Financial Institutions, Markets and Regulation: A Survey | COEURE Workshop on Financial Markets

Financial Institutions, Markets and Regulation:

A Survey

by Thorsten Beck, Elena Carletti, and Itay Goldstein

Discussion by Evren Örs (HEC Paris)

COEURE Workshop on Financial Markets

European University Institute

Florence, June 6, 2015

Beck, Carletti and Goldstein (2015) discussion by Örs 1

Introduction

- A survey of a vast literature on banking & its regulation - A major undertaking giving the multi-faceted nature of the subject

- Interaction between theoretical work, empirical findings, and the emerging regulatory environment

- With a focus on European research

- A very valuable undertaking for the understanding of the effectiveness of the new EZ regulatory framework being adopted

- Regulatory arbitrage is assured to show its head in the new environment

- Very important to understand the strength and weaknesses of the new system in an ever-changing financial environment where rule avoidance is common

- Banking theory and empirical evidence help us to the extent they provide tools for a critical assessment for the question at hand:

- The ever changing nature of banking, shadow banking (and their interaction) and their regulation while financial innovation keeps on evolving

- What’s at stake is European tax payers’ money


Outline of the Review 1. Introduction

2. What types of market failures does financial regulation tries to address?

2.1 Panics vs. fundamentals related crises

2.2. Inefficient liquidity in the interbank markets

2.3. Interbank interconnectedness, systemic risk, and contagion

2.4. Incentives, bubbles and crises

3. Financial Regulation

3.1. Capital regulation

3.2. Liquidity requirements

3.3. Safety nets: CB interventions and deposit insurance

4. Regulatory reforms: What has been done in the EZ and the EU?

4.1. Capital and liquidity requirements

4.2. Banking union, resolution frameworks, and bail-in instruments

4.3 Activity restrictions

5. The traditional financial system in Europe six years after the Crisis

5.1 Banks vs. markets? A new financial structure debate

5.2. Complexity and globalization


Outline of the Review 6. Financial innovation: regulatory arbitrage & fragility or financial deepening?

7. Regulatory perimeter: Fragility in banks vs markets

8. Creating arbitrage-safe regulatory frameworks

8.1 Complexity vs. simplicity

8.2. Complementary micro- & macro-prudential regulation

8.3. Focus on resolution

8.4. A dynamic approach to regulation

9. Looking forward: what is known, not known, and should be known

9.1. Complexity vs. simplicity





First set of comments

- An ambitious project: - Very timely and very valuable undertaking given the new regulatory

frameworks that are being adopted in the EU and the EZ

- We would like to know how the newly adopted regulations will perform in the dynamic environment in which banks and shadow banks operate

- Ambitious because the Review spans a large set of inter-related research areas that need to be related to each other in a limited number of pages

- The authors cover theory and empirical papers, but the balance and the interactions between the two sets could be improved

- An excellent initiative! - There is a lot of good research by European researchers that is highly relevant

for public policy that this survey aims to highlight

- We need more resources (funding and data) to contribute further



- Very important topic: - Lucas, Schwaab & Zhang (2015):



- The structure of the Review

- Currently:

Review of the theoretical literature followed by a coverage of the empirical evidence, followed by the description of the new regulatory environment and finally by an assessment of the new rules and tools.

- An alternative could be:

-Start with a brief description of the new regulatory environment in the EU/EZ,

-review the literature that’s pertinent/related with each of the new areas of regulation,

-and then provide a critical assessment of the strengths and weaknesses of the new set of rules and tools

-what could go wrong in this set-up given what we know from theoretical and empirical evidence in the literature?


An alternative outline for the Review

1. Introduction

5. The traditional financial system in Europe six years after the Crisis

5.1 Banks vs. markets? A new financial structure debate

5.2. Complexity and globalization

4. Regulatory reforms: What has been done? 4.1. Capital and liquidity requirements

4.2. Banking union, resolution frameworks, and bail-in instruments

4.3 Activity restrictions

8. Creating arbitrage-safe regulatory frameworks 6. Financial innovation: regulatory arbitrage & fragility or financial deepening?

8.1 Complexity vs. simplicity





An alternative outline for the Review

3. Financial Regulation 3.1. Capital regulation

2.1 Panics vs. fundamentals related crises

2.4. Incentives, bubbles and crises

3.2. Liquidity requirements

2.2. Inefficient liquidity in the interbank markets

3.3. Safety nets: CB interventions and deposit insurance

7. Regulatory perimeter: Fragility in banks vs markets

2.3. Interbank interconnectedness, systemic risk, and contagion

9. Looking forward: what is known, not known, and should be known 8.1. & 9.1. Complexity vs. simplicity

8.2. & 9.2. Complementary micro- & macro-prudential regulation

8.3. & 9.3. Focus on resolution

8.4. & 9.4. A dynamic approach to regulation


Second set of comments

1. More balance is needed between theory papers vs. empirical work - Initial parts of the Review are almost exclusively focused on theoretical papers.

