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Financial Institutions, Markets and
Regulation: A Survey
Thorsten Beck, Elena Carletti and Itay Goldstein
COEURE workshop ...
Starting point
 The recent crisis has led to intense discussions on
 Role of financial systems – growth versus stability...
Structure of the survey
 Reasons for financial regulation – market failures
 Typology of financial regulation
 Main reg...
Structure of the survey
 Market failures in the financial system
 Typology of financial regulation
 Main regulatory ref...
Structure of the presentation
 Market failures in the financial system
 Typology of financial regulation
 Main regulato...
Structure of the presentation
 Market failures in the financial system
 Typology of financial regulation
 Main regulato...
Financial regulation and market failures
 Regulation seems to be more a response to past crises
 Problems in designing r...
Panics, runs and fundamental crises
 Context
 Banks provide liquidity insurance to risk adverse depositors
 Banks inves...
Inefficient liquidity in interbank markets
 Context
 Banks face idiosyncratic liquidity shocks
 Interbank markets redis...
Bank interconnections, systemic risk and
contagion
 Two sources of systemic risk
 Aggregate shock (real estate bubble, p...
Bad incentives and bubbles
 Bubble: significant price increase above fundamentals
 Real estate bubbles are the most impo...
Financial Regulation: Typology
 Micro and macroprudential regulation
 Individual bank versus systemic stability
 Main r...
Recent reforms
 Basel III and CRD IV
 Capital: definition, size supplements, two dynamic buffers, leverage
ratio, liquid...
(Some) open questions
 Much more is needed on the effects of new regulation on
banks (and markets)
 Systemic risk and ma...
Structure of the presentation
 Market failures in the financial system
 Typology of financial regulation
 Main regulato...
Six years after the crisis
 Sluggish credit recovery (slower than in U.S. due to
delayed bank restructuring)
 Supply vs....
Banks vs. markets – a new structure debate
 First generation of research showed insignificance of financial
structure in ...
Financial structure in
Europe - heavily
bank-based
Source: Langfield and Pagano (2015)
 Or is it rather an issue of
missi...
Limited private equity in Europe
19
0.0
0.2
0.4
0.6
0.8
1.0
1.2
2012 2013 2014
VC EU %GDP VC USA %GDP
PE EU %GDP PE USA %G...
Complexity
 More complex organizational structure of financial institutions
 in 1990 only one U.S. bank holding company ...
Number of subsidiaries for largest
foreign banks in the US
Source: Cetorelli and Goldberg, 2014
Number of subsidiaries across different financial
segments for largest foreign banks in the US
22
Source: Cetorelli and Go...
Financial innovation
 What is financial innovation: new financial products and services, new
financial intermediaries or ...
Regulatory perimeter
 Traditional prudential focus on banks
 Over the years, other financial institutions have started
t...
Where do we stand
 Regulatory reform to prevent the last crisis
 Regulation focused on institutions and markets, less on...
Looking beyond the feedback loop – creating
arbitrage-safe regulatory frameworks
 Complexity vs. simplicity:
 Fine-tune ...
Looking beyond the feedback loop – creating
arbitrage-safe regulatory frameworks (2)
 Focus on resolution
 Knowing that ...
Future research
 Complexity vs. simplicity
 Assess impact of new regulation
 Theory and empirics
 Effectiveness of dif...
