-ins 666 bailouts 95–6 capital requirements 205–7 capital surcharges 723–6, 725t changes to business models 1012 classification 95n Page 36 of 74

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Index corporate complexity 95–129 cross-border complexity 104, 105t, 120–2 data and data-processing 127–9 definition 723–4 drivers of corporate complexity 113–18 enhanced supplementary leverage ratio 725–6 geographical diversification 104, 105t and globalization 934–5 leverage ratios 726–7, 730f listed 176t mergers and acquisitions 115 and non-financial corporations 116–18 policies to enhance resolvability 118–25 quantity of capital 730f regulation 3, 113 regulatory changes during and after 456–7 and resolution authorities 119–25 risk-based capital 724 size and complexity 100, 101t, 103–4 subsidiaries 104, 107t, 112t, 116–18 surcharges 206t and systemic risk 175–6 and systemic stability 97–9 taxation 113–14 total loss-absorbing capacity (TLAC) 727–8 in 2017 724t US 111, 112, 113 globalization, see cross-border entry Goddard, John 26, 1000–26 Goldman Sachs 111, 116, 156, 159, 439, 636, 986 governance, see corporate governance government debt 51 government guarantee lending programs 1057–8 Government National Mortgage Association (GNMA), see Ginnie Mae government policies and banking crises 890 and community banks 339 government regulation 979–80 government subsidies 340 government support after global financial crisis 1002 Australia 1204–6 Europe 1017 New Zealand 1204 for small business lending 455–6 government-issued digital currencies 292–4 government-sponsored enterprises (GSEs) 485–6, 487f, 490, 506, 554 Grameen Bank 406, 414 Page 37 of 74

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Index Grammen Pension Scheme 414 Gramm-Leach-Bliley Act (1999), US 113, 745–6, 984, 986 Great Depression 575, 580, 912, 913–17 (p. 1236) Great Recession 314–15, 965–70 Greece bail-ins 659, 1024 bailouts 3 banking concentration 1007 banking in pre-modern era 954 and global financial crisis 903–4 savings banks 334 sovereign debt crisis 1003, 1018 Greece, Ireland, Italy, Portugal, Spain (GIIPS) 3, 622, 623, 639 Greek Resolution Fund 659 Greenspan, Alan 592 Greenspan put 592 group lending 406–12 growth, role of banks 52–3 Guarantee Scheme for Large Deposits and Wholesale Funding, see Australian Government Guar­ antee Scheme guarantees bank liabilities 639 off-balance sheet 648 response to global financial crisis 640t risk-taking 134–5 success of bailouts 653, 654 Guedhami, Omrane 19, 359–99 Guinea 899 H Hagendorff, Jens 17, 131–48 hard information and bank consolidation 444 and bank size 449–50 and small business lending 432, 435, 436–7, 443–6 Hartmann, Philipp 24, 847–75 Hasan, Iftekhar 27, 1132–50 Hayne, Kenneth Madison 1210 hedge funds 75 Herring, Richard J. 17, 95–129 heuristics decision-making 816, 820–1, 827–30, 838–9 fast and frugal 837–8 high leverage 892–3 high-quality liquid assets (HQLA) 211–12, 564 Hokkaido Takushoku Bank 1060 Home Affordable Modification Program (HAMP) 482–3 Honohan, Patrick 24, 885–906 Hoover, President 917 Page 38 of 74

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Index house price bubble Australia and New Zealand 1194–5, 1200 household assets 492–3, 492f house prices and credit supply 494 and global financial crisis 985 and household assets 492–3, 492f, 493f and mortgages 477–8, 478f, 489 household assets and asset price bubbles 492–3, 492f different economies 40–1, 41f US 980 household durables, and decision-making 816–18 households risk-sharing role 42–4 success of bail-ins 668–9 housing policies 986–7 HSBC 117, 156, 328, 361, 758, 1116 Hughes, Joseph P. 18, 229–56 human capital, and microfinance 405–6, 421–2, 424 Humphrey, David 19, 285–316 Hungary banking nationalism 1141 banking system 1134 barriers to financial exclusion 1148 barriers to financial inclusion 1149 foreign-owned banks 1135 global financial crisis 1139–40 hyperbolic discounting, and decision-making 823–5 I Iceland bailouts 895 bank failures 899 currency mismatches 901 deposit insurance 697 and global financial crisis 901 LOLR policy 622 Ijara contracts 368, 368t, 369, 371 IKB Deutsche Industriebank 1016–17 (p. 1237) illiquidity and contagion 175, 612, 613–14 distinguished from insolvency 609–11, 665, 688, 893, 913–17 Islamic banking 385t incentives, systemic risk 852 income gap, Africa 1092–6, 1094f, 1095f Index of Small Business Optimism 458 India 404, 420 indirect market discipline 739, 763 Page 39 of 74

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Index individual lending, and microfinance 412–15 Indonesia 899 Industrial and Commercial Bank of China 1116 industrial organization new empirical (NEIO) 781–8 traditional 778–81 industries, and bank competition 960–3 IndyMack 606 inflation and benefits of stability 574 and monetary phenomenon 575 targeting 584–6 and unemployment 575–6 influence, market discipline 738–9, 740–2, 749–50 information adverse 78 asymmetric., see asymmetric information and community banks 336–9 costs 936–7 and dynamic regulation 905 hard 337–8 private 169–72 sharing 802–5 soft 67, 337 systemic events 853–4 information disclosure 614–16 information processing 64–70 initial coin offerings (ICOs) 274–5 inside debt 140 insolvency, distinguished from illiquidity 609–11, 665, 688, 893, 913–17 insolvency shocks 870 institutional culture 145–6 Institutional Microfinance Fund 413 instrument rules 583–4 insurance deposit., see deposit insurance life 414 liquidity 79 and microfinance 414 microinsurance 1100 rainfall 1100 reinsurance 76–7 state-sponsored 688–9 insurance schemes, state-sponsored 688–9 InterAmerican Development Bank (IADB) 1183, 1184 interbank exposure, and contagion 867–8, 870 interbank linkages, and contagion 50 interbank markets, and systemic risk 858–61 Page 40 of 74

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Index interchange fees 298–9 interconnectedness and systemic risk 314–15, 852–3 too-interconnected-to-fail (interconnectedness) 643–4, 663 interest rates and cash 294–6 and decision-making 817–18 East Asia and the Pacific 1167 Latin America 1166–9, 1167t, 1168t, 1179 and LOLR policy 617–18, 619f and monetary policy 580–1 and mortgages 478–9, 479f negative 294–6 and rationality of credit card use 831–2 and risk-taking 591–4 zero-lower-bound problem 580–1, 585–6 Intermediate Holding Company Rule (2014), US 113 International Air Transport Association (IATA) 300 international coordination, increasing integration of banks and financial markets 81–2 International Financial Institutions (IFIs) 1139–40 International Index Company (IIC), iTraxx 167 International Islamic Financial Market (IIFM) 361 (p. 1238) International Monetary Fund (IMF) 3, 16, 550, 690, 699 international payments 286–7 Internet bubble 492, 492f Internet-based payments 983 Internet-only banks 276 Intesa Sanpaolo bank 660 investment benefits and risks of securitization 522–3 consumer decision-making 816–18, 830 market discipline 741–2, 760 measurement of opportunities 252 investment banks 994t Iran 360, 361, 362 Ireland bailouts 3, 638, 641, 895 bank assets 1002 bank failures 899 deposit insurance 691, 699 and global financial crisis 901 guarantees 1017 LOLR policy 621 sovereign debt crisis 1003, 1025 Islamic banking 359–99 balance sheets 370–2, 371t characteristics 365–72, 367t compared with conventional banks 372–85, 373t, 374t, 378t, 386–9 Page 41 of 74

