Chapter 9. Keeping banks in check

References [ CPB | General | Scientific ]     Summary

Authors

Michiel Bijlsma & Gijsbert Zwart
Contact: Michiel Bijlsma

In this chapter

The government has no choice but to guarantee the savings of savings account holders. However, this guarantee also encourages excessive risk-taking among banks.

An aggregate banking crisis comes at a great cost to society because companies that are dependent on bank loans could get into difficulties with regard to their financing.

This makes it essential to regulate the risks taken by banks.

The financial regulator will be able to fulfil its task better if it can force banks to recapitalise or close as soon they get into trouble.

This also means that the regulator will have to be under sufficient pressure to take action.

A market estimate of the bank's state of health could help make the regulatory conditions more effective and could force the regulator to intervene in time.

References

CPB

Marcel Canoy, Machiel van Dijk, Jan Lemmen, Ruud de Mooij and Jürgen Weigand, 2001, Competition and Stability in Banking, CPB Document 15.

An overview of the literature on competition between banks and its relationship with financial stability.

Lans Bovenberg and Coen Teulings, Europe at a cross roads, 2009 , CPB publication.

Explains why rescuing banks is so difficult.

General

Adviescommissie Toekomst Banken, 2009, Naar herstel van vertrouwen.

Report with recommendations for the Dutch financial sector, commissioned by the Dutch Association of Banks. It assumes banks act in their own self-interest and focuses on best practices.

The high level group on financial supervision in the EU, chaired by de Larosière, 2009.

Report with recommendations for reform of financial market supervision in the EU, commissioned by the European Commission. Focuses on coordination at the European level.

The Turner Review: A regulatory response to the global banking crisis, 2009.

Report with recommendations for reform of financial market supervision in Britain, commissioned by the British Chancellor of the Exchequer. Advanced analysis and does not shy away from criticising oversight.

Andrew G. Haldane, 2009, Why banks failed the stress tests, 13 February.

A thought-provoking discussion of the roots of the crisis and the consequences for the regulation of banks.

Jeroen Smit, 2008, De Prooi.

Reconstruction of the collapse of ABN Amro.

Richard A. Posner, 2009, A Failure of Capitalism: The Crisis of '08 and the Descent into Depression.

A book about the crisis by the famous judge and economist Richard Posner.

Adam S. Posen and Nicolas Véron, 2009, A solution for Europe’s banking problem, Bruegel Policy Brief 2009/03.

Proposal by the Brussels-based think tank Bruegel to restructure banks at the EU level.

Michiel Bijlsma, 2009, Nederland neemt Zweedse crisislessen onvoldoende serieus, Me Judice, Volume 2, 19 April.

An analysis of the lessons to be learnt from the Swedish crisis.

Scientific

Frederic S. Mishkin, 2006, How Big a Problem Is Too Big to Fail? A Review of Gary Stern and Ron Feldman's “Too Big to Fail: The Hazards of Bank Bailouts”, Journal of Economic Literature 44(4), pp. 988-1004.

A comprehensive book review with a brief summary of the economic rationale behind regulation and a description of the US system of prompt corrective action.

Mathias Dewatripont, Xavier Freixas and Richard Portes, March 2009, Macroeconomic Stability and Financial Regulation: Key Issues for the G20.

A collection of short articles by leading economists on almost all aspects of the crisis, including credit rating agencies, crisis management, securitisation and capital regulation.

Oliver Hart and Luigi Zingales, May 2009, A new capital regulation for large financial institutions, CEPR DP7298.

A proposal to make use of information generated from within the market by forcing a bank to recapitalise if the market value of a guarantee against bankruptcy threatens to fall below a critical threshold level.

Markus Brunnermeier, Andrew Crockett, Charles Goodhart, Avinash Persaud, and Hyun Shin, 2009, The Fundamental Principles of Financial Regulation.

Analysis of the crisis and proposals to adapt the regulation of banks, focusing mainly on limiting system risks.

Raghuram G. Rajan, 2009, The Credit Crisis and Cycle Proof Regulation, Homer Jones Lecture.

Analysis of the crisis and proposals for the regulation of banks.

Charles Calomiris, 2008, The subprime turmoil: what’s old, what’s new, and what’s next?, Lecture at the Jackson Hole symposium.

An overview of the development of the credit crunch, the similarities with earlier bank crises, the role of government policy in the emergence of the crisis and the US's policy response to the crisis.

Charles W. Calomiris and Charles M. Kahn, 1991, The role of demandable debt in structuring optimal banking arrangements, American Economic Review 81, pp 497-513.

Explains how short-term debt can provide incentives for monitoring by creditors.

Summary

What did the banking crisis teach us about financial regulation? Financial regulation is motivated by the fact that the government will, either explicitly or implicitly, guarantee deposits and loans to the bank, especially during a system-wide crisis. This reduces the bank's creditors' incentives to monitor the bank, and induces banks to take excessive risks if no measures were taken.

Bank regulation mainly consists of requiring banks to satisfy minimum capital requirements. By forcing banks to put a significant part of their shareholders' money at stake alongside their depositors' money, banks should be encouraged to reduce their risk.

Monitoring capital levels is not sufficient; when a crisis hits, banks' equity and capital levels fall, so regulators should intervene in a timely manner and force recapitalisation, if necessary against the will of the bank's shareholders. Such forced recapitalisation requires a system of prompt corrective action, which generally does not yet exist in Europe. Such a system should also be designed to discipline regulators themselves, who without such discipline might be tempted to exercise excessive forbearance, as the US Savings and Loans crisis has demonstrated.

Regulation relies on the measurement of banks' risks and capital. The current crisis has shown that banks will try to evade regulation: risk was transferred to a shadow banking system that was out of reach of standard capital regulation. One way to create regulation that is more robust to regulatory arbitration is to rely in part on market assessments of banks' well-being. Market prices of bank shares, debt instruments or credit insurance convey information on banks' financial health that is harder to manipulate. Using such information for regulatory purposes should make regulatory arbitration more difficult. In addition, market information may also help reduce the risk of regulatory capture, as regulators would have to act on publicly observable and objective market signals.

The crisis in Europe has clearly shown the need for coordinated action in rescuing banks that operate across national borders. The challenge will be to devise mechanisms for bank rescue or closure that allows EU member states to share the burdens of such actions in a way acceptable to all states.

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