The Micro, Macro and International Design of Financial Regulation Jeff Gordon and Colin Mayer

Avalanche of New Corporate Governance Proposals UK – Financial Reporting Council corporate governance and stewardship codes; Walker report on corporate governance in banks and other financial institutions European Commission Green Paper on corporate governance in financial institutions Dodd-Frank proposals on corporate governance, sequel to Sarbanes-Oxley

Cause Failure of financial institutions in credit crisis and perceived contribution of poor corporate governance In particular, companies took undue risks that jeopardized stability Failure to monitor, measure and manage risks

Policy Responses I: Board Structure and Effectiveness Board composition, including gender Independence and conflicts of interest Nominations and appointment Induction Time commitment Information and servicing of board Annual re-election Annual evaluation of board performance Scrutiny by non-executive directors Separate functions of chairman, CEO

Policy Responses II: Accountability, Risk and Remuneration Audit committee and internal controls Risk management committee and CRO Relation of pay to performance and risk – “say on pay”, equity, options, golden parachutes, deferred compensation, accounting restatements, executive compensation committee

Policy Responses III: Shareholder Engagement and Stewardship Two-way communication from and to shareholders Shareholder monitoring Public engagement – shareholder resolutions, proxy voting, voting policy and behaviour Private engagement – meetings with directors Collective action Relation between pension funds and fund managers

Micro-Prudential Regulation Source of Systemic Risk Identification Unintended consequences Homogeneity Create externalities where otherwise would not exist

Harmonization Extends problem from domestic to international context Harmonization can be implied rather than formal – mistaken belief in the effectiveness of particular remedy and desire not to fall behind “best practice”

Three Examples Example I: Narrow Banking Discourages diversification Impact on asset prices of for example government securities Interconnections between banks because of holdings of similar asset classes

Example 2: Board Independence Evidence of negative relation of board independence on performance of banks during financial crisis Possibly reflects regulatory distortions

Example 3: Executive Remuneration Worse performance during financial crisis of banks with executive remuneration closely tied to performance Strong relationship between residual executive compensation and risk taking in banks Problems of risk shifting and underinvestment Ease with which mimicking strategies can be devised

Systemic Risks Interconnections through Financial instruments such as CDS Risk of runs Interbank wholesale markets These create externalities, for example failure to price risk of default of credit protection sellers

Public Health Analogy with distinction between medicine and public health Public health concerned with protection of the public as against aggregation of protection of individuals Focused on interaction, transmission, isolation and inoculation Most vulnerable elderly; most relevant the young

Macro-Prudential Regulation Transmission of losses, isolation and containment Current identification of risks neither necessary nor sufficient for protection Not necessary – failures of financial institutions may not have systemic consequences, eg Barings, Société Générale and UBS Not sufficient – risk weights do not identify where interactions between institutions most pronounced Failure to focus on right issues exacerbate problems. Require immunization, isolation, intervention

Current Situation Little information about interconnectedness between banks and risk propagation Banks hold as little capital as possible in the face of strong tax incentives to issue debt Resolution of banks only occur when they are insolvent Bondholders protected from losses by governments keen to avoid systemic repercussions

Current Initiatives New institutions – ESRB, FSC, FSOC, FSB Systemic measures of risk based on CoVar, inclusion of financial sectors in macro-models, stress testing through simulations of failures Additional capital – Basel III defining new measures of risk, pro-cyclical capital provisions, counter-cyclical buffer, liquidity requirements, G- SIB requirements Special resolution regimes conferring powers on regulatory authorities to restructure failing institutions

Systemic Approaches Taxation? –Financial stability contribution (FSC) –Financial activities tax (FAT) –Financial transactions tax (FTT) –Versus (still large?) implicit subsidy of anticipated bail-out Regulation? –Loss-absorbency capital, liquidity, bail-inable debt ratios –Structure resolvability, separation, size limits Aim of presentation: to examine economics of the`taxation versus regulation' question

“Taxation and Regulation of Banks to Manage Systemic Risks” Brian Coulter, Colin Mayer, John Vickers (2012) Contrasts with pollution control: `polluter pays' can't work for banks Recast the `taxation versus regulation' question in terms of forms of pre-paid levy Benchmark model with correlated returns and no taxes or subsidies `Taxation' = `regulation' equivalence results Pros and cons of a crisis fund with uncorrelated returns Taxes and implicit subsidies; second-best taxation given regulation Conclusions on capital and complementary reforms

Related Literature - Taxation Revenue-focused vs. corrective taxation FAT, FSC (FCRF) - Keen (2011), Devereux (2011), IMF (2010) FTT - Vella et al (2011) Liquidity: Perotti and Suarez (2009) SES: Acharya et al (2010) CoVaR: Adrian and Brunnermeier (2009)

Related Literature - Regulation Analogy with private contracting: Black et al (1978) Capital ratios: Admati et al (2010) Analogy to LTV ratio Liquidity regulation: Acharya et al (2009) Analogy to liquidity covenants Various proposals: Squam Lake Report (2010)

Parallel with Pollution Control ‘ Knowing that bailouts are inevitable because governments will rescue firms whose collapse may cause systemic failure, financial institutions fail to internalize risks their investments impose on society, thereby creating a "risk externality“.’ `Just as taxes are imposed to deal with pollution externalities, taxes can also address risk externalities.' `A well-designed tax system can entirely eliminate the risk externality generated by inevitable government bailouts.' Kocherlakota (2010), 'Taxing Risk and the Optimal Regulation of Financial Institutions'.

