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

Corporate Governance Proposals Post Financial Crisis 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 – Action Plan on Company Law and Corporate Governance 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

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

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

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

Examples Evidence of negative relation of board independence on performance of banks during financial crisis 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 debt overhang and risk shifting Financial crises was not global because of diversity

Micro-Governance 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”

Systemic Risks Interconnections through Financial instruments such as CDS Risk of runs Interbank wholesale markets which create genuine externalities

Macro-Governance Transmission of losses, isolation and containment Micro-governance 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 Shift to macro-governance required

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

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. FDIC/ Bank of England harmonization

Macro-Governance Issues Taxation versus regulation Bail-ins versus bail-outs

Taxation Versus Regulation “Taxation and Regulation of Banks to Manage Systemic Risks” Brian Coulter, Colin Mayer, John Vickers (2012) Taxation? –Financial stability contribution (FSC) –Financial activities tax (FAT) –Financial transactions tax (FTT) –To cover implicit subsidy of anticipated bail-out Regulation? –Ex ante loss-absorbency capital, liquidity, bail-inable debt ratios –Ex post resolvability, separation

Tax Versus Regulation Issues 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

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) Systemic Expected Shortfall (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 Integrated 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 Central macro-governance questions: –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

Equivalence Between Taxation and Regulation Assumptions: –Perfect correlation between returns on loans –Return on levy funds independent of who owns or manages them –No flows to or from government, in particular no taxes (or retention of levy funds by government) and no subsidies `bail-outs' so no time- inconsistency problems Result: There is an economic equivalence between ex ante levies ('taxation') and requirements that banks hold capital themselves ('regulation')

Relaxing Equivalence Assumptions With uncorrelated returns, there is benefit of pooling if capital is socially costly – benefits of pooling occur when least needed and moral hazard risks created If privately employed funds more productive because of moral hazard, capital is preferred to levy – capital analogous to insurance deductible “Double edged sword” – unless levied in capital, taxation increases required debt funding and risks of failure

The Importance of Capital 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

Bail-In Versus Bail-Out 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 Bondholder bailouts threatened domestic sovereign solvency - Iceland and Ireland Failing to rescue banks threatened foreign systemic stability – Lehman Brothers

Bail-Ins 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

Resolution 1 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

Resolution 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)

Resolution 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.

Macro-Governance Harmonization In contrast to micro-governance, harmonization of macro-governance is essential It is required to: –Identify failures –Avoid regulatory arbitrage between rules –Internalize international repercussions of regulatory rules and interventions

FDIC- Bank of England Initiative Example of these proposals Home country responsibility for organizing resolutions and avoiding foreign country failures However, does not make explicit protection of second round institutions Failure to pre-announce policy could paralyze financial system by creating uncertainty about solvency of banks that are creditors of failed institutions

Conclusion Micro-governance intensifies systemic instability through identification, unintended consequences and homogeneity failures Harmonization elevates instability to global level Macro-governance: ex post polluter pays tax fails Ex ante taxation equivalent to regulation under certain conditions but inferior when conditions relaxed Capital should be held by institutions not centrally Bail-ins can avoid costs of capital raising in crises Ex post minimum cost bail-outs that do not have systemic repercussions need to be identified Harmonization of macro-governance is essential