Abstracts

• By Charles W. Calomiris and Richard Herring

Though the regulatory landscape post-crisis remains far from fixed, contingent capital, or CoCos, appear likely to form part of policymakers' toolkits. There is undoubtedly widespread support from regulators the world over to have instruments that can be converted from debt to equity at times of financial market stress. Yet there is little consensus as to what the trigger for conversion should be.

Before looking at the question of designing the right trigger, it's worth noting why there is so much support among regulators for CoCos. A proper CoCo requirement, alongside common equity, would be more effective as a prudential tool and less costly than a pure common equity requirement. CoCos can create strong incentives for the prompt recapitalisation of banks after significant losses of equity but before the bank has run out of options to access the equity market. That dynamic incentive feature of a properly designed CoCo requirement would encourage effective risk governance by banks, provide a more effective solution to the ‘too-big-to-fail' problem, reduce forbearance risk - supervisors' reluctance to recognise losses of book equity - and address uncertainty about the appropriate amount of capital banks need to hold, and the changes in that amount over time. If a CoCo requirement had been in place in 2007, the disruptive failures of large financial institutions and the systemic meltdown after September 2008 could have been avoided.

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• By Stijn Claessens

When the dust settles and the final numbers are tallied up, it should be no surprise if the massive support provided in the (ongoing) crisis to banks and other financial institutions ‒ directly in the forms of assistance from governments and central banks, and indirectly through support from international organizations, including to sovereigns under stress ‒ has meant that taxpayers, especially in Europe, have engaged in the largest cross-border transfer of wealth since the Marshall plan. The crisis has also shown that the ad-hoc solutions typically used to deal with failed globally systemically important financial institutions (G-SIFIs) lead to much turmoil in international financial markets and worsen the real economic and social consequences of crises.

Importantly, events have made abundantly clear (again) that, for all the efforts invested in the harmonization of rules and agreements to share more information, supervisors had little incentives to genuinely cooperate before the crisis and did too little to help prevent the weaknesses and failures of many G-SIFIs. Together, these facts, and the ongoing turmoil in Europe and elsewhere, remind us of the high costs from not having a system that can effectively and efficiently deal with G-SIFIs under stress.

A better approach to dealing with G-SIFIs is thus sorely needed. Many policy efforts are underway (by individual countries, the Basle Committee on Banking Supervision, the Financial Stability Board, the IMF, and others) to strengthen regulatory and supervisory frameworks, improve the robustness of these institutions, and enhance actual supervision internationally to prevent distress. At the same time, any approach has to be based on clear analysis of the underlying problem and not on wishful think(er)ing. Logic suggests starting from the endgame, i.e., resolution, the process of how a weak financial institution is (in part) liquidated, closed, broken up, sold, or recapitalized. Specifically, the rules governing who is in charge of the restructuring and liquidation process and how losses are allocated when a G-SIFI runs into trouble are crucial. The endgame strongly affects supervisory incentives and market behavior long before difficulties arise. And the endgame rules affects the time-consistency problem whether or not an ad-hoc bail out is ex-post the most efficient solution.

As policy makers realize all too well, however, especially in Europe today, approaches to resolution of G-SIFIs can conflict with three other policy objectives – preserving national autonomy, fostering cross-border banking and maintaining global financial stability. These three objectives are not always mutually consistent ‒ i.e., they create a financial trilemma, and approaches to resolution have to operate within this trilemma. In this paper I examine the causes for the resolution problem of G-SIFIs and review three approaches to improving cross-border resolution which address the financial trilemma head on acknowledging solutions are to be found in partly giving up fiscal and legal sovereignty or putting restrictions on cross-border banking.

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• By Martin Čihák, Asli Demirgüç-Kunt, and R. Barry Johnston

It would be wrong to conclude from the recent crisis experience that just "regulating more" is the way to go. It would be also wrong to conclude that more detailed regulations, such as more complex systems to calculate risk-weighted asset ratios, are necessarily better than simpler ratios. Complicated regulations, for instance those that try to mimic markets in estimating economic capital required by each institution commensurate with its risk, may end up leading to regulatory arbitrage and manipulated ratios. More fundamentally, changes in ratios are unlikely to address the underlying failures in economic incentives that led to the global financial crisis.

In this piece, we call for a re-orientation of the regulatory approach, so that it has at its center identification of incentive problems on an on-going basis. The challenge of financial sector regulation is to align private incentives with public interest without taxing or subsidizing private risk-taking. Credible threats of market entry and exit, healthy competition, and disclosure of quality information are essential in getting this balance right.

Specifically, we propose “incentive audits” as a tool to help identify and address perverse incentives faced by financial institutions, market participants, regulators, supervisors and politicians, before they give rise to systemic risk. These audits need to be combined with basic but well-defined capital and liquidity ratios, strong enforcement of transparency and use of complementary market signals. Transparency does not mean simply more reporting: what matters is the usefulness, clarity and comparability of disclosures.

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• By Loretta J. Mester

This session poses the question: is it time to break up the big banks? Breaking up the banks to make them smaller in size has been suggested as a solution to banks being viewed as “too-big-to-fail” (TBTF). TBTF is an insidious problem because it undermines the ability of private-sector investors to provide market discipline. Indeed, TBTF has been an issue that U.S. regulators have struggled with since the failure of Continental Illinois in 1984, and that experience suggests that once market discipline is undermined, it takes time to reestablish it.