Contrasts with Pollution Control Natural to think of parallels with pollution control but...`Polluter pays' doesn't work because in a systemic crisis banks can't pay that's what the crisis is Likewise ex post taxation distorts risk-taking because it is not paid in bad states Ex ante taxation is a form of `potential polluter pre- pays' In a sense so is capital ratio regulation - akin to `potentialpolluter posts collateral' Indeed we can recast the `taxation versus regulation' question in terms of forms of pre-paid levy (see next) Taxation might exacerbate the externality (see later)

Forms of Pre-Paid Levy As well as the question of what levy rate to set, there are basic design issues, including: –Who owns the fund of levies while there is no crisis? –How are levy proceeds invested while there is no crisis? –How are they disbursed if there is a crisis? (More than 100%?) –What happens to control rights in a crisis? With `taxation' the levies go into general government funds, from which the government chooses (or feels compelled) to make payments in a crisis With `regulation' they form a reserve of capital owned by the banks' shareholders unless and until there is a crisis, at which point they absorb losses and control rights may shift

The Importance of Capital as Form of Immunization The model underlines that banks need to be properly capitalized Higher capital is the first-best solution to externality problem Inadequate capital requires high taxation especially if bail-out is anticipated Taxation not a substitute for capital unless in the form of capital Sub-optimal capital requires complementary reforms

Isolation Restructuring while institutions still viable Postponement prompts confidence collapse Need for PCA but did not assist in crisis because of off-balance sheet liabilities and failure to write-down assets, eg Citibank Tier 1 capital ratio was 11.8% in Dec but market cap was 1% of assets Importance of bail-ins derives from the asymmetries of extinguishing and raising capital in crisis Wealth transfers make equity issuance privately if not socially expensive Capital raising in crises can therefore prompt reduced lending

Intervention: 1 Bondholder bailouts threatened domestic sovereign solvency - Iceland and Ireland Failing to rescue banks threatened foreign systemic stability – Lehman Brothers Alternative: write-down shareholder and bondholder claims in failing institutions and avoid second round failures of creditor institutions – Swedish banking crisis approach Minimizes moral hazard and costs of rescues by imposing losses on first round shareholders and bondholders and second round shareholders

Intervention: 2 Let A i be the non-bank net assets of bank i; A ij be the credit of bank i in bank j; and D ij be the liabilities of bank i to bank j. There are three classes of banks. First, there are N-I banks that are insolvent as a result of the asset shock: A i + Σ j=1 N A ij - Σ j=1 N D ij < 0 V i = I N(1) Second, there are I-K banks out of a total of N banks that are solvent after the asset shock even after the write-down of the liabilities of the first class of banks: A i + Σ j=1 I A ij - Σ j=1 N D ij > 0 V i = I-K(2) Third, there are K banks that would have been solvent were it not for the write-down of the liabilities of the first class of banks: A i + Σ j=1 N A ij - Σ j=1 N D ij > 0 V i = I-K+1....I(3) but would be insolvent as a result of the write-downs of the liabilities of the first class: A i + Σ j=1 I A ij - Σ j=1 N D ij < 0 V i = I-K+1....I(4)

Intervention: 3 So the first class of banks is insolvent in any event and is closed down with their liabilities written off. The second class suffers a decline in share value of Σ j=1 N A ij - Σ j=1 I A ij but remains solvent. The third class would be insolvent as a consequence of the write-downs and the loss in value of Σ j=1 N A ij - Σ j=1 I A ij but otherwise would not be. It is this third class that it is the potential cause of systemic risk beyond the immediate failures of the first class. To avoid this, the central authorities inject an amount Σ j=1 N D ij - A i - Σ j=1 I A ij into each of the K banks. Note that this is less than or equal to Σ j=1 N A ij - Σ j=1 I A ij because of (3), namely that the third class of banks participate in the funding costs through their own equity. The total cost to the authorities is Σ i=I-K+1 I {Σ j=1 N D ij - A i - Σ j=1 I A ij } which is the minimum cost at which the restructuring could be undertaken because the liabilities of the first class of banks is written off entirely, the second class bear the full cost of their share and the third class bear as much as they can without themselves becoming insolvent.

Harmonization In contrast to micro-prudential regulation, harmonization of macro-prudential regulation is essential It is required to: –Identify failures –Avoid regulatory arbitrage between rules for immunizing and isolating failures –Internalize international repercussions of regulatory rules and interventions

Conclusion Focus of harmonization to date precisely wrong Micro-prudential regulation intensifies systemic instability through identification, unintended consequences and homogeneity failures Harmonization elevates instability to global level Macro-prudential regulation: identification, immunization, isolation and intervention in failures Taxation not substitute for capital Bail-ins can avoid costs of capital raising in crises Importance of low cost forms of resolution Harmonization of macro regulation is essential