Edmund Cannon

Banking CrisisUniversity of VeronaLecture 4

Plan for today2

Brief discussion of essaysFinish yesterday’s lecture:

Endogenous riskI 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 presentationsToday: banking regulationCapital requirements and the cost of regulationRing-fencing

“Endogenous” Risk3

Basic idea:Economic insitutions magnify good and bad

shocks.Mechanism 1: Leverage

Unexpectedly good results increase capital (equity)

Banks lend moreCreates a bubble

Mechanism 2: Expectations / perceptions of riskFirms only use recent data to evaluate riskSelection biasToo 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

01.03

.1999

01.08

.1999

01.01

.2000

01.06

.2000

01.11

.2000

01.04

.2001

01.09

.2001

01.02

.2002

01.07

.2002

01.12

.2002

01.05

.2003

01.10

.2003

01.03

.2004

01.08

.2004

01.01

.2005

01.06

.2005

01.11

.2005

01.04

.2006

01.09

.2006

01.02

.2007

01.07

.2007

01.12

.2007

01.05

.2008

01.10

.2008

01.03

.2009

01.08

.2009

€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-tryExisting 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

01/0

3/19

7001

/03/

1972

01/0

3/19

7401

/03/

1976

01/0

3/19

7801

/03/

1980

01/0

3/19

8201

/03/

1984

01/0

3/19

8601

/03/

1988

01/0

3/19

9001

/03/

1992

01/0

3/19

9401

/03/

1996

01/0

3/19

9801

/03/

2000

01/0

3/20

0201

/03/

2004

01/0

3/20

0601

/03/

2008

01/0

3/20

10

10

100

1000BelgiumSwitzerlandDenmarkUnited KingdomUSA

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 riskB Structured productsC VaR and risk measurementD Capital requirementsE 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 lobbyingFurther 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 costs16

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 costs18

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 consumersSMEs 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 consumersSMEs 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.