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Index corporate governance 380 corporate social responsibility (CSR) 382 definition 359 differences with conventional banking 367t, 370–2 directions for future research 389–91 and earnings quality 381–2 and economic growth 386–8 efficiency 372–6, 373t and entrepreneurship 388 and financial development 386–8 and financial inclusion 388 financial products 366, 367–9, 368t financial strength 375–6 and global financial crisis 377–80, 378t growth around the world 360–5 lack of standardization 390 liquidity creation 382–3, 384t and market discipline 388–9 market share by country 361, 362f numbers of banks 362, 363f population increase 365, 365f profitability 372–6 and risk 390–1 share of total banking assets 362, 364f stability 376–80 stock liquidity 383, 384, 385t summary of literature 392 total assets 362, 363f Islamic Development Bank (IDB) 360 Islamic Financial Services Board (IFSB) 361, 380 Istisna contracts 368t, 369 Italy bail-ins 659–60, 667, 668 bank failures 923 banking in Roman era 953–4 competition 788, 790–1, 793 credit and debit cards 292 relationship banking 351–2 savings banks 334 sovereign debt crisis 622, 623 J JA Bank (Japan Agriculture Bank) 1045 Jacklin and Bhattacharya (1988) model 44–5 Japan 1033–66 bank assets 1034, 1191 bank failures 1059–60 bank types 1040–6, 1042t, 1049t cash use 291 Page 42 of 74

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Index city banks 1040–1 commercial versus universal 1052 competition 1046–7 cooperatives 1045 corporate assets and liabilities 1034, 1037f, 1040f credit cooperatives 1044–5 credit crunch 1061–2, 1063–5, 1065f efficiency 1047–8, 1052 evergreening 1065–6 financial assets 1034, 1035t, 1039, 1040f financing structure 40–1, 40f foreign banks 1044 funding sources 1196–7 global financial crisis 904, 1062–3, 1064f (p. 1239)

government assets and liabilities 1034, 1037f, 1040f government guarantee lending programs 1057–8 household assets and liabilities 40–1, 41f, 1034, 1037f, 1039, 1040f importance of banking 1034–9 Japanese banking crisis 1058–62 keiretsu 1053–5 lending attitude 1065f lending technologies 1056–8 loans outstanding of private banks 1041f long-term credit banks 1044 lost decades 1063–6 main bank system 53–4, 1053–5 market structure 1046–7 monitoring role of banks 53–4 non-financial corporations 41, 41f other financial institutions 1045 overview of banking system 1034–53 payment structure 288 post-crisis 1062–6 private banks 1041f profits and losses for ordinary banks 1064f public banks 1045–6 regional and second regional banks 1041, 1044, 1047 regulation 1053 relationship banking 1053–6 risk-sharing 43 role of collateral 1056–7 segmentation 1039–47 Shinkin banks 1044–5, 1047 small business credit scoring (SBCS) 1057 trust banks 1044 universal versus commercial 1052 Japan Bank for International Cooperation (JBIC) 1046 Page 43 of 74

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Index Japan Finance Corporation (JFC) 1046 Small and Medium Enterprise Unit 1058 Japan Housing Finance Agency 1046 Japan Post Bank 1045–6 Japan Post Holdings 1045 Japanese banking crisis 1058–62 Jay, Pierre 332 joint liability lending and adverse selection 407–9 and microfinance 406–12 and moral hazard 409–10 and welfare 414–15 joint stock banks 322b, 325 JPMorgan Chase 145, 182n, 439, 636, 758, 986 RiskMetrics 158, 159–60 judgement lending 440 K Kahneman, Daniel 820–2, 828 Kazakhstan 1137 Kenya agent banking 1098 ATMs 1097 branching 1097 financial inclusion 1086, 1088–9, 1091–2, 1097–8 household access to finance 1091–2 mobile banking 1101, 1103 mobile money accounts 1092 savings and investment 1099 Key Attributes of Effective Resolution Regimes for Financial Institutions (KA), FSB, G20 97, 119– 23, 128 Keynes, John Maynard 575 Kim, Dasol 19, 321–54 Klapper, Leora 27, 1113–29 Kosovo 582 Kuwait 361, 362 Kuwait Finance House 360 L labor force gap, Africa 1092–6, 1094f, 1095f Laiki Bank (Cyprus Popular Bank) 659 Laplanche, Renaud 439 large-scale asset purchases (LSAPs) 12, 587, 618 Latin America 1152–85 agent banking 1098 allocation of credit 1177–9 ATMs 1166 bank consolidation 1154–7, 1162–3, 1177–9 bank performance 1169–71 bank solvency and asset quality 1181t Page 44 of 74

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Index bank stability 1173, 1174t banking concentration 1155, 1156t, 1172–7 branching 1166 capital 1173, 1174t (p. 1240)

and China 1153, 1155 competition 1172–3 cost structure 1175t credit 1163–4 credit costs 1167 cross-border entry 1176–8 debt crisis 708–9 deposits 1164 development banks 1181–4 effects of bank consolidation 1169–71 efficiency 1170–2, 1175–7, 1175t evolution of financial policy 1157 financial depth and credit indicators 1165t financial inclusion 1092f, 1164, 1166 financial liberalization 1158–60 financial penetration 1163–9 foreign direct investment (FDI) 1155 foreign-owned banks 1154–7, 1156t, 1169–71 global financial crisis 1153, 1162–3, 1180 interest margins 1167 interest rates 1166–9, 1167t, 1168t, 1179 leverage ratios 1173, 1174t liberal reforms 1152–3 liquidity 1167, 1168t market structure 1169 mergers and acquisitions 1157 non-performing loans 1180, 1181t political factors 1182 privatization 1154, 1161–2, 1169–71, 1178–9 profitability 1173, 1174t ratios 1173 regulatory developments 1179–81 universal banking 1160–2 Latvia 1144, 1148 lazy bank hypothesis 1061 leasing, and technology 437 legislation, see regulation Lehman Brothers 51, 96, 98–9, 122, 903, 986, 993 Lehnert, Andreas 20, 470–97 lender of last resort (LOLR) 602–26 and bank failures 603 and banking crises 898–900 and deposit insurance 687 Page 45 of 74

