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4 The Post-Crisis Paradigm of Regulation

4 The Post-Crisis Paradigm of Regulation

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Theoretical Aspects of Banking Regulation


sider regulatory standards, or the existence of the lender of last resort as

legitimate, they may be demotivated to collect the disclosed information

(Dewatripont & Freixas, 2012).

The lack of transparency led to a similar treatment of solvent and insolvent banks in the wake of and during the financial crisis, which indicated

the failure of market discipline. The immediate reaction of regulators was

the introduction of stress tests, which alleviated a part of the information asymmetry. To enhance their credibility and counteract behavioural

biases the tests were based on clear, identical scenarios for all banks and

were certified by regulatory agencies. Stress tests allowed market participants to discriminate between well, and badly, performing banks and

hence to reinforce market discipline.

A further solution put forward to counter the problem of pronounced

information asymmetry during crises is to require disclosure standards

based on information that cannot be manipulated, instead of arbitrary

bank risk models. This would help to avoid practices like asset reclassification and window-dressing of financial statements. Given that investors

base their decisions on multiple information sources, clear-cut reports

should be also required from rating agencies. Information provision and

market discipline could also be improved by explicit bank resolution


The pre-crisis information asymmetry and the lack of market discipline were due to important fallacies of regulations. These include, above

all, regulatory arbitrage resulting from an unregulated shadow banking

system, insufficient regulation of systemically important institutions,

the materialisation of endogenous systemic risk, as well deficient international coordination of regulation despite the increased international

interconnectedness of banks. These four issues are analysed in the subsections below.

1.4.1 Shadow Banking and Regulatory Arbitrage

Major challenges for regulators arose due to pronounced regulatory arbitrage, resulting from the activity of shadow banking institutions. Shadow

banks, for instance money markets funds or special purpose vehicles, play


Post-Crisis Banking Regulation in the European Union

a major role in the wholesale banking market and have taken over, to

some extent, the intermediary and liquidity provision function of banks.

Shadow banking institutions provide a great deal of liquidity to the

wholesale markets, often against very good bank collateral. This helps to

alleviate the costs of bank lending and to boost the provision of structured

derivatives, conforming to the needs of specific customer segments. Until

the outbreak of the crisis, money market funds were viewed as relatively

safe institutions, resistant to runs due to their constant monitoring by

investors (Bengtsson, 2013). The traditional banking sector and shadow

banking became increasingly interconnected due to their common activity on the repo market, as well as due to the ownership of shadow banking entities by traditional banks (White, 2014).

On the other hand, the activity of shadow banks created a substantial

source of fragility in the banking sector. Shadow banks were substantially

involved in the securitisation of traditional banks’ collateral. To a large

extent, securitisation involved the transformation of risky, long-term

loans to short-term, liquid assets, with a low-risk perception. Hence,

besides “securitising away” the credit risk, this type of activity entailed

prevalent maturity mismatches on the interbank market. Moreover,

the securities issued by nonbank financial institutions are vulnerable to

liquidity shocks and tend to be pro-cyclical (Duca, 2016). An additional

factor, which rendered banks fragile, is the pronounced international

exposure of shadow banking entities, entailing strong spillover effects.

The risk related to the activity of shadow banking institutions materialised during the financial crisis. The financial turmoil led to price drops

of money market funds’ assets, as well as substantial investor redemptions and subsequent decreasing price spirals (Bengtsson, 2013). The

withdrawal of funds by shadow banking institutions from the wholesale

transactions affected largely the liquidity of the interbank market. As a

consequence, the securitised assets were transferred back on to banks’ balance sheets, putting their solvency at risk. Hence, the subsequent banking sector rescue programmes were also used to assist unregulated shadow

banks (White, 2014).

The above mentioned developments entailed important implications

for banking regulations. The shadow banking led credit expansion before

the outbreak of the financial crisis was not backed by regulatory capital.


Theoretical Aspects of Banking Regulation


Bank loans were funded with uninsured debt. A substantial problem was

also a lack of auditing standards. Banks’ exposures to shadow banking

entities were kept as off-balance sheet positions. The lack of transparency

caused the assets of shadow banks to be perceived as far less risky than

they were in reality. The absence of proper regulation thus contributed to

a failure of market discipline.

