The Crisis Aftermath: New Regulatory Paradigms

157 Pages·2012·0.9 MB·English

The current crisis and its high social cost have shattered the confidence of T The Crisis Aftermath:
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economic agents in the banking system and questioned the capacity of financial e

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markets to channel resources to their best use. While it is essential for the well r
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functioning of economic activity that financial institutions do take risk, the i
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decisions taken by financial intermediaries have proven ex post to be excessively A New Regulatory
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risky. So, what was wrong with financial regulation? How were overoptimistic e
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expectations, short termism and inaccurate risk models implicitly encouraged? m
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This book is devoted to exploring the general issue of the origins of excessive th
: Paradigms
risk-taking in the banking industry. The four years since the start of the crisis, N
covering the period from the first turmoil in the interbank market to the fully e
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fledged sovereign crises of 2011, gives us sufficient perspective to make a better
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assessment of some of the main issues and challenges it has raised. We focus here g
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on the four main issues that provide the incentives for excessive risk-taking.
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Because it is the board of directors that is ultimately accountable for the level of o
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risk that is taken in a firm, we start with financial institutions’ corporate y

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governance. We analyse whether, in their strategic decisions, board members a
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consider their own bonuses, short-term stock price movements, shareholders’ a
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short-run interests (rather than stakeholders’ long-run ones) or simply the ig
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financial institution’s culture of risk.
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We next turn to the misperception of risks, related to managers’ and shareholders’
understatement of the business-cycle risk of downturn, as the procyclicality of
capital may lead to excessive lending, the emergence of bubbles and a financial
accelerator effect. The regulatory proposal of Basel III on countercyclical buffers
is intended to solve this issue. Still, rigorous analysis of the procyclicality of banks’
capital may indicate that the matter is more complicated than it seems.
In a third chapter, we ask why neither supervisory authorities nor market
discipline, which was given a preeminent role in Basel II, did a proper job. Is it true
that information disclosure was inaccurate?
Finally, in our last chapter we consider whether excessive risk-taking was the
result of implicit guarantees such that all banks in distress expected to be bailed
out. This implies that the way regulatory agencies and treasuries organise banks’
resolutions is critical in determining future moral hazard. It is therefore worth
considering how a bank in distress can be restructured in an orderly way –
whether it is to be closed or bailed out in such a way as to preserve banks’
incentives and be credible while limiting contagion to other banks.
This volume will provide the analytical ammunition required to rigorously
examine regulatory policy at a time when it is undergoing a complete
metamorphosis.
ISBN 978-1-907142-51-2
Edited by
Mathias Dewatripont and Xavier Freixas
9 781907142512