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Index distinguishing between insolvent and illiquid banks 609–11 effects of liquidity injection 623–5 Eurozone 620, 621–3 function of central banks 589–90 hedge funds as 75 lending penalties 625 and liquidity 185 and liquidity provision 79–80 and liquidity requirements 215 and liquidity shocks 605–9 and monetary policy 618–20 new background for policy 617–18 open market operations 625 policy 617–25 role 602–5 role in global financial crisis 625–6 role of liquidity creation 619–20 and systemic crises and contagion 611–17 lending asset-based 437 automation of decisions 349 and capital market funding 70–3 discount window., see discount windows financial statement 437 FinTech 354, 438–9, 442–3 fixed-asset 437 funding 71 group 406–12 individual 412–15 intertemporal smoothing of rates 66 joint liability 407–10, 414–15 origination 71–2 P2P 63 poverty 425 relationship., see relationship lending residential., see mortgages risk processing 71 and securitization 71–2 servicing 71 small business., see small business lending soft-budget-constraint problem 67 subprime 191, 269–72 technology 435–43 timely intervention 67–8, 70, 75 transaction 69 transition countries 1144–5, 1146t US 73 (p. 1241) lending booms 864, 873–4 Page 46 of 74

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Index lending rates, intertemporal smoothing of 66 lending technologies, Japan 1056–8 LendingClub 277–8, 438, 439 Lensink, Robert 19, 404–25 Lerner Index 783–4, 804 less significant institutions (LSIs) 326 Level 3 assets 128n leverage and corporate governance 134–5 and industries 135f leverage cycles and macroprudential supervision 591 and shadow banking 548 leverage ratios 726–8, 727t, 1173, 1174t leverage risk 643, 662–3 liabilities covered by deposit insurance 691, 691f financial business 537–9, 538f market discipline 742–4 life insurance 414 Liikanen Report, EU 3, 84, 1011–14, 1020 liquidity 181–216 adverse selection-driven dry-ups 610–11 and contagion 861 injection 617, 621–3, 623–5, 639, 640t, 653 Latin America 1167, 1168t research studies 9 shortages 687–8, 861 and systemic risk 850–2 liquidity coverage ratio (LCR) 210–13, 563–4, 751–2, 756, 987 liquidity creation, see also maturity transformation and bailouts 649 and banking crises 892–3 by banks 183–96 and capital requirements 190–6, 207–10 and cash reserve requirements 190–3 empirical evidence 188–9 by the Federal Reserve 621t in Islamic banking 382–3, 384t regulation 182–3, 189–90, 201–15 role of banks 77–86 role of LOLR 619–20 theories 181–2, 183–8 liquidity insurance 79 liquidity provision and financial stability policy 589–90 by fragile banks 78–80 liquidity requirements Page 47 of 74

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Index and capital requirements 214–15 purpose and effect 213 regulation 210–15 liquidity risk Islamic banking 376–7 liquidity creation 182 shadow banking 1123 SIVs 154–5 structured leverage finance 561n and systemic risk 865 wholesale payments 310–11 liquidity shocks and adverse selection 610–11 and contagion 48–9, 607–9, 859, 870 and liquidity-triggered systemic risk 607–9 and LOLR policy 605–9 and maturities transformation risk 605–7 and systemic risk 863 unidentifiable 609–10 liquidity-savings mechanisms 311–12 Lithuania 1143 living wills 111, 116, 123–5, 126t, 753, 857 Lloyds 328, 673, 903 loan certificates 614 loan markets 788–91 loans Australia 1199, 1199t automobile 270, 437, 981 bad 661, 1132, 1136, 1141 commercial 647–8 commitments 187–9 credit card 270 New Zealand 1199, 1199t pricing 66 and securitization 349, 981 loan-to-value (LTV) 457, 472–3 local banks and competition 788–90, 791–2 and small business lending 450–1 local government financing vehicles (LGFVs) 1121, 1123–4 local government funding 1121, 1123–4 locality, and small business lending 450–1 (p. 1242) Long Term Credit Bank of Japan 1060 long-term credit banks 1044 long-term finance 1104–6 long-term refinancing operations (LTROs) 622–3, 1019 LTCM hedge fund 614 Lucius Caecilius Jucundus 953, 970 Page 48 of 74

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Index Lula da Silva, President 1182, 1184 M Maastricht Treaty (1993) 1000 machine learning 268–9 macroeconomic factors, and cross-border entry 938–9 macroeconomic models, and systemic risk 866 macroprudential supervision 494–6, 590–1, 593–4, 854–5 Madoff, Bernard 888 main bank system, Japan 1053–6 main refinancing operations (MROs) 622, 1019 Malawi 1099 Malaysia 360, 361, 889, 1100 malpractice and misconduct 145, 1210–11 management, and banking crises 887–90 marginal expected shortfall (MES) 869 market discipline 736–66 and bank failures 912–13 concept 738–44 direct 739, 740 effects of recent reforms 751–6 evolution 744–50 ex ante 738 ex post 738 forecasting 747–8 impact of reforms 754–6 increasing integration of banks and financial markets 82–5 indirect 739, 763 influence 738–9, 749–50 influence induced by investors’ quantity changes, runs 741–2 influence induced by security price changes 740–1 Islamic banking 388–9 logical discipliners 742–4 monitoring 738–40, 745–7, 748–9 and Pillar 3 756–9, 759t potential impediments 760–6 pre-depression era 922 market environments 838–9 market risk 155 Basel regulations 718–19 Islamic banking 377, 379 measurement 160–2 market structure 788–94 Japan 1046–7 Latin America 1169 and regulation 795–6 market values bank customers 650–1 success of bailouts 650 Page 49 of 74

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Index market-based finance difference to shadow banking 540–4 structural characteristics 540–2, 541t marketplace lenders 276–8, 438 Markit credit index data service 167 Markowitz, Harry, theory of portfolio risk measurement 157 Martin, Alex 20, 470–97 Massachusetts Credit Union Act (1909), US 332 MasterCard 301 maturity transformation, see also liquidity creation and bank runs 692 and banking crises 892–3 economic benefits 686 and risk 605–7 and systemic risk 850–2 Mauritania 360 Mauritius 1077, 1079, 1092 Maysar (excessive risk-taking) 359 McFadden Act (1927), US 327, 339, 979–80, 983 McKillop, Donal 19, 321–54 mental accounting 822–3 mergers and acquisitions after deregulation 983, 985f, 1005 bank acquisitions 930f, 933f banking globalization 928–9 Brazil 1157 community banks 344–6, 345f (p. 1243)

and corporate complexity 115 cross-border acquisitions 929–34, 931f, 932t cross-border acquisitions determinants 935–40 Europe 1007, 1011 Latin America 1157 numbers in US 985f Meridien BIAQ 888 Merrill Lynch 156, 159, 636, 993 Mester, Loretta J. 18, 229–56 Metro Bank 328 Mexican Tequila crisis (1994–5) 888, 1161, 1169 Mexico ATMs 1166 bank stability 1175 banking concentration 1155 credit 1164 cross-border entry 1176–7, 1178 deposit insurance 696, 697–8 deposits 1164 efficiency 1173 Page 50 of 74