The response put forward by researchers and regulators is the introduction of capital and reporting standards, diversification requirements,

credit risk and maturity limits, as well as oversight procedures for shadow

banking entities. The regulations should aim to reduce the spillovers

between the traditional and shadow banking sector and the propensity

of shadow banking entities to creditor runs. They should also strive to

mitigate procyclicality and systemic risk in the shadow banking sector.

Potential instruments are the introduction of central clearing counterparties, limitations on securitisation transactions, liquidity requirements and

stringent collateral valuations. A useful regulatory tool, which helps to

separate the risk perception of the traditional and shadow banking segments, is stress tests for both type of entities (Duca, 2016).

1.4.2 The Too-Big-To- Fail Problem

Substantial attention has been devoted to the regulation of systemically

important institutions due to the sharp deterioration of their solvency

during the crisis. The bankruptcy of these institutions would have triggered a collapse of the whole financial system; hence the authorities had

no alternative but to bail them out. This was another example of market

discipline failure during the crisis, pointing to substantial flaws in existing regulations.

The rescue programmes of the Too-Big-to- Fail banks entailed large

social costs. The gains of their risky activity were privatised, while the

losses socialised. To avoid such scenarios in the future, regulators put

forward new solutions to reduce the costs and risks of systemically important banks’ activity. New measures encompassed enhanced supervision,

additional capital surcharges and specific resolution regimes. The drawback of these solutions is that the mere labelling of the banks as Too-


Post-Crisis Banking Regulation in the European Union

Big-to-Fail signals that the authorities will be always willing to provide

state aid to these institutions; hence, such regulations may impede market discipline (Moenninghoff, Ongena, & Wieandt, 2015). Large banks

have access to financing at a lower cost than dictated by market prices,

which creates additional incentives for them to take on excessive risk. The

potential cost of this risky activity would still be borne by the taxpayer.

The new regulatory paradigm did not solve the existing agency conflict,

it rather contributed to a shift of the potential bail-out costs from bank

creditors to taxpayers.

The risk taking incentives of the large banks depend substantially on

the market discipline produced by their liability structure so additional

capital buffers for large banks are surely a necessary solution (Freixas,

Lóránth, & Morrison, 2007). Nevertheless, there are no feasible ex-ante

capital ratios for Too-Big- to- Fail banks, since they require small amounts

of capital during normal times while needing exorbitant buffers during

crises. Capital regulations themselves are hence an insufficient response

to the Too-Big-to- Fail problem.

Further regulatory responses are geared towards restricting or separating

the activity of the Too-Big-to-Fail banks. Large banking conglomerates

pursue different business models to small banks. They usually combine

traditional banking, brokerage, underwriting as well as shadow banking

activities. They often also own non-bank financial entities, for example,

insurance companies. Due to the activity diversification large conglomerates are subjected to large market volatility and counterparty risk. The

latter is most pronounced in the case of derivative contracts. Since transactions are settled daily there is an immediate liquidity need. Moreover,

Too-Big- To- Fail banks’ counterparty risk is underpriced, which constitutes a further source of fragility (Blundell-Wignall, Atkinson, & Roulet,

2014). The Too-Big- To- Fail problem is further exacerbated by the

shadow banking activity of the conglomerates. Due to the requirement

of collateral management in those types of activities only large firms are

able to provide shadow banking services. This type of activity allows them

to shift to the unregulated sector (White, 2014).

The assumption of regulators is that large conglomerates can better

internalise the risk due their activity diversification; nevertheless they

also have more incentives to take on excessive risk. They can always roll


Theoretical Aspects of Banking Regulation


over the costs of their risky activity to their traditional banking segments,

which are backed by deposit insurance. This risk shifting incentive leads

to inefficient, distorted strategies impeding market discipline (Freixas

et al., 2007).

Regulation of systemically important institutions needs to foster correct risk pricing, that is, impose requirements on those segments of activities where risk really occurs. To address this problem, several ring-fencing

proposals for large banks have been put forward, from complete separation of deposit taking and lending, through proprietary trading prohibition, and retail banking separation, to drawing the line on the riskiness

of securitisation activities. Each of these proposals has its advantages and

drawbacks. Complete separation of traditional and non-traditional banking activities, for instance, would wipe out all the synergy and diversification benefits, while the milder forms of ring-fencing may give raise to

regulatory arbitrage. The main idea of ring-fencing is to prevent investors

ripping off the benefits of deposit insurance and LOLR and to contribute

to a correct pricing of the large banks’ assets and liabilities. The separation of the various bank activities also entails easier resolution procedures

(Blundell-Wignall et al., 2014).