Thank you
Elena, Itay and Thorsten
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Financial Institutions, Markets and Regulation: A Survey | COEURE Workshop on Financial Markets

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COEURE Workshop on Financial Markets

By: Thorsten Beck, Elena Carletti and Itay Goldstein

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

  1. 1. Financial Institutions, Markets and Regulation: A Survey Thorsten Beck, Elena Carletti and Itay Goldstein COEURE workshop on financial markets, 6 June 2015
  2. 2. Starting point  The recent crisis has led to intense discussions on  Role of financial systems – growth versus stability  Regulatory reforms – need, scope, effects  Role of financial innovation - risk sharing versus risk taking  Main tension  Regulatory reforms tend to be backward looking  Financial innovation is more forward looking  Many questions  Where do we stand?  What is the optimal balance between financial stability and innovation? 2
  3. 3. Structure of the survey  Reasons for financial regulation – market failures  Typology of financial regulation  Main regulatory reforms  European financial system 6 years after the crisis  Pros and cons of financial innovation  Banks versus markets  Looking ahead: Creating arbitrage-safe regulatory frameworks 3
  4. 4. Structure of the survey  Market failures in the financial system  Typology of financial regulation  Main regulatory reforms  European financial system 6 years after the crisis  Pros and cons of financial innovation  Banks versus markets  Looking ahead: Creating arbitrage-safe regulatory frameworks  Vast use of theoretical and empirical research 4
  5. 5. Structure of the presentation  Market failures in the financial system  Typology of financial regulation  Main regulatory reforms  European financial system 6 years after the crisis  Pros and cons of financial innovation  Banks versus markets  Looking ahead: Creating arbitrage-safe regulatory frameworks 5
  6. 6. Structure of the presentation  Market failures in the financial system  Typology of financial regulation  Main regulatory reforms  European financial system 6 years after the crisis  Pros and cons of financial innovation  Banks versus markets  Looking ahead: Creating arbitrage-safe regulatory frameworks 6
  7. 7. Financial regulation and market failures  Regulation seems to be more a response to past crises  Problems in designing regulation  Balance between fragility and provision of credit/innovation  Political process  Our stance: regulation should preserve systemic stability  Market failures in the financial system  Panics, runs and fundamental crises  Inefficient liquidity in interbank markets  Bank interconnections, systemic risk and contagion  Bad incentives, bubbles and crises 7
  8. 8. Panics, runs and fundamental crises  Context  Banks provide liquidity insurance to risk adverse depositors  Banks invest in long term assets, which are costly to liquidate  Reasons behind runs  Coordination problems among depositors (Diamond and Dybvig, 1983) – multiple equilibrium and panics  Information-based response by depositors (Jacklin and Bhattacharya, 1988) – fundamental crises  Global game approach (Goldstein and Pauszner, 2005)  Market discipline 8
  9. 9. Inefficient liquidity in interbank markets  Context  Banks face idiosyncratic liquidity shocks  Interbank markets redistribute liquidity from banks in excess to banks in shortage  Problems of externalities, insufficient liquidity provision and market freezes  Aggregate uncertainty and fire sales (Allen et al., 2009)  Overhang of illiquid securities (Diamond and Rajan, 2009)  Asymmetric information (Acharya et al, 2009; Heider et al., 2009)  Strategic complementarities (Bebchuk and Goldstein, 2011) 9
  10. 10. Bank interconnections, systemic risk and contagion  Two sources of systemic risk  Aggregate shock (real estate bubble, panics, fire sales, etc.)  Contagion: idiosyncratic shock and propagation mechanism  Propagation mechanisms  Interbank connections (Allen and Gale, 2000)  Information spillover (Chen, 1999))  Portfolio readjustments (Goldstein and Pauszner, 2004)  Fire sales and common exposures (Allen and Carletti, 2008)  Some empirical evidence of both direct and indirect forms of contagion 10
  11. 11. Bad incentives and bubbles  Bubble: significant price increase above fundamentals  Real estate bubbles are the most important  Financial liberation and credit extension  Theories of bubbles  Agency problems (Allen and Gale, 2000)  Financial accelerator (Bernanke and Gertler, 1989)  Role of collateral (Kyotaki and Moore, 1997) 11