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Index financial inclusion 1166 financial liberalization 1159 foreign-owned banks 1155, 1156, 1161–2, 1169–70 interest rates 1166 privatization 1169 profitability 1169 Tequila crisis 888, 1161, 1169 textiles industry 964 microfinance 404–25 antecedents 406–7 commercialization 412–15 group lending and joint liability 406–12 individual lending 412–15 microfinance institutions (MFIs) 405–6, 412–15, 416–17, 421–4, 422f microfinance-plus strategy 421–4 product design 419–20 skills enhancement 420–4 subsidization 424–5 success 416–19 Microfinance Information Exchange (MixMarket) 416 Microfinance Summit Campaign 416 microinsurance 1100 microprudential supervision 590, 855 Microsoft 300 Middle East 1092f Ministry of Finance (MOF), Japan 1053 misconduct 145, 1210–11 Mishkin, Frederic 21, 573–95 Mitsubishi-Tokyo-UFJ (MUFJ) 103, 1040 Mitsui-Sumitomo (SMBC) 1040 Mizuho 1040 mobile banking Africa 1101, 1102t, 1103–4 China 1127, 1128 Kenya 1103 mobile money accounts 1092 Modigliani-Miller theory 711 Molyneux, Philip 1–28, 1000–26 Monaco 582 monetary policy, see also lender of last resort (LOLR) commitment to a nominal variable 578–9 and credit bubbles 593–4 effect of electronic payments 303 exchange rate pegs 582–3 and financial crises management 623–5 and financial intermediaries 966–70 and financial stability policy 591–5 forward guidance 587–9 Page 51 of 74

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Index importance of central bank independence 579 inflation targeting 584–6 instrument rules 583–4 interest rates 580–1 large-scale asset purchases 587 and LOLR policy 618–20 nominal anchors 582–9 nominal-GDP targeting 586 non-conventional 586–9 price-level targeting 586 research studies 12 response to global financial crisis 637 role of expectations 576–7 and systemic risk 855–6, 864–5, 874 time-inconsistency problem 577–8 monetary targeting 583–4 money laundering 300–1 money market deposit accounts (MMDAs) 983 (p. 1244) money market funds (MMFs) 550–1, 551f, 558 money market mutual funds (MMMFs) 622, 980 monitoring deposit insurance 698, 701–2 equity prices 748–9 market discipline 738–40, 745–7, 748–9 role of banks 42, 53–4, 55, 75–6 role of private equity firms 74–5 monoliners 76–7 monopolistic competition 782 Moody’s 439 moral hazard and deposit insurance 688, 694–8, 699 increasing integration of banks and financial markets 81–2 and joint liability lending 409–10 LOLR policy 623 and regulation 182, 189 and shadow banking 1124 and systemic risk 856–7, 865 Morales-Acevedo, Paola 23, 776–805 Morgan Stanley 111, 636, 986 mortgage-backed securities (MBS) evolution 506–7 as financial assets 493–4 financial innovation 981 and global financial crisis 900–2 holders of debt 487f for holding mortgages 476, 484–8 issuance and outstanding 486f, 507, 508t, 553f, 555f primary-secondary mortgage market spread 488f Page 52 of 74

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Index subprime crisis 504–5 mortgages 470–97 Africa 1083 amortization 479–80 Australia 1197–200 cash-out refinancing 481 and community banks 349–50 and credit risk 489–90 and credit scores 473f and credit supply 494 and credit-extension decision 471–3 defaults 480–1 as financial assets 483–8, 491–2 and financial stability 491–6 and FinTech 278 foreclosure 473–5, 474f, 475, 481–3 holders of debt 487f and house prices 477–8, 478f, 489 household decision-making 477–83 industrial organization of the market 476, 487 interest rates 478–9, 479f lenders 349 macroprudential policies 494–6 market share 349 modification programs 481–3 New Zealand 1197–200 payments 471 penalties 480 refinance or default decisions 480–1 refinancing incentive 484, 485f regulation 488–90, 494–6 securitization 476, 484–8, 981 servicing 475–6 subprime 153–6, 270–2 and success of bailouts 647 US 980 valuing 484 Moshirian, Fariborz 28, 1190–211 M-Pesa 1101, 1103 M-Shwari 1103 Mudaraba (silent partnership) contracts 367, 368t, 371, 376 multi-market banks competition 790–1, 792–4 small business lending 450–1 multinational banking 935–6 multiple-bank relationships 55 Murabaha (cost-plus-profit) contracts 367, 368, 368t, 369, 371 Musharaka (joint partnership) contracts 367, 368t, 369, 376 Page 53 of 74

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Index mutual banks 321, 322b, 325, 337–8, 979 mutual funds 977–9 mutual savings banks 333, 335 N narrow banking 892–3 National Australia Bank (NAB) 1192 National Bank of Commerce 1107 (p. 1245) National Bank of Greece 659 National Banking Acts (1863 and 1864), US 190, 537, 964 National Credit Union Administration (NCUA) 350, 353 National Credit Union Share Insurance Fund 341 National Development Bank 1162 National Economic and Social Development Bank (BNDES) 1182–4 National Microfinance Bank 1107 National Savings Bank 1162 Nationally Recognized Statistical Rating Organization (NRSRO) 77 NCUA, see National Credit Union Administration (NCUA) negative equity 481 negative interest rate policy (NIRP) 12 net cash outflows (NCOF) 211 net stable funding ratio (NFSR) 211–13, 987 Netherlands bailouts 639, 641 corporate governance 132 payment costs 296 recapitalizations 1017 network theory 49–50, 859 New Zealand 1190–211 authorized deposit-taking Institutions (ADIs) 1195 bank assets 1191, 1192t, 1197–9, 1198f banking concentration 1192–5, 1193t capital requirements 1207–8, 1207t competition 1192–5 debt funding 1196–7 deposits 1195–6 efficiency 1200–4 funding sources 1195–7, 1196t funding uses 1197–200 global financial crisis 1204–6 government support 1204 house price bubble 1194–5, 1200 loans 1199 mortgages 1197–200 profitability 1200–4 regulatory reforms 1208–11 resilience of the banking system 1207–11 sector concentration of loans 1199t size and significance of banking 1191–2, 1192t Page 54 of 74

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Index Niger 1103–4 Nigeria 1106 Nippon Credit Bank 1059, 1060 non-bank credit intermediation (NBCI) 549–50, 554, 556–9, 556f non-bank firms financial inclusion 304–5 mortgage market share 349 mortgages 476 shadow banking 533f, 534f and systemic risk 314–15 non-financial corporations 41, 116–18 non-financial services 421–4 non-local banks 450–1 non-mortgage securitization 506 non-performing loans (NPLs) China 1117–18 Eastern Europe 889 Europe 1025 Islamic banking 377, 380 Italy 377, 380 Japan 1060–1 Latin America 1180, 1181t performance 244–5 transition countries 1141 non-structural approach to performance measurement 233–4, 236, 241–3, 252–5 Norges Bank 588 Northern Rock 44, 155, 606, 626, 901, 1017 Norway 297 Novo Banco 660, 1024 NPLs, see non-performing loans (NPLs) O off-balance sheet guarantees 648 Office of the Comptroller of the Currency (OCC) 327 Oman 361, 369 OnDeck Capital platform 439 Ongena, Steven 23, 776–805 online banking China 1127, 1129 and community banks 352 growth 983 use of 272, 273–4 (p. 1246) open market operations 624 operational risk 156, 161, 377, 390, 719, 720 options 164–5 orderly liquidation authority (OLA) 632, 657, 664–5, 666, 674, 753, 997–8 orderly liquidation fund (OLF) 657 organizational forms 246–7 organizational innovation 275–8 Page 55 of 74