Another proposition to mitigate the pronounced risk taking incentives of large banks is a two-part capital requirement, consisting of a core

capital component and an additional special account involving Treasury

securities or similar instruments. In the case of bank insolvency the special account would be forfeited by shareholders and accrue to regulators. The market discipline would be enhanced by the need to hold more

equity as uninsured debt. Such a solution would directly affect the incentives of bank stakeholders and mitigate the pronounced agency conflicts

(Acharya, Mehran, Schuermann, & Thakor, 2012).

1.4.3 Systemic and Endogenous Risk

The recent financial crisis demonstrated the drastic consequences of systemic risk materialisation in the banking sector. While not much attention has been devoted to measures counteracting systemic risk in the


Post-Crisis Banking Regulation in the European Union

pre-crisis era, this issue has gained pronounced consideration in the postcrisis regulatory frameworks.

Systemic risk occurs if many institutions fail at the same time. Such

a situation may arise if, for example, banks are prone to herding, that

is, they invest in similar asset classes. This increases the correlation of

their risk and the probability of their joint failure (Acharya et al., 2012).

Paradoxically, even if the system consists of individually sound institutions, exogenous events may trigger the instability of the system and

make the institutions fail. This situation is described by the term “fallacy

of composition”.

Following Danielsson, Shin, and Zigrand (2013) one could define systemic risk as the sum of the risk of market volatility due to fundamental

changes and the endogenous feedback of market participants, that is,

trading patterns. Systemic risk is endogenous, because on the one hand it

depends on the behaviour of market participants and, on the other hand,

this behaviour depends on the perceived risk. If market players anticipate

higher risk in the future, they act this way and contribute to market volatility (Danielsson et al., 2013).

More precisely, the endogenous risk mechanism works as follows: a

negative piece of information decreases capitalisation or increases prices

volatility which makes regulation constrained market participants lessen

their exposure to risk. A feedback loop occurs: if financial conditions

deteriorate, the risk aversion increases and this worsens the financial conditions again. The feedback loop occurs even if there is no additional

bad news. The main driver of the loop is the behaviour of market participants. The strength of the feedback loop depends on the capitalisation of the system. Low capitalisation implies that institutions find it

harder to absorb risk. If a large part of the banks is undercapitalised,

its common feature, risk aversion, will induce similar investment patterns and increase endogenous risk. For instance, simultaneous selling of

risky assets can bring down their prices to the levels of fire sales, which

again decreases the levels of capital and forces banks to further deleveraging. Hence, in the case of low capitalisation, feedback loops are stronger

(Danielsson et al., 2013).

In terms of regulations this implies that stringent capital requirements

could prevent herding behaviours, which trigger systemic and endoge-


Theoretical Aspects of Banking Regulation


nous risk. The importance of capital adequacy is especially pronounced,

given that the deleveraging triggered by the exogenous factor may be

stronger than that dictated by the banks’ fundamental portfolio features.

An important regulatory aspect is also portfolio diversification, since the

correlation of risky assets enforces feedback loops. On the other hand,

uniform risk constraints on credit institutions mean that even if the

fundamentals of securities are uncorrelated, there can be correlation in

market price fluctuations between seemingly unrelated assets, due to the

identical and simultaneous behaviours of banks. One of the propositions

to solve this problem is to impose an additional capital buffer which

would vary depending on the growth rate of specific assets and the resulting maturity mismatch (Danielsson et al., 2013).

An implication of the endogeneity of systemic risk is that regulators

have to take into account the collective irrationality of individual institutions. Even if one assumes that banks act rationally from an individual

perspective, collectively their behaviour is irrational and destructive for

the system as a whole (Jain, 2005). Under some circumstances it may even

appear rational for a bank to follow the strategy of others, for instance, if

the costs of analysis are high.

