Chapter Six Regulation

After the Crisis Since the wave of government-backed bank bailouts, recapitalization plans, liquidity injections, and credit guarantee schemes promulgated by the financial crisis there have been widespread policy concerns about the business models pursued by banks and how they were regulated. Large scale banking rescues have raised serious concerns about the social and economic costs of ‘Too-Big-To-Fail’ (TBTF) or ‘Too Systemically Important to Fail’. An important question for policy makers 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.

After the Crisis In addition to the actions of national governments, the European Commission has issued several communications concerning aspects of the crisis covering: the application of state aid rules to the banking sector; the treatment of banks' impaired assets; the recapitalisation of financial institutions; and the provision of restructuring aid to banks. Many of the regulatory or supervisory frameworks for dealing with problems in the financial system at an EU level were found to be lacking.

Frequency of Crises There were 124 systemic banking crises in 101 countries and they often occur regularly in the same countries, with 19 countries experiencing more than one banking crisis (e.g., Argentina, 4; Mexico, 2; USA, 2). Banking crises can have very large fiscal costs (e.g., Argentina, 75% of GDP; Chile, 36% of GDP; China, 18% of GDP; Korea, 31% of GDP; Indonesia, 57% of GDP; Mexico, 20% of GDP). Banking crises are often associated with very large output losses. For example, relative to trend output, losses reached 73% in Argentina, 92% in Chile, 37% in China, 59% in Finland, and 31% in Sweden.

Rationale for Regulation Monopoly power. Regulation may be needed to prevent banks from distorting competition if they have monopoly power Welfare considerations. Regulating for welfare reasons mainly reflects the desire to protect people in cases where information is limited or is costly to obtain Externalities. The riskiness of an individual bank is the responsibility of the bank’s managers, owners and debt holders except in so far as the bank’s failure impacts on the wider system via spillover externalities

Information Asymmetries This occurs when the party to one side of an economic transaction has more information than the other party. There are two types of asymmetric information in financial institutions and markets: adverse selection - the riskiest individuals/institutions will be the most eager to borrow, but lenders are aware of this and may not lend to low and high risk borrowers because they cannot distinguish between them moral hazard – borrowers take actions that harm lenders, which means that lenders may not lend because they cannot monitor borrowers effectively

Too-Big-To-Fail Too-big-to-fail is a problem if governments care more about the largest institutions, then banks have an incentive to become large and then take on too much risk Systemic risk refers to all events capable of imperiling the stability of the banking and financial system Most Systemically Important Financial Institutions (SIFIs) are European

Regulatory Response to the Crisis Main regulatory response to the crisis has been the US Dodd Frank Act 2010, recommendations made by the UK Vickers Commission in September 2011, Basel 3 (to be implemented by 2019) and in Europe the establishment of the ESFS and EBA stress testing. All seek to re-capitalize the banks, boost liquidity and constrain activity. Recent stress tests still reveal capital shortages in the banking sector, and more pessimistic scenarios regarding sovereign debt haircuts suggest that many European banks in particular will have to continue to keep on capital raising into the foreseeable future.

EU Bank Performance & Stress Tests The ECB estimates of the performance of large and complex banking groups in the Euro Area between 2005 and 2010 highlighting the disastrous losses made in 2008 and small pick-up in ROE thereafter. See the colossal increase in cost-income ratios in 2008 due to a collapse in income in following Table Also witness the substantial increase in Tier 1 capital and solvency ratios in 2009 and 2010.

Performance of Large and Complex Banking Groups in the Euro Area Year Return on Equity (%) Impaired Loans/ Total Assets (%) Cost-Income Ratio Tier 1 RatioSolvency Ratio (%) MedianAverageMedianAverageMedianAverageMedianAverageMedianAverage Source: Adapted from ECB, Financial Stability Review, June 2011, Table S5, page S30-S31.

European Banking Authority (EBA) Stress Tests European Banking Authority (EBA) did bank stress tests on 15 th July 2011 that covered 90 banks operating in 21 European countries. The main findings can be summarised as follows: By December 2010 twenty banks would not have achieved the benchmark 5% Tier 1 capital ratio over the two-year horizon – of the exercise. This amounts to a capital shortfall of some EUR 26.8 billion. The 90 banks in question raised an additional EUR 50 billion between January and April Eight banks did not achieve the 5% the capital threshold amounting to a shortfall of EUR2.5 bn. 16 banks achieved a Tier 1 ratio of between 5% and 6%.

Overhaul of Regulatory Architecture An overhaul of current regulatory structures will inevitably continue to take place. New rules place a greater emphasis on: simple leverage and liquidity ratios; the curtailment of opaque business models; and minimising the distortions caused by TBTF or/and strategically important banks. A new supervisory architecture will gradually be put in place.