The Crisis Aftermath:
New Regulatory Paradigms
Centre for Economic Policy Research (CEPR)
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© Centre for Economic Policy Research 2012
ISBN: 978-1-907142-51-2
The Crisis Aftermath:
New Regulatory Paradigms
Edited by
Mathias Dewatripont, Université Libre de Bruxelles and CEPR
Xavier Freixas, Universitat Pompeu Fabra and CEPR
This book is produced as part of the project ‘Politics, Economics and Global
Governance: The European Dimensions’ (PEGGED) funded by the Socio-
Economic Sciences and Humanities theme of the European Commission’s 7th
Framework Programme for Research. Grant Agreement no. 217559.
Centre for Economic Policy Research (CEPR)
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and Affiliates, based primarily in European universities. The Centre coordinates the
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Chair of the Board Guillermo de la Dehesa
President Richard Portes
Chief Executive Officer Stephen Yeo
Research Director Lucrezia Reichlin
Policy Director Richard Baldwin
Contents
About the Contributors vi
Foreword vii
1 Introduction 1
Mathias Dewatripont and Xavier Freixas
2 Corporate Governance and Banks: What Have We Learned
from the Financial Crisis? 11
Hamid Mehran, Alan Morrison and Joel Shapiro
3 The Countercyclical Capital Buffer of Basel III: A Critical Assessment 45
Rafael Repullo and Jesús Saurina
4 Disclosure, Transparency and Market Discipline 69
Xavier Freixas and Christian Laux
5 Bank Resolution: Lessons from the Crisis 105
Mathias Dewatripont and Xavier Freixas
About the Contributors
Mathias Dewatripont holds a Ph.D. in Economics from Harvard University, 1986.
Before joining in 2011 the Executive Board of the National Bank of Belgium (in
charge of Prudential Policy and Financial Stability), he was Professor of Economics
at the Solvay Brussels School of Economics and Management, Université Libre de
Bruxelles (where he still teaches part-time) and a member of its research centre
ECARES. He was also part-time Visiting Professor at the Massachusetts Institute of
Technology and Research Director of CEPR from 1998 until 2011.
Fellow of the Econometric Society, laureate of the 1998 Belgian Francqui Prize
and of the 2003 Yrjo Jahnsson Prize for Economics, he was elected President of
the European Economic Association for the year 2005 and appointed founding
member of the Scientific Council of the European Research Council this same year
He was a member of European Commission Presidents R. Prodi and J.M. Barroso’s
Group of Economic Policy Analysis (2001-09), and of the Economic Advisory
Group for Competition Policy of DG Competition (European Commission)
(2004-11). He was outside Director of CGER-Bank in Belgium (1992-99).
His general research area is the theory of incentives and organizations, with
applications to banking in particular. His publications include The Prudential
Regulation of Banks (with J. Tirole, MIT Press, 1994), Contract Theory (with P.
Bolton, MIT Press, 2005) and Balancing the Banks: Global Lessons from the Financial
Crisis (with J. Tirole and J.-C. Rochet, Princeton University Press, 2010).
Xavier Freixas is Professor at the Universitat Pompeu Fabra in Barcelona and at
Barcelona Graduate School of Economics, and a Research Fellow at CEPR. He is past
president of the European Finance Association and has previously been Deutsche
Bank Professor of European Financial Integration at Oxford University, Houblon
Norman Senior Fellow of the Bank of England and Professor at Montpellier and
Toulouse universities. He has been a consultant for the European Investment
Bank, the New York Fed, the European Central Bank, the World Bank, the
Interamerican Development Bank, MEFF and the European Investment Bank. He
is currently a consultant for the European Central Bank for its research network
on Macroprudential Regulation (MARS). He was also Chairman of the Risk Based
Regulation Program of the Global Association of Risk Professionals (GARP)
He has published papers in the main economic and finance journals such as
Econometrica, Journal of Political Economy, Journal of Finance, Journal of Financial
Economics, and Review of Financial Studies. He is Associate Editor of Journal of
Financial Intermediation, Review of Finance and Journal of Financial Services Research.
vi
About the Contributors vii
His research contributions deal with the issues of payment systems risk, contagion
and the lender of last resort and the He is well known for his research work in the
area of banking, which has been published in the main journals in the field, as
well as for his book Microeconomics of Banking (MIT Press, 1997, 2007 second
edition), co-authored with Jean-Charles Rochet.
Hamid Mehran is Assistant Vice President in the Research Group of the Federal
Reserve Bank of New York and a fellow of the Wharton Financial Institutions
Center. He has been on the faculty of the Carroll School of Management at
Boston College, the Kellogg Graduate School of Management at Northwestern
University, MIT Sloan School of Management, and the Wharton School at
University of Pennsylvania. Dr. Mehran was previously a Research Associate at
Hewitt Associates. His central research interest is in corporate finance.
His research has been published in the Economic Policy Review, Journal of Accounting
and Economics, Journal of Corporate Finance, Journal of Finance, Journal of Financial