Systemic risk materialisation has similar consequences as the insolvency

of Too-Big-To-Fail banks. If banks know that they will be bailed out as a

system, they will have incentives to take on correlated risk. Hence, banking should be regulated from a systemic point of view and not just from

an individual one. One should view a bank’s risk as a function of both

its individual bank-specific risk and its joint correlated risk with other

banks. To pursue this goal systemic risk needs to be quantified appropriately. The economic literature identifies two basic ways of quantifying

systemic risk: from macroeconomic and microeconomic points of view

(Vallascas & Keasey, 2012). The macroeconomic perspective focuses on

the contribution of each individual institution to systemic risk (Acharya,

Pedersen, Philippon, & Richardson, 2010; Adrian & Brunnermeier,

2011; Brunnermeier, Dong, & Palia, 2012; Huang, Zhou, & Zhu,

2010). The microeconomic approach, on the other hand, focuses on how

individual banks react to systemic shocks (Bartram, Brown, & Hund,

2007; De Jonghe, 2010; Vallascas & Keasey, 2012). The empirical studies

of both approaches provide important findings for regulators about the


Post-Crisis Banking Regulation in the European Union

main determinants of systemic risk which are the degree of leverage, the

extent of maturity mismatch, the share of non-interest income, as well as

bank size.

The regulatory response to pronounced systemic risk in the banking

sector was the shift from a microprudential to macroprudential oversight

policy over the past decade. Whereas the microprudential approach aims

at limiting the distress of individual banks, the macroprudential view targets system-wide distress mitigation. While the microprudential view is

concentrated on investor, or depositor, protection, the macroprudential

approach focuses on avoiding output costs (Borio, 2003). Further differences between the two views concern: the risk models applied (exogenous in the micro approach and endogenous in the macro approach);

the consideration of common exposures (disregarded in the micro view

and pronounced in the macro view); as well as the calibration of prudential standards (bottom-up in the case of the micro view, and top-down in

the macro approach).

The macroprudential regulations aim at addressing potential contagion channels. These are primarily common exposures to various asset

and liability categories, interconnections via the interbank market and

payment system as well as expectations and behavioural factors. Since systemic risk is largely due to the interconnectedness of credit institutions,

to obtain the full picture of systemic risk exposures of the individual

countries’ banking systems, it is essential to account for the international

interdependencies between banks. For this purpose national regulators

should be required to disclose proper data to supranational supervisory

institutions. Issues concerning international coordination in regulations

are discussed in the next section.

1.4.4 International Coordination

Deregulation and liberalisation in banking have contributed to increased

international interconnectedness of banks via consolidation, foreign

expansion or reciprocal exposures. As a result, if shocks occur in  local

banking systems, the international exposures of banks transmit them globally. Additionally, the changes in banks’ business models triggered major


Theoretical Aspects of Banking Regulation


and sudden reforms in country-level regulatory frameworks around the

world. The need for banking regulatory reform became even more apparent after the financial crisis of 200709. According to ihỏk, DemirgỹỗKunt, Soledad Martớnez Perớa, and Mohseni-Cheraghlou (2012) one

could notice substantial changes in country-level banking regulations in

terms of bank capitalisation, governance, activities, diversification, auditing and deposit insurance after the crisis. Countries differ largely in terms

of banking regulatory frameworks. The menace arising from the variety

of regulations is the possibility of regulatory arbitrage, especially in an

internationalised banking sector. Due to the mentioned factors international banking regulation became a common issue of concern worldwide.

Regulators are confronted with the question of whether to regulate banking locally or globally. In the presence of different national frameworks

the need of international coordination becomes apparent.

The international coordination of the guidelines for prudential regulations of banks worldwide is the responsibility of the Basel Committee

on Banking Supervision (BCBS). The BCBS sets the basic framework

for multinational banks’ operations. Other institutions involved in this

process are the Financial Stability Board (FSB) and the International

Accounting Standards Board (IASB). Due to the high interconnectedness

of the banking sector with non-bank financial institutions an important

regulatory body is also the Joint Forum consisting of BCBS and the global

committees of securities regulators and insurance supervisors. Until the

emergence of the financial crisis the main function of these institutions

was to set the standards for regulations, but since the outbreak of the

crisis they have expanded their activities to peer review and monitoring

of the implementation of their standards. Worth stressing is that there

has been increased coordination between national banking supervisory

authorities through the activity of international supervisory colleges, that

is permanent, although flexible, multilateral working groups of supervisors assigned to specific international banking group (Black, 2013).

