1. Edmund Cannon Banking Crisis University of Verona Lecture 4

2. Plan for today • 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

3. “Endogenous” Risk 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.

4. Leverage and endogenous risk (Shin) Leverage increases endogenous risk in all leveraged institutions, not just banks.

5. Endogenous risk – the crash 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).

6. House price bubbles • 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

10. UK House Prices (Nationwide BS survey)Ratio of first-time buyer houses to earningsSource: http://www.nationwide.co.uk/hpi/

11. Ratio of house prices to average earnings (long run)Source: Nationwide, National Statistics, author’s calculations

12. Confirm arrangements for Monday • 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

13. Banking regulation • 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).

14. Bank Regulation • Independent Commission on Banking • “Vickers Commission” • Capital Requirements (loss absorbancy) • What is the cost? • Structural Changes (the “ring fence”) • Details • Competition • I ignore this

15. Suggested capital requirements

16. The fallacy that capital requirements raise costs • 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.

17. Silly argument against capital requirements Higher capital requirements mean a bank has more assets earning low rates of return.

18. The fallacy that capital requirements raise costs • 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.

19. Independent Banking Commission (Vickers) 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)

20. The Retail Ring Fence • “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.

21. The Retail Ring Fence • “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.

22. The Retail Ring Fence • 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.

23. Why not complete separation? 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.