Economics, Journal of Financial Intermediation, Journal of Financial and Quantitative
Analysis, Journal of Financial Services Research, Financial Management, B.E. Advances
in Economic Analysis & Policy, Journal of Regulatory Economics, and the Review of
Financial Studies. He has written widely on the governance of banks and edited
the volume Corporate Governance: What Do We Know, and What is Different About
Banks?
Christian Laux is a Professor of Finance at the Department of Finance,
Accounting, and Statistics at the WU Vienna (Vienna University of Economics
and Business). He was Professor at the Goethe University Frankfurt and held
visiting positions at the University of Chicago Booth School of Business, Wharton
School, University of Pennsylvania, London School of Economics, and Harvard
University. Christian’s current research interests include the role of fair-value
accounting in the financial crisis and the structure of risk transfer. His work has
been published in academic journals such as, for example, The Accounting Review,
Journal of Economics Perspectives and RAND Journal of Economics.
Alan Morrison is Professor of Finance at the Saïd Business School, University of
Oxford. His research interests are in the regulation of commercial banking, and
the organization of the investment banking industry. He has published widely in
academic journals, and his book Investment Banking: Politics, Institutions, and Law,
co-authored with Bill Wilhelm, was recently published by Oxford University
Press. He has performed consultancy work for a variety of financial institutions,
and was recently specialist advisor to the House of Lords Economic Affairs
Committee’s inquiry into Banking Supervision and Regulation.
Rafael Repullo is Professor of Economics and Director of the Centre for Monetary
and Financial Studies (CEMFI) in Madrid, Spain. He is Executive Vice-President
of the Econometric Society, Fellow of the Econometric Society and of the
European Economic Association, CEPR Research Fellow, member of the Financial
viii The Crisis Aftermath: New Regulatory Paradigms
Economists Roundtable, and founding member of the European Corporate
Governance Institute. He holds a PhD in Economics from the London School
of Economics (LSE), and has worked in the Department of Economics of the
LSE and the Research Department of the Bank of Spain. He has been a Houblon-
Norman Fellow at the Bank of England, and has held visiting appointments at the
European Central Bank, the Federal Reserve Board, the Federal Reserve Banks of
Minneapolis and New York, the London School of Economics, and the Universities
of Columbia, Pennsylvania, Princeton, and Tel Aviv. He is currently Co-Editor of
the International Journal of Central Banking. His recent research is in the areas of
banking and corporate finance, working on topics such as venture capital, market
liquidity and shareholder activism, insider trading and real investment, central
banks as lenders of last resort, capital requirements, competition, and risk-taking
in banking, and the pro-cyclical effects of risk-sensitive bank capital regulation.
Jesús Saurina is Director of the Financial Stability Department at Banco de España.
Among other duties, he is responsible for the Financial Stability Report, banking
regulatory policy analysis and banking research. He is a member of the Advisory
Technical Committee of the European Systemic Risk Board and of the Financial
Stability Committee of the European Central Bank/Eurosystem, and a member of
several working groups of the Basel Committee on Banking Supervision dealing
with systemic institutions, pro-cyclicality of capital requirements and research in
banking. He holds a Ph.D. in Economics at Universidad Complutense de Madrid
and is a CEMFI postgraduate. He is a former Associate Professor at Carlos III
University in Madrid, collaborates with the Financial Stability Institute in Basel
and has worked as a short-term consultant for the World Bank.
He has a number of papers published at top economics, finance and banking
journals, including American Economic Review (monetary policy and financial
stability), Review of Financial Studies (credit lines), the Journal of Financial Economics
(collateral), the Journal of Financial Intermediation (capital buffers), the Journal of
Money, Credit and Banking (competition through interest rates and guarantees),
the Journal of Banking and Finance (banking size and organization, determinants of
credit risk), the Journal of Financial Services Research (impact of capital regulation on
SMEs lending, procyclicality in mortgages), European Accounting Review (earnings
and capital management), the European Economic Review (financial deregulation
and risk taking), the Review of Industrial Organization (search cost in interest rates)
and the International Journal of Central Banking (dynamic provisions), among
others.
Joel Shapiro is a University Lecturer of Finance at the Said Business School,
University of Oxford. He was previously a tenured Associate Professor at
Universitat Pompeu Fabra and has been a visiting researcher at NYU Stern, and the
Federal Reserve Bank of New York. Joel currently does research on the regulation
and governance of financial institutions and has published in academic journals
such as the Journal of Finance, Journal of Financial Economics, and the Journal of
Public Economics.