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Index originate-to-distribute (OTD) model 198–201, 199f, 504, 607, 981, 988–9, see also transaction banks originate-to-hold (OTH) model 197–8, 199f, 201, 504, 988f, 989, see also relationship banking origination in securitization 71–2, 518–20 OTP bank 1141 output floor 720 outright monetary transactions (OMT) 6, 622–3, 1018, 1019 over-the-counter (OTC) contracts 166–7, 550 ownership structure and bank performance 246–7 and relationship to bank value 254–5 P P2P (Peer-to-Peer) lending 63, 438 Pakistan 304 Panama 582 Panellinia Bank 659 Paraguay bank stability 1175 efficiency 1176 financial intermediation 1164 interest rates 1166, 1179 private credit 1164 Parigi, Bruno M. 21–2, 602–26 Paula, Luiz Fernando de 27, 1152–85 pay, executive., see executive pay Payment Services Directive 2 (PSD2) 269, 300 payments and payment systems 285–316 availability of data 304–5 card security 301 and competition 299–300 and contagion 861 Continuous Linked Settlement (CLS) Bank 312–13 costs 296–7 current policy issues on wholesale payments 314 daylight overdrafts 309–10 differences in structure 287–9 direct versus indirect pricing 297–8 effect on monetary policy 303 fast payments 24/7 302–3 fees 287–8 and financial inclusion 303–4 and financial innovation 272–4, 982 and financial stability 314–15 and FinTech 996 government-issued digital currencies 292–4 Internet-based 983 and liquidity and other risks 310–11 and liquidity-savings mechanisms 311–12 Page 56 of 74

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Index money laundering 300–1 mortgage 471 negative interest rates 294–6 overview 285–9 payment cards 298–9 payment theory 287 pricing 297–8 record-keeping 301–2 retail payments 289–305, 289t securities settlement systems 313–14 wholesale payments 305–15 PayNet 438 PBoC, see People’s Bank of China (PBoC) penalties 480, 625 pension schemes 40–1, 414 People’s Bank of China (PBoC) 1119, 1121 performance, see bank performance performance measurement 233–6, see also bank performance non-structural approach 233–4, 236, 241–3 specifying capital structure 243–4 specifying output quality 244–5 specifying outputs and inputs 243 structural approach 234, 236–41 and technology 255–6 Pería, María Soledad Martínez 27, 1113–29 personal contact 445–6 personal cultural views 146–7 personal identification 301, 1100 (p. 1247) Peru ATMs 1166 bank stability 1175 deposits 1164 development banks 1184 financial inclusion 1166 financial intermediation 1164 foreign direct investment (FDI) 1155 interest rates 1166, 1179 Phillips curve 575–6, 577, 579 Piacentino, G., see Donaldson, Piacentino and Thakor model Pigou tax 857 Pinochet, General Augusto 1158 Piraeus Bank 659 Poland banking nationalism 1141 banking system 1134–5 credit unions 333 financial intermediaries 1142 foreign-owned banks 1135 Page 57 of 74

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Index policy responses and implications after global financial crisis 2, 637 corporate governance 147–8 financial stability 589–95 fiscal 294, 575–6, 856 LOLR 617–25 monetary., see monetary policy shadow banking 555–65 systemic risk 854–7 Ponzi schemes 888 portfolio risk 157, 489–90, 642–3, 646, 661–2 Portugal bail-ins 660–1, 667, 670 bailouts 3 deposit insurance 697 liquidity 9–10 sovereign debt crisis 1003 Postal Services Agency 1045 poverty and Islamic banking 387, 388 and microfinance 404, 405, 417, 418–22, 424–5 pre-payment cards 300–1 price stability 574, 578–9 prime brokerage 563–4 private credit bureaus 802–5 private equity firms 63, 74–5 private information and risk management 169–72 and small business lending 440–1 privatization Africa 1089, 1106–7 Argentina 1161 China 1117 Japan 1046 Latin America 1154, 1161–2, 1169–71, 1178–9 transition countries 1135–8, 1143 process innovation 265–9 product innovation 269–75 profit elasticity 784–5 profitability Africa 1082–3 Australia 1200–4 Europe 1011–14, 1015t global 1203t Islamic banking 372–6 Latin America 1173, 1174t New Zealand 1200–4 prompt corrective action (PCA) 590, 898, 905, 1024 Page 58 of 74

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Index prospect theory 821–2 Prosper Marketplace 438, 439 Provision of Trust Business by Financial Institutions Act (1943), Japan 1044 Prudential Regulatory Authority (PRA), UK 564 PSD2, see Payment Services Directive 2 (PSD2) psychology, and economic behavior 815–30 public banks, Japan 1045–6 public sector purchase program (PSPP) 1019 Q Qatar 361 qualitative asset transformation 64–8 qualitative data 436 quantitative data 436 quantitative easing (QE) 12, 587, 637, 1019, 1066 quiet life hypothesis 1172 R Rabobank 1107 Raiffeisen, Friedrich Wilhelm 329, 332 (p. 1248) rainfall insurance 1100 rating triggers 76 rational expectations revolution 576–7 RBS, see Royal Bank of Scotland real economy 953–71 and banking deregulation 956–7 and banking in Roman era 953–4 causality debate and portance of banks 954–6 and dynamics in product markets 960–5 effects of banks 4–7 importance of banks 39–41, 956–8 role of bank competition 959–60 role of banks 64–8 success of bail-ins 669 success of bailouts 649–50, 653 unintended consequences of the Great Recession 965–70 real estate markets 874 real estate mortgage investment conduits (REMICs) 506 Real Plan (Brazil) 1161 real-time gross settlement (RTGS) networks 285, 305, 310–12 Real-Time Payments transfers 302, 308–9 recapitalizations 639, 640t, 653–4 Reconstruction Finance Corporation (RFC) 917 Recovery and Resolution Directive (2014), EU 1020 regime changes 888–9 regional banks Brazil 1155 Colombia 1154–5 Japan 1041, 1044, 1047 regulation, see also deregulation Page 59 of 74

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Index during and after global financial crisis 456–7 after global financial crisis 1, 737, 1012, 1019–25 and bank strategy 796–7 and banking competition 794–801 capital 84 capital requirements 202–10 community banks 339, 350 and conduct 796 and corporate complexity 113 and credit rating agencies 552 cross-border entry 937–8 deposit insurance 701–2 Europe 1019–25 financial stability 797–801 firm financing 801 and global financial crisis 904–5 Japan 1053 Latin America 1179–81 and liquidity creation 182–3, 189–90, 201–15 and liquidity requirements 210–15 and market structure 795–6 and moral hazard 182, 189 mortgages 488–90, 494–6, 979–80 prudential 795 re-regulation 987–8 retail banking 1020 risk-taking 230–1 and securitization 524–6, 552 shadow banking 549–55 small business lending 432–3, 456–7 US 979–80, 987–8 wealth management products (WMPs) 1125 Regulation Q 980, 983 regulatory arbitrage China 558 shadow banking 539–40, 544–5, 554 regulatory constraints, China 1119–21 regulatory reforms Africa 1107–8 after global financial crisis 3–4 Australia 1208–11 EU 753–4 New Zealand 1208–11 suggestions 82–6 US 753 regulatory structure and financial integration 80–2 and reform suggestions 82–6 Page 60 of 74

