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Edmund Cannon
Banking CrisisUniversity of Verona
Lecture 4
Plan for today2
Brief discussion of essays
Finish yesterday’s lecture:
Endogenous risk
I shall NOT teach on REPO after all (if you have questions then e-mail me or see me on Monday!)
Confirm details for Monday’s presentations
Today: banking regulation
Capital requirements and the cost of regulation
Ring-fencing
“Endogenous” Risk3
Basic idea:
Economic insitutions magnify good and bad shocks.
Mechanism 1: Leverage
Unexpectedly good results increase capital (equity)
Banks lend more
Creates a bubble
Mechanism 2: Expectations / perceptions of risk
Firms only use recent data to evaluate risk
Selection bias
Too optimistic in good times; too pessimistic in bad times.
Leverage and endogenous risk (Shin)4
Leverage increases endogenous risk in all leveraged institutions, not just banks.
Endogenous risk – the crash5
As asset prices fall (losses mount) leverage rises.
Firms sell assets to reduce leverage.
Distress selling is an externality to other banks’
balance sheets (especially with mark-to-market
pricing).
House price bubbles6
House prices are very variable.
House prices rise
Fewer defaults
Mortgage banks make high profits and increase equity
Under-estimate default risk
Lend more money on easier terms
House prices rise further
7
01.0
3.19
99
01.0
8.19
99
01.0
1.20
00
01.0
6.20
00
01.1
1.20
00
01.0
4.20
01
01.0
9.20
01
01.0
2.20
02
01.0
7.20
02
01.1
2.20
02
01.0
5.20
03
01.1
0.20
03
01.0
3.20
04
01.0
8.20
04
01.0
1.20
05
01.0
6.20
05
01.1
1.20
05
01.0
4.20
06
01.0
9.20
06
01.0
2.20
07
01.0
7.20
07
01.1
2.20
07
01.0
5.20
08
01.1
0.20
08
01.0
3.20
09
01.0
8.20
09€0
€100,000
€200,000
€300,000
€400,000
€500,000
€600,000
Irish Property PricesSource: BIS, taken from Dept of Environ-ment, Heritage & Local Government, Eire.
Existing properties: whole coun-try
Existing properties: Dublin
8
01/1
991
01/1
992
01/1
993
01/1
994
01/1
995
01/1
996
01/1
997
01/1
998
01/1
999
01/2
000
01/2
001
01/2
002
01/2
003
01/2
004
01/2
005
01/2
006
01/2
007
01/2
008
01/2
009
01/2
010
01/2
011£0
£20,000
£40,000
£60,000
£80,000
£100,000
£120,000
£140,000
£160,000
£180,000
£200,000
UK House PricesSource: Nationwide BS average house price
9
01
/03
/19
70
01
/03
/19
72
01
/03
/19
74
01
/03
/19
76
01
/03
/19
78
01
/03
/19
80
01
/03
/19
82
01
/03
/19
84
01
/03
/19
86
01
/03
/19
88
01
/03
/19
90
01
/03
/19
92
01
/03
/19
94
01
/03
/19
96
01
/03
/19
98
01
/03
/20
00
01
/03
/20
02
01
/03
/20
04
01
/03
/20
06
01
/03
/20
08
01
/03
/20
1010
100
1000Belgium
Switzerland
Denmark
United Kingdom
USA
UK House Prices (Nationwide BS survey)Ratio of first-time buyer houses to earningsSource: http://www.nationwide.co.uk/hpi/
10
0
1
2
3
4
5
6
1983 Q1
1985 Q1
1987 Q1
1989 Q1
1991 Q1
1993 Q1
1995 Q1
1997 Q1
1999 Q1
2001 Q1
2003 Q1
2005 Q1
2007 Q1
2009 Q1
Ratio of house prices to average earnings (long run)Source: Nationwide, National Statistics, author’s calculations
11
0
1
2
3
4
5
6
1963
1965
1967
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
Confirm arrangements for Monday12
Produce a short ppt presentation (bring it on a memory stick).
Divide the presentation between you.
Talk for ten-twelve minutes in total.
Time for discussion, questions and feedback.
There are five groups:
A Endogenous risk
B Structured products
C VaR and risk measurement
D Capital requirements
E Ring-fencing
Banking regulation13
Very large number of suggestions: difficult to categorise:
Basel approach – regulations on how banks behave (eg capital requirements).
More structural approach – define what financial institutions are allowed to do (eg Glass-Steagall).
Other details (eg accounting practices).
Issues of regulatory quality and political lobbying
Further issue of how to handle a bank ex post (ie after something has gone wrong).
Bank Regulation14
Independent Commission on Banking
“Vickers Commission”
1. Capital Requirements (loss absorbancy)
• What is the cost?
2. Structural Changes (the “ring fence”)
• Details
3. Competition
• I ignore this
Suggested capital requirements
Basel II Basel III Basel III + counter-cyclical buffer
Vickers
Equity / RWAs
2% 3.5% 6% Investment: 7%
Retail: 10%
Total Capital / RWAs
8% 8% 10.5%
Tier 1 / Total Assets
3%
15
The fallacy that capital requirements raise costs
16
Banks have argued that higher capital requirements raise the cost of capital.
There are two versions to this argument.
One is silly.
One is wrong.
Silly argument against capital requirements17
Higher capital requirements mean a bank has more assets earning low rates of return.
The fallacy that capital requirements raise costs
18
Banks have argued that higher capital requirements raise the cost of capital:
The cost of capital is greater than the cost of debt because it is more risky;
More capital means higher cost.
Why this is wrong (Modigliani-Miller theorem):
Higher capital means the risk is shared by a larger part of the bank’s liabilities;
Therefore the cost per unit of capital is lower.
Independent Banking Commission (Vickers)19
Largely in line with Kay’s suggestion: ring-fence the retail part banking operations.
The purpose of the retail ring-fence is to isolate those banking activities where continuous provision of service is vital to the economy and to a bank’s customers in order to ensure, first, that this provision is not threatened as a result of activities which are incidental to it and, second, that such provision can be maintained in the event of the bank’s failure without government solvency support. (IBC ¶3.3)
The Retail Ring Fence20
“Location”: what goes either side of the fence?
“Height”: how separate from other banking activity must a retail bank be within a banking group?
Retail means:
personal consumers
SMEs under Companies Act definition:
fewer than 250 employees;
turnover less than £25.9m;
balance sheet less than £12.9m.
The Retail Ring Fence21
“Location”: what goes either side of the fence?
“Height”: how separate from other banking activity must a retail bank be within a banking group?
Retail means:
personal consumers
SMEs under Companies Act definition:
fewer than 250 employees;
turnover less than £25.9m;
balance sheet less than £12.9m.
The Retail Ring Fence22
Mandatory services:
Deposit accounts (including payment services);
Overdrafts connected to payment services.
Forbidden services:
Services to entities outside the EEA;
Exposure to risk of a bank outside ring fence;
A trading book;
Any service which requires capital to be held against risk;
Any involvement in derivatives;
Services relating to secondary markets in securities;
Anything else which puts the bank at risk and ICB hasn’t yet thought of.
Why not complete separation?23
Implementing the legal rules to maintain a retail ring fence are no harder than implementing the rules for complete separation;
There are reputational effects which may be valuable: if the whole retail sector gets into trouble via a retail-sector-specific shock, then links to other financial institutions will provide a hedge.