Nevertheless, given that the BCBS tasks each regulator with the responsibility of preserving the national banking sector growth, the international

regulations are not by definition cooperative (Freixas, 2010).

In terms of coordinated supervision, a challenge for regulators is to

capture the complexity of international banks’ operations. One of the


Post-Crisis Banking Regulation in the European Union

main tasks that falls to regulators is to identify systemic risk. This is usually done by analysing balance sheet data in terms of asset and liability

composition and maturity/currency mismatches. This way, regulators can

identify common exposures, interbank linkages and funding concentrations. A major difficulty of this task is the complexity of banks’ foreign

exposures. The banking system’s foreign exposure to credit granted to

banks in a different country consists of direct cross-border exposures,

exposures via subsidiaries and branches abroad, and off-balance sheet

units. Similarly, a borrower country’s banking system’s exposure to foreign

funding consists of the same elements (Cerutti, Claessens, & McGuire,

2011). This way, the banking system in one country is exposed to the risk

of disruptions in credit flows from the counterparty country, in the case

of the deterioration of its balance sheet in any third location.

A difficulty in identifying systemic risk is the lack of a multi-national

approach in compiling the necessary data. A specific concern for international banking regulations is also systematically important international

banks, the balance sheets of which are particularly opaque. Cerutti et al.

(2011) find three major problems with the application of current regulatory standards internationally:

(1) Weak coordination of national approaches: national policymakers

are accountable to taxpayers and national parliaments, hence they

have no incentive to be accountable to global institutions; for

instance, there is no global lender of last resort.

(2) Large complexity in the international activity of banks entails various

risk exposures for the lender and borrower country.

(3) The lack of incentive for national regulators to collect data for global

purposes which results in scarcity of data that captures the international dimensions of systemic risk.

Currently available data do not allow us to measure, for instance, banks’

foreign asset exposures, a borrower country’s reliance on credit from foreign banks, or banks’ cross-currency funding and maturity transformation activities, nor does it carry information on banks’ organisational and

legal status or the geographic structure of banks’ operations. For the purpose of measurement of systemic risk, the availability of such data would


Theoretical Aspects of Banking Regulation


be of crucial importance, with regards to distinguishing between exposures of branches (parts of the same entity, subordinated to the same legal

system as the parent company), and subsidiaries (separate legal entities,

subordinated to the legal system of the host country). The organisational

structure of the bank impacts the international income distribution and

loss absorption; hence the information about this structure is of substantial relevance to regulators. Identification of systemic risk is the more

complicated when taking into account offshore banking entities (e.g.,

shell branches) which are not assigned to an explicit jurisdiction and

lender of last resort. An initiative that involves compiling multinational

firm level data encompassing the geographic and organisational structure

of banks (the Data Gaps Initiative) is currently undertaken by the G20

countries (Cerutti et al., 2011).

An important issue relating to international coordination of banking

regulation is home-host country information sharing. As separate legal

entities, international subsidiaries should be supervised by the regulator of the country where they operate, while branches should be subject

to “home regulator” supervision. In practice, foreign subsidiaries and

branches may be systemically important for the host country, but not

necessarily for the parent bank. On the other hand, a subsidiary or a

branch may weigh largely on the parent bank’s financial condition, while

it may be insignificant for the host banking sector. Hence, the information exchange between regulators and coordination of their activities are

crucial for effective supervision (Black, 2013).

A method of oversight coordination over multinational banks is the

above mentioned supervisory colleges. As international multilateral

working groups of supervisors assigned to specific banking groups they

aim at enhancing information exchange and effective supervision over the

appointed, internationally active, entities. The supervisors’ responsibility

within the colleges is to reach joint decisions on the capital adequacy of

the banking groups and their subsidiaries.

Further difficulties arise in terms of international banks’ resolution in

the case of their failure. Bankruptcy codes are established on national

levels, while banks’ failures affect assets and liabilities of the group internationally. Not only are foreign bank entities exposed to the failure, but

also all claimholders in the host countries. National bankruptcy proce-

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