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Index reinsurance 76–7 relationship banking, see also originate-to-hold (OTH) model business strategies following global financial crisis 988f, 989–91, 990t capital market funding 73 community banks 337–8, 351–2 and competition 68–70 (p. 1249)

and information processing 65–70 Japan 1053–6 OTH model 197–8 and private information 169–72 theoretical studies 54–6 relationship lending empirical studies 440–1 and financial crises 454–5 and small business lending 446 and soft information 439–40 relative market power (RMP) hypothesis 434 relative profit differences, and banking competition 784 Remuneration Code (2009), UK 14, 132, 138, 1022 repurchase agreements (Repos) 154–5 required stable funding (RSF) 211–12 Reserve Bank of Australia 590, 1200, 1205 Reserve Bank of New Zealand 113 residential mortgages, see mortgages residential real estate lending 437 residual saving 819 Resolution and Collection Bank 1059 resolution authorities 119–25 Resona bank 1040–1, 1047 retail markets integration 860–1 retail payments 289–305, 289t cash and negative interest rates 294–6 and competition 299–300 credit and debit cards 298–9 direct versus indirect pricing 297–8 government-issued digital currencies 292–4 money laundering 300–1 payment costs 296–7 retail runs 44 Rhineland 1016 Riba (receipts of interest) 359, 365–6 Riegle-Neal Interstate Banking and Branching Efficiency Act (1994), US 253, 327, 983, 986 Ripple payment system 302 risk and bank assets 8 credit 155–6, 160–1 effects of cross-border entry 942–4 Page 61 of 74

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Index Europe 1014–16 financial intermediaries 530–1 increasing integration of banks and financial markets 63, 81–2 Islamic banking 390–1 liquidity 154–5, 156 market 155, 160–2 and maturities transformation 605–7 neglected in shadow banking 545–7 operational 156, 161 performance measurement 234–7 processing 71 shadow banking 1123–5 systemic 607–9 time-gap 312–13 wholesale payments 310–11 withdrawal 184, 186 risk management 153–7, 162–9, 169–72, 173–7 risk measurement 156, 157–62 risk sharing and contagion 859 and financial markets 80 Islamic banking 371–2 role of banks 42–4 risk transformation 535–6, 537, 540–1 risk-based pricing 269, 698–701, 700f risk-taking and bank culture 85–6 and conflicting incentives 231–3 and deposit insurance 694–8 and derivatives 162–9 and diversification of scale 232–5, 232f and executive pay 135–40 and financial leverage 134–5 and guarantees 134–5 and low interest rates 591–4 and monetary policy 591–4 regulation 230–1 risk-weighted assets (RWA) 708–9, 714, 717–22, 718t, 719t, 727–8, 730f, 732f role of banks 39–57 asset transformation 64–8 corporate governance 53–4 economic 64–8 growth 52–3 information processing 64–70 liquidity creation 77–86, 183–96 monitoring 42, 53–4, 55, 75–6 in pre-modern era 953–4 risk sharing 42–4 Page 62 of 74

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Index rollover risk, see liquidity risk Roman, Raluca A. 22, 630–76 Romania 1141, 1143 rotating savings and credit associations (ROSCAS) 406 Royal Bank of Scotland 103, 328, 758, 903, 1012 Royal Banking Commission, Australia 1208 Royal Commission into Misconduct in the Banking, Superannuation, and Financial Services In­ dustry, UK 1210 Russia bank lending 1145 banking concentration 1144 banking sector structure 1143 banking system 1137 deposit insurance 693 dollarization 1144 foreign-owned banks 1137, 1143 global financial crisis 1140 two-tier banking system 1135 Rwanda 424, 1103 S Safaricom 1101, 1103 Saitama Resona bank 1040–1, 1047 Salam contracts 368t, 369 Salomon Brothers 159 Santander 103, 661 Sarkisyan, Anna 20, 503–26 Saudi Arabia 360, 361, 362, 582 Saunders, Anthony 17, 153–77 savings and decision-making 818–19, 825, 835 and financial inclusion 1147–50 Savings and Loans crisis (1980s) 609 savings and loans (S&Ls) 334, 335 savings banks 333–5, see also community banks composition by size 343t defining features 322b, 333 and deregulation and industry consolidation 341–6 entry and exits 346–7, 347f, 349–50 historical origins 333–4 historical trends 341–4, 342f mortgages 349–50 numbers 977, 993f today 334–5 scale economies, see economies of scale Schulze-Delitzsch, Hermann 329, 332 Schwartz, A.J. 913–15, 918 Second Banking Directive (89/646/EEC) (1989) 964, 1001–2, 1011 sectoral capital requirements (SCRs) 496 (p. 1250)

Page 63 of 74

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Index securities market discipline 740–1, 761–2 settlement systems 313–14 Securities and Exchange Commission (SEC), US 456, 552 Securities and Exchange Law (1948), Japan 1052 securities financing transactions (SFTs) 550, 554 Securities Market Programme, ECB 1018, 1019 securities settlement systems 313–14 securitization 503–26 and adverse selection 512–13 and asset selection 511–13 asset-backed securities 154–5, 503, 517–18 and banking crises 46–7 benefits and risks 518–24 cash flow allocation 518 creation of an SPV 514 and credit booms 493–4, 872 and credit enhancements 515–16, 517f economic importance 504–5 evolution 505–11, 549 financial innovation 981 and global financial crisis 900–2 growth 503–4, 552 increasing importance 71–2 and interest retention 515–16 issuance 508t, 510f issuance of asset-backed securities 517–18 lending operations 349 as ‘market for lemons’ 511–12 mechanics 511–18 mortgages 476, 484–8 OTD model 198–200 outstanding volume 506f, 511 (p. 1251)

regulatory reforms 524–6, 552 and risk retention 516, 525 and shadow banking 199f, 1123 simple, transparent, and comparable (STC) securitization 505 and ‘skin in the game’ 515–16, 525, 552 structuring the transaction 514–16 subprime mortgages 271 vs.traditional banking 199f transaction 512f transfer of assets 514 security price changes, market discipline 740–1 Senegal 1098 SEPA, see Single Euro Payments Area (SEPA) SES, see systemic expected shortfall (SES) Page 64 of 74

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Index settlement systems securities 313–14 and systemic risk 852, 861 shadow banking 530–65 agency problems 549–50 capital requirements 210 China 1118–25, 1119f concerns 544–9 credit enhancements 541 credit guarantees 542 credit intermediation chain 536f definition 62n, 63n, 531–2, 1118 difference to market-based finance 46–7, 199f, 540–4 emergence 62–3 financial stability 542–4 funding fragilities 547 growth 531 importance 75 innovation in composition of money 537–9 leverage cycles 548 liabilities 537–9, 538f measurement 532–4 monitoring 549–55 neglected risks 545–7 OTD model 200–1 policy challenges 555–65 reasons 534–40 regulation 549–55 and regulatory arbitrage 539–40, 544–5, 554 securitization 199f, 493–4 SIVs 154–5 size 533 specialization 534–7 structural characteristics 540–2, 541t supervision 549–55 and systemic risk 851 shareholders corporate governance 141–2 risk-taking 134 Sharia law 359, 360, 365–6 Sharia supervisory board (SSB) 380 Sharpe, Bill 157 Shawbrook Bank 328 Shinginko Tokyo bank 1057 Shinkin banks 1044–5, 1047 shocks aggregate 862–3 credit 5–7 Page 65 of 74