- A more blended approach: theory and empirics complement each other

2. Some of the potential sources of new financial risks that might arise are not in the Review

- LIBOR scandal

- ETFs

- Insurance industry

- Clearing Houses (Centralized Counterparties)

3. Some of the historical facts that are provided not very pertinent to the EU context, others more relevant could be covered in more detail

- Some of the US history can be shortened,

- Some of the EU context can be further explained/highlighted (with respect to the US context, for example the case of EZ deposit insurance)


1. More balance between theory and empirical papers

In the interest of time, I’ll just provide some examples:

-Pros & cons of financial integration through banks on real economy -Morgan, Rime & Strahan (2004), Kerr & Nanda (2009), Michalski & Ors (2012, 2014), Acharya, Imbs & Sturgess (2011)

-Financial crisis affects bank lending to the real sector Campello, Graham & Harvey (2010), Duchin, Ozbas & Sensoy (2010), Ivashina & Scharfstein (2010), Cornett, Marcus, McNulty & Tehranian (2011), Puri, Rocholl & Steffen (2011), Berger & Roman (2015b)

-European integration -Empirical evidence by Bekaert, Harvey, Lundblad & Siegel (2013), Laeven & Tressel (2014)

-European banking integration (M&As) and regulatory arbitrage -Carbo-Valverde, Kane & Rodriguez-Fernandez (2008, 2012)



- Regulatory structures involving banking unions - US federal vs state bank regulators by Agarwal, Lucca, Seru & Trebbi (2014)

- Theoretical work by Colliard (2015)

- Price of bank liquidity in the EU Fecht, Nyborg & Rocholl (2011), Cassola, Hortaçsu & Kastl (2013)

- Empirical evidence on flight to quality by investors - For ex., Baele, Bekaert, Inghelbrecht & Wei (2015)

- (Removal of) government guarantees and bank behavior

- Fischer, Hainz, Rocholl & Steffen (2104), Korner & Schnabel (2013)

- Banks’ risk management and derivative use - Theoretical work by Vuillemey (2015)



- Sovereign-bank loop/spiral - For ex., Gray (2014), Kallestrup, Lando & Murgoci (2014), Black, Correa,

Huang & Zhou (2013)

- Effectiveness of liquidity provision through discount window (TAF) - Berger, Black, Bouwman & Dlugosz (2014)

- Government aid and distortion of bank competition (TARP) - Berger & Roman (2015a)

- Depositor + firm runs (credit line draw-downs) & bank liquidity risk

- Ippolito, Peydro, Polo & Sette (2015)

- Bank stress tests


2. New problems and sources of risk in the financial system

- Different definitions of shadow banking system, the one I like: - “Shadow[y] banking is financial activity that is engineered to extract implicit

subsidies from government safety nets. … [It] may also be called Safety-Net Arbitrage” Kane (2014)

- ETFs - $ 2.6 trillion in assets worldwide

- In the EU from € 40 billion in 2005 to almost € 400 billion at the end of 2014 !(approx. 50% of the EU market belongs to one company !! )

- Ben-David, Franzoni and Moussavi (2014), Hurlin, Iseli, Pérignon, and Yeung (2015), Cheng, Massa and Zhang (2015)

- LIBOR scandal: importance of transparency - $4 trillion LIBOR indexed loans, derivative notional of >$300 trillion

- Duffie, Dworczak and Zhu (2014), Duffie and Stein (2014), Duffie, Skeie and Vickery (2014), Eisl, Jankowitsch and Subrahmanyam (2014)


2. New sources of risk in the financial system

- Central Counterparties (CCPs) or Clearing Houses

- Duffie, Scheicher & Vuillemey (2015), Boissel, Derrien, Ors & Thesmar

(2015)


Emphasis and de-emphasis

- Given the imposed page limit:

- Some of the US-related historical background could be reduced - Reg. Q and interest ceilings when covering MMMFs

- Instead, some of the EU-related coverage could be increased - Deposit insurance differences across EU

- Cross-country DI studies:

Anginer, Demirguc-Kunt, and Zhu (2015),

Demirguc-Kunt, Kane and Laeven (2008),

Demirguc-Kunt and Kane (2002),

Demirguc-Kunt and Detragiache (2002).


Conclusion

- Review paper combines theoretical and empirical papers to help us better understand that major changes and challenges in EU banking

- Additional critical (and unresolved) issues: - Harmonization of Deposit Guarantee Systems, pan-EZ DI, ex ante risk-

based premiums, …

- Rapidity with which bank cease & desist orders and resolutions can be accomplished (SRM/BRRD vs EC-DG Comp, non-representation of non-CB supervisors in CB Governing Council, political horse-trading), …

- BRRD does not include insurance or CCPs

- National vs EZ resolution trusts/failed asset management companies

- This Review, which is in a preliminary stage, could make an important contribution for the assessment of the banking union

- Additional resources (funding and data) would further research in these crucial areas of public policy

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￼￼￼ Financial Institutions, Markets and Regulation: A Survey | COEURE Workshop on Financial Markets

Financial Institutions, Markets and Regulation: A Survey | COEURE Workshop on Financial Markets