When creditors believe that the government will not allow an institution to fail and therefore they will be fully protected, their ex ante incentive to monitor the firms’ risk-taking is undermined. The market discipline creditors could impose on the firm is potentially even greater than that of equity holders, since unlike equity holders, they do not share in any of the upside benefits from risk-taking. Yet, when creditors believe they will be bailed out ex post should the institution get into trouble, they have little incentive to provide discipline. To the extent that trouble at one of these institutions has spillovers to others and the potential to create a systemic event, the institution’s risk-taking imposes an externality. However, left to their own devices, the firms do not internalize the impact of their risk-taking on the likelihood of a systemic event. This suggests a role for government policy; however, the recent financial crisis suggests that the pre-crisis bank supervisory apparatus was not adequate to solve the problem.

If some banks are TBTF, then it seems reasonable to ask whether breaking them up will solve the problem. My answer is no, for two reasons. First, I am skeptical that such an approach can adequately address the concerns that the policy is intended to solve. Second, the approach ignores the costs that would be associated with breaking up the banks. To evaluate such a potential solution, it is important to know why banks have gotten so large. Research suggests that some institutions have grown in size, not to game the system, but for reasons of efficiency. The globalization of financial markets has led to larger markets, and better performing banks will grow in size. The systemic risk posed by large, complex institutions might still outweigh the efficiencies gained by scale, but without estimating the risks and these efficiencies, it is impossible to compare costs against benefits. Moreover, the effectiveness of size limits depends on knowing the market pressures on banks that encourage growth. Effective regulation needs to work with market forces, not against them. I believe that there are better strategies for addressing TBTF that focus on the externalities created by systemically important institutions. In particular, I believe a more effective approach to TBTF would be to institute a credible and less discretionary resolution method for systemically important financial institutions and to impose higher costs on firms that impose more systemic risk on the financial system.

In the remainder of this discussion, I present some information on the size and complexity of banking firms and some new results on the scale economies in banking. I discuss other approaches to addressing TBTF that I believe would be more effective than breaking up the banks. I conclude with some suggestions for future research that would help us evaluate policies.

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• By Harvey R. Miller

The MS Costa Concordia is an Italian passenger cruise vessel carrying more than 4.800 passengers and crew that rolled over on its side on Friday, January 13, 2012, hitting a rock in the Tyrrhenian Sea just off the shore of Isola del Giglio near the west coast of Italy.  For days after this calamitous event, the news media alternated hourly footage of the Concordia lying on its side with clips of James Cameron’s film Titanic.  Subsequent coverage of the accident focused on the fact that the ship’s captain, Francesco Schettino, had brought the ship within shouting distance of the island in order to “salute” a retired captain, Mario Palombo, who lived on the island.  Ultimately, it emerged that the practice of “saluting” has been a maritime custom and known to regulators even in the cruise industry for years.  As the Italian government was taking up consideration of legislation to ban the practice of saluting, the only major incident, perhaps, of reckless conduct that caused the sinking of a vessel, that anyone could recall was the Titanic catastrophe in 1917.  Despite this statistical reality, according to the 2012 annual report of Carnival Corporation PLC, the individual owner of the Concordia, because of the Concordia tragedy, booking volumes for group declined in the mid-teens compared to the prior year.

The response of regulators and the public is only natural.  Psychologists refer to this as the availability heuristic.  The response to Lehman’s failure on September 15, 2008 has been no different.  The legislative and regulatory response – embodied in Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act – has been to minimize “systemic impact” of the next Lehman-like failure through the creation of an entirely new process for the resolution of systemically important financial institutions (“SIFIs”).  Under this new regime, the Federal Deposit Insurance Corporation (“FDIC”) may be appointed as the receiver for a failing SIFI, and may act expeditiously to save the SIFI’s systemically important business lines from peril through a sale to a third party,  or a transfer of such business lines to a “bridge financial company” that is created, owned and controlled by the FDIC. The FDIC has stated on many occasions that this mechanism enables the FDIC to conduct the same rescue operation that is has successfully conducted in the past with respect to failed insured depository institutions.

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• By Ira M. Millstein

This is not a plea to “break up” the banks. Those words are still too ill and multi-defined. This is rather a suggestion that there is a serious missing element in today’s considerations of the future of the banking industry and systemic risk – antitrust and competition issues.

Three years after the financial collapse, basic antitrust principles have not been sufficiently considered as applicable to the current “big bank” market – if there is such a market. A study of the appropriate focus for antitrust in the banking industry is needed because on the face of it, there seems to be a “big bank” market, both commercial and investment banking, which is relatively concentrated. But, this is debatable and needs unfolding because the big banks arguably have become conglomerates selling a number of different financial products and services, many of which have become increasingly sophisticated.

The focus, instead, has been on regulation, perceived gaps in enforcement, and the enactment of legislation, principally the Dodd-Frank Act, in order to try to address risk taking and to stabilize financial institutions.  Antitrust law and competition values have taken an almost non-existent role, which is best exemplified by the fact that no antitrust regulator is a member of the Financial Stability Oversight Council (“FSOC”) established by the Dodd-Frank Act.

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• By Katharina Pistor

Proponents of global governance presume a strong complementarity between the location of a governance problem and its solutions. Local problems are said to require local solutions; it follows that global problems need global solutions. In this short paper I argue that this complementarity presumption does not hold in finance and that, therefore, attempts to deepen global standardization of financial regulation and adjacent fields are counterproductive. Instead, disruption and fragmentation of regulation is more likely to enhance financial stability than legal harmonization.

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For powerpoint, click here.