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Index insolvency 870 liquidity 48–9, 605–11, 850, 859, 863 Shoko Chukin Bank 1046 Sierra Leone 1077 significant institutions (SIs) 326 simple, transparent, and comparable (STC) securitization 505, 520 Singapore 691 Single Euro Payments Area (SEPA) 291, 297, 298 Single Market (EU) 328, 1000, 1002 single point of entry (SPOE) strategy 123–4, 657, 997 Single Resolution Fund (SRF), EU 658, 754, 1023 Single Resolution Mechanism (SRM), EU 658, 753–4, 1014, 1026 Single Supervisory Mechanism (SSM), EU 1022, 1026 single-market banks 450–1 SKS microfinance 413 Slovakia 1142, 1143, 1148 Small Business Administration (SBA) 455–6 small business credit scoring (SBCS) 266–7, 437–9, 441–2, 444, 1057 (p. 1252) Small Business Jobs Act (2010), US 455–6 small business lending 431–59 and bailouts 648 and bank competition 433–4, 451–3 and bank consolidation 69, 433, 446–51 and bank funding 431–2 and bank locality 450–1 and bank market 450–1 and bank size 447–50 changes in distance over time 445–6 and FinTech 438–9 and foreign-owned banks 451 and global financial crisis 434, 453–8 government support 455–6 and hard information 432, 435, 436–7, 443–6 market share 431 markets 450–1 and personal contact 445–6 recovery 457–8 regulation 432–3, 456–7 and soft information 432, 435, 436–7, 444 technological innovation 432, 433, 435–43 Small Business Lending Fund (SBLF) 637 SMP, see Securities Market Programme, ECB SNS bank 413 social costs and benefits of bail-ins 663–4, 669, 673 of bailouts 631, 644, 652, 655, 663–4, 674 of bankruptcy 674–5 of decline in community banks 350–3 Page 66 of 74

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Index of microfinance 413 social services offered by MFIs 421, 422f stored value cards for 301 Société Générale 888 soft information and bank market 450 and bank size 449 in relationship lending 439–40 in small business lending 432, 435, 436–7, 444 Solanko, Laura 27, 1132–50 solvency shocks, unidentifiable 609–10 South Africa 1077, 1079, 1091 South America 361 South Sudan 1077, 1079 Southern Europe 1132–50 sovereign debt 1024–5 sovereign debt crisis (2009–11) Eurozone 2–3, 626, 639, 1003–4, 1018 and global financial crisis 902–3 LOLR policy 620–3 research studies 6–7 Soviet Union 1132–50 Spain bail-ins 661 bailouts 3, 639, 641 bank assets 1002 capital requirements 208 credit supply 6 deposit insurance 691 dynamic loan-loss provisioning 496 low interest rates 592 savings banks 334 sovereign debt crisis (2009–11) 1003, 1025 special purpose vehicles (SPVs) 114, 154, 198, 503, 511, 514, 851 SRISK (systemic risk measure) 11, 173–4, 617, 645, 653, 869 St George Bank 1195 Standard Bank 1089, 1106–7 Standard Chartered 103, 117, 1116 state intervention 687, 890 State Street Corporation 636 state-owned banks 797 state-owned commercial banks (SOCBs) 1134–6, 1137 state-owned enterprises (SOEs) 1136 stock and bond prices 740–1 stock liquidity 383, 384, 385t stored value cards 301 strategic defaulting 410 Page 67 of 74

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Index stress tests 3, 615–16, 637–8, 641, 728–9 structural demand models 787–8 structure-conduct-performance (SCP) hypothesis 434, 777, 778–80, 779t structured investment vehicles (SIVs) 153–6, 509 structured leverage finance 559–61, 559f, 560f subordinated bank debt (subordinated notes and debentures (SNDs)) 744–7 subprime crisis (2007), US 72, 76, 153–6, 191, 210, 270–2, 504–5, 584, 606–7, 618–19 (p. 1253) subprime mortgages 153–6, 269–72, 489–90, 489f, 552 Sudan 360, 362 sunspot phenomena 44, 46, 184n supervision 549–55, 590–1, 694, 701, 897–8 supervisory capital assessment program (SCAP) 456, 637–8 swaps 165–9, see also credit default swaps (CDSs) Sweden 292–3, 1193 SWIFT payment transfer 286–7 Swiss Interbank Clearing 584 Swiss National Bank 582, 583, 584 Switzerland 186, 291 syndicated lending 981 systemic crises 611–17, 850 systemic events 850, 853–4, 867–8 systemic expected shortfall (SES) 11, 173–4, 616–17, 645, 869 systemic risk after the global financial crisis 847–75 and aggregate shocks 862–3 and bail-ins 663, 669–70 and bailouts 633, 641–2, 643–4, 645–7, 649–50 and Co-Cos 672 concept 849–57 and contagion 858–62 efficient versus self-fulfilling events 853–4 empirical evidence 867–74 financial fragility hypothesis 850–2 Great Recession 314–15 and G-SIBs 175–6 horizontal 849 and interconnectedness 314–15 liquidity-triggered 607–9 measurement 616–17, 645–6 public policy 854–7 regulation 85 risk management 173–7 and settlement systems 313–14, 852, 861 SRISK measure 11, 173–4, 617, 645, 663, 869 and systemic events and crises 849–50 theoretical models 11, 858–66 vertical 849 wholesale payments 306–9 Page 68 of 74

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Index T tail risk 46, 545–7, 608 Tanzania 1107 Target 2 payment transfer 286, 306 targeted investment program (TIP) 636 targeted longer-term refinancing operations (TLTROs) 1019 Tawarruq instruments 369 tax evasion 291 tax havens 114 tax policies 545 Tax Reform Act (1986), US 506 tax subsidies 340 taxation 10–11, 113–14 Taylor rule, US 583–4, 617, 966 technological innovation Africa 1101–4 community banks 348–50 and efficiency 1012–13 and financial innovation 262–79 impact on banking 1005 performance measurement 255–6 in small business lending 432, 433, 435–43 temporary liquidity guarantee program (TLGP) 637 Tequila crisis 1161, 1169 term auction facility (TAF) 10, 637 term discount window program, see discount windows textiles industry 963–4 Thailand 417–18 Thakor, Anjan V. 17, 62–87, see also Boot-Thakor model; Donaldson, Piacentino and Thakor model 3-6-3 banking 980 time-gap risk 312–13 timely intervention 67–8, 70, 75, 84 Tokyo Kyowa 1059 too big to save 902 too-big-to-fail (TBTF) 81–2, 626, 643–4, 663, 698 too-interconnected-to-fail (interconnectedness) 643–4, 663 too-many-to-fail 624, 626, 643–4, 663 total loss-absorbing capacity (TLAC) 727–8, 752–3, 754–5, see also bail-ins (p. 1254) traditional banking 540–2, 541t, 1115 vs. securitization 199f transaction banks 69, 989–91, 990t, see also originate-to-distribute (OTD) model transition countries 1132–50 after global financial crisis 1140–2 bad loans 1136, 1141 bank performance 1145 banking concentration 1137, 1144 banking crises 889 banking history 1133–42 Page 69 of 74

