1 Issues in Prudential Regulation: The Treatment of Distressed Banks Mathias Dewatripont (ULB) Jean-Charles Rochet (TSE) January 2009

2 Motivation “To protect banks and banking systems against the risk of international financial contagion, bank regulators around the world have embarked on an extensive program of harmonizing prudential banking standards among countries and fostering closer cooperation between national bank regulators. … It is fair to say that, as a result, the principal licensing and prudential requirements written into national banking laws have reached a high degree of uniformity. One of the reasons for this success is that it has been comparatively easy to identify best practices for these requirements. In contrast, little international uniformity of law or practice exists in the area of banking regulation governing the treatment of banks in distress.” (Asser, 2001)

3 Punchline Harmonized capital ratios is a sound idea (although existing ones need reform!) It should be extended to the treatment of distressed banks, because of ‘political economy’ considerations: whether in good or bad times, supervisors always face pressure from lobbies and from politicians that under- mine the proper functioning and stability of the financial system. There is therefore a cost in leaving things vaguely speci- fied or even unspecified and therefore at the discretion of supervisors. They need to be protected ex ante through a system of transparent rules. Goal: try and move closer to a rule-based system that maintains enough flexibility.

4 The case of individual banks A harmonized special bankruptcy regime should be established for banks involving ‘prompt corrective action’, i.e. giving to the supervisory agency powers to limit the freedom of bank managers (and possibly remo- ve them) and shareholders (and possibly expropriate them) before the bank is technically insolvent. Supervisors should have the independence, resources and expertise to fulfill their mission properly. If public authorities are unwilling to raise supervisory budgets, this pleads, ceteris paribus, for a simplification of the regulatory regime.

5 The case of individual banks (2)  In terms of the structure of regulation, one should not allow banks to ‘play one regulator against the other’ (as has been the case in the US with OCC and OTS).  Beyond this, while consolidated supervision – bundling ex-ante monitoring and ex-post intervention – allows for cost savings and simpler coordination, it may reduce accountability.  Guarding against this can be achieved through reduced discretion in terms of intervention by the supervisors (as in the US FDICIA).

6 The case of individual banks (3) One should think of the signals triggering intervention as admittedly crude indicators of the risk of potential pro- blems. Therefore, simplicity if crucial, because it reduces manipulability and enhances transparency & credibility. A single capital requirement, even when very complex, is not enough to limit risk taking by banks. Therefore, a battery of indicators have to be designed by regulators, in order to provide simple signals of the various dimen- sions of banking risks (including liquidity and transfor- mation risks, risks of large losses, exposure to macro- economic shocks, …) and used simultaneously to deter- mine whether supervisory corrective action is needed (see e.g. Brunnermeier et al.).

7 Systemic problems  Public authorities should expect crises to happen.  They should therefore put in place a mechanism that allows a crisis to be formally declared (an event which will allow the release of public funds).  This means formalizing ex ante cooperation between the relevant actors (Central Bank, supervisor, Treasury) with this contingency in mind.

8 Systemic problems (2)  Ex-post crisis management should keep in mind that undercapitalized banks do not function well.  One should therefore go for ‘real’ recapitalization, even if it is costly.  Several options – temporary nationalization, insuring bank loans or parking toxic assets in bad banks – are possible. The (difficult) objective should be to get lending going again without delay by properly capitalized banks, without excessively burdening taxpayers.

9 Systemic problems (3)  Ex-ante crisis prevention: Under current regulation, maintaining adequate capitalization in bad times is difficult & leads to potentially severe procyclical effects.  Avoiding this calls for introducing ‘automatic stabilizers’ into the regulatory system, such as higher capital ratios in good times, dynamic provisioning, capital insurance (privately or publicly provided), or procyclical deposit insurance premia (see Brunnermeier et al., Kashyap et al., Suarez, Dewatripont-Tirole, …).

10 International cooperation in crisis management In economic areas which are meant to be very integra- ted, like the EU, one should move towards a centralized supervisor and a centralized deposit insurer. If one wants to keep integrating the world banking mar- ket, one should seriously consider partial centralization of supervision and deposit insurance at the world level. Barring such centralization, it is important to foster best practices in establishing credible Memoranda of Under- standing for cross-border banking crisis management between authorities that detail in particular the respective rights and obligations with respect to intervention thres- holds and deposit insurance.