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Index banking nationalism 1141 banking sector 1142, 1143–4 banking systems 1134–7 credit 1138 current state of banking 1142–5 deposit funding 1143, 1144t, 1146t dollarization 1144 euroization 1144–5 European banking union 1141 financial inclusion 1145, 1147–50 financial intermediaries 1142–3 financial restructuring 1136 first decades of transition 1134–8 foreign-owned banks 1135–9, 1143, 1144–5 gender gap 1147–8 global financial crisis 1138–40 legislation 1137–8 lending 1144–5, 1146t Treaty of Lisbon (2009) 1001 Treaty of Rome (1957) 1000 troubled assets relief program (TARP) and bailouts 631 and capital injections 636f effects 638 and global financial crisis 986 purpose 611 research studies 4–5 and small business lending 456 success 633, 645–52 Trump, Donald 457 trust banks 1044 trust preferred securities (TruPs) 746 Turkey 793 Tversky, Amos 820–2, 828 24/7 payments 302–3 U UBS 156 Uchida, Hirofumi 26, 1033–67 Udell, Gregory 26, 1033–67 Uganda 1087–8, 1087t, 1099 Uganda Commercial Bank (UCB) 1106–7 UK bailouts 639, 641 bank assets 1002, 1007, 1191 banks and growth 52 branching 1006, 1166 Brexit 1025 building societies 340 Page 70 of 74

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Index capital requirements 208, 1207t checks (cheques) 292 competition 803 corporate governance 132 credit and debit cards 292 employment in banking 1006 financial services 1191 financing structure 39–41, 40f funding sources 1197 global financial crisis 901, 903 G-SIBs 122 guarantees 1017 household assets 40–1, 41f joint stock banks 328 non-financial corporations 41, 41f pension schemes 40 recapitalizations 1017 regulation 1020 retail banking 1020 risk-sharing 43 savings banks 334 tax subsidies 340 Ukraine 1140, 1144, 1148, 1149 unconventional monetary policies (UMPs) 12 Undertakings for Collective Investment in Transferable Securities (UCITS industry) 562–3 unemployment 575–6 Unibanco 1157 Unicredit 104, 117 Union Bank of Switzerland 1012 United Arab Emirates 361 universal banking 1001, 1052, 1160–2 (p. 1255) Upstart 438 Uruguay 1155, 1166, 1175 US 977–98 asset distribution 977–9 bail-ins 632, 657, 666 bailouts 631, 635–8, 645–52 bank assets 341, 345 bank consolidation 991–4, 994t bank failures 897, 915–17, 919–21 bank lending and capital market funding 73 bank ratios 984f, 990t bank runs 918–19 banking crises 712 banking panics 911–12, 920–1 bankruptcy code 123, 674 board diversity 144 boards of directors 141 Page 71 of 74

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Index branching 1166 business strategies following global financial crisis 988–91, 988f capital ratios 194f, 713f capital requirements 190–6, 203, 205, 208, 209, 714, 1207t cash in circulation 303 cash reserve requirements 190–3, 192f cash use 290, 291, 294 checks (cheques) 288, 291 clearing houses 688 commercial banks 326–8, 341–2, 344–7, 349–50, 447, 979–80, 982f, 984f, 985f, 991–4, 992f, 993f, 994t community banks 337, 339, 340–53, 342f competition 788, 789, 790, 798, 799–800, 803 contagion 918–19 corporate governance 132 credit and debit cards 273, 292 credit scores 995 credit unions 332, 341–2, 344, 345–6, 346–7, 350, 991–2, 993f deposit insurance 688–9, 691, 696, 699 deregulation 5, 983–4 discount brokerage 995–6 economies of scale 249–50 evolution of banking 979–88 evolution of capital 712 evolution of securitization 505–6 financial innovation and change 980–3 financial services 1191 financing structure 39–41, 40f FinTech 13, 995–7 funding sources 1196–7 future of banking 995–8 global financial crisis 453–4, 900–1, 984–7 G-SIBs 111, 112, 113, 122, 123–5, 126t, 724, 725–6, 725t House of Representatives 123 house prices 478f, 491, 985 household assets 40–1, 41f, 492, 492f, 980 housing policies 986–7 importance of banks 956–7 Internet-only banks 275–6 interstate banking 983 large banks 994t, 997–8 leverage 134, 135 leverage ratios 726, 727t liquidity creation 79, 620 liquidity requirements 212 living wills 123–5, 126t loans 981 market discipline 755–6 Page 72 of 74

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Index marketplace lenders 276–7 MMFs 551, 981 mortgage rates 479f mortgage-backed securities (MBS) 981 mortgages 471–2, 475, 478f, 980 mutual savings banks 335 non-financial corporations 41, 41f number of banks 342f, 343t, 991, 993f online banking 983 payment services 286, 982 private information 170 regulation 456–7, 997–8 regulatory reforms 753 re-regulation 987–8 restrictive government regulations 979–80 risk measurement 158–9 risk-sharing 43 savings and loans (S&Ls) 334, 335, 336 savings banks 334, 335, 338, 341–2, 344, 346–7, 349–50, 993f (p. 1256)

securitization 505–6, 506f, 508t, 511, 549, 981 shadow-banking 62, 533 small business lending 431, 453–4, 455–6, 458 state-sponsored insurance schemes 688–9 stress tests 728–9 structured leverage finance 559–61, 559f, 560f subprime lending 269–70 syndicated lending 981–2 tax subsidies 340 textiles industry 963–4 tier 1 capital 715 Treasury 635–7, 986, 998 Uzbekistan 1149 V Valenzuela, Patricio 27, 1076–109 Value at Risk (VaR) model 11, 156, 158–62, 173, 315, 616, 868–9 Van Der Weide, Mark E. 22, 707–33 Van Rompuy plan, EU 1018 vault cash 191, 192f Veneto Banca 660 Venezuela 887–8, 1166 Vickers Commission (Independent Commission on Banking), UK 1020 Vickers Report, UK 84 Vienna Initiative (VI) 1139 Vietnam 423–4, 423t Visa 301 Volker rule, US 3 W Page 73 of 74

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Index Wachovia 993 Wachtel, Paul 27, 1132–50 Wakefield, Priscilla 334 Walker, Sir David 132 Wall, Larry 18, 262–79 warehouse banking 182 Washington Mutual 606, 657n, 993 wealth management products (WMPs) 155, 1118–20, 1119f, 1121, 1123, 1125 welfare 414–15 Wells Fargo 103, 300, 438, 636, 758, 996 Westpac 1192, 1195 White, Lawrence J. 18, 262–79 wholesale funding 852, 866 wholesale payments 305–15 wholesale runs 44 Wicker, E. 914–15 Williams, Jonathan 27, 1152–85 Wilson, John O.S. 1–28, 1000–26 withdrawal risk 184, 186 withdrawals 686–7 women Africa 1092–6 China 1126, 1127–9 and microfinance 412, 416, 417, 418–19, 420–1 World Bank 690 Global Financial Inclusion Database 16 Wu, Eliza 28, 1190–211 X Xian Gu 16, 39–57 Xinming Li 19, 359–99 Y Yu ’E Bao MMF 558 Yugoslavia 1134 Z Zambia 1079 Zap m-system 1104 zero lower bound (ZLB) 12 zero risk entails zero return 366 Zhang, Jeffery Y. 22, 707–33 Zia, Bilal 27, 1113–29 Zimbabwe 582, 1090

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