  12. 12. Financial Regulation: Typology  Micro and macroprudential regulation  Individual bank versus systemic stability  Main regulatory tools  Capital regulation should absorb losses; maintain confidence; protect creditors; provide incentives (focus of micro theories)  Liquidity regulation should reduce panics, fire sales and mispricing of assets (new regulation introduced in Basel III)  Safety nets  Central bank (Rochet and Vives, 2004; Allen et al., 2009)  Deposit insurance and government guarantees (Diamond and Dybvig, 1993; Allen et al., 2015) 12
  13. 13. Recent reforms  Basel III and CRD IV  Capital: definition, size supplements, two dynamic buffers, leverage ratio, liquidity requirements)  Liquidity: Liquidity Coverage Ratio and Net Stable Funding Ratio  Banking Union  Single Supervisory Mechanism (SSM) and Single Resolution Board (SRB)  Single Rulebook  Bank Recovery and Resolution Directive (BRRD)  Activity restrictions  Vickers and Liikanen reports 13
  14. 14. (Some) open questions  Much more is needed on the effects of new regulation on banks (and markets)  Systemic risk and macroprudential regulation  Relationship micro-macro prudential regulation  Role and cost of capital and liquidity regulation  Guarantees, bail-outs and bail-in instruments  Ban on banks of certain actions such as trading for speculative motive  Both theoretical and empirical research  General equilibrium type of approach  Causual effect of regulation – scope for controlled experiments? 14
  15. 15. Structure of the presentation  Market failures in the financial system  Typology of financial regulation  Main regulatory reforms  European financial system 6 years after the crisis  Pros and cons of financial innovation  Banks versus markets  Looking ahead: Creating arbitrage-safe regulatory frameworks 15
  16. 16. Six years after the crisis  Sluggish credit recovery (slower than in U.S. due to delayed bank restructuring)  Supply vs. demand-side constraints  Shortage of long-term finance  Giovannini et al. (2015): on average, not, but with wide cross- country variation  recent increases in long-term funding have been more on the debt side, in the form of bank lending and corporate bonds, less on equity side (IPO and SEO) 16
  17. 17. Banks vs. markets – a new structure debate  First generation of research showed insignificance of financial structure in growth regressions, BUT: more recent reseafch...  For less developed countries, development of banking systems seems more important, while for more more developed countries, markets seems more important (Demirgüç-Kunt, Feyen und Levine, 2013, Cull und Xu, 2013)  Capital market development enhances firm innovation (as measured by patents) while banking sector development might actually be damaging (Hsu, Tian und Xu, 2014)  Countries with bank-based financial system have lower growth, especially during crisis times (Langfield und Pagano, 2015) 17
  18. 18. Financial structure in Europe - heavily bank-based Source: Langfield and Pagano (2015)  Or is it rather an issue of missing market segments?
  19. 19. Limited private equity in Europe 19 0.0 0.2 0.4 0.6 0.8 1.0 1.2 2012 2013 2014 VC EU %GDP VC USA %GDP PE EU %GDP PE USA %GDP
  20. 20. Complexity  More complex organizational structure of financial institutions  in 1990 only one U.S. bank holding company had more than 1,000 subsidiaries,  in 2012 at least half a dozen had (Cetorelli and Goldberg, 2014)  Structure across up to four layers  Different dimensions:  Number of subsidiaries  Different activities  Cross-border  Implication for supervisory efficiency  Regulatory capture by sophistication (Hakenes and Schnable, 2014) 20
  21. 21. Number of subsidiaries for largest foreign banks in the US Source: Cetorelli and Goldberg, 2014
  22. 22. Number of subsidiaries across different financial segments for largest foreign banks in the US 22 Source: Cetorelli and Goldberg, 2014
  23. 23. Financial innovation  What is financial innovation: new financial products and services, new financial intermediaries or markets, and new delivery channels  Examples: ATM, mobile money, peer-to-peer lending  Innovation-growth view: financial innovations help reduce agency costs, facilitate risk sharing, complete the market, and ultimately improve allocative efficiency and economic growth, thus focusing on the bright side of financial innovation  Investment banks to finance railroad expansion in US in 19th century  Venture capitalists to support IT start-ups in 20th century  Innovation-fragility view: financial innovations contribute to systemic risk  Allows bank to take more risk  Better risk diversification might result in higher systemic risk  Financial innovations as the root cause of the recent Global Financial Crisis,  Financial innovation used for regulatory arbitrage (example: SPV) 23
  24. 24. Regulatory perimeter  Traditional prudential focus on banks  Over the years, other financial institutions have started taking on bank-like features:  Example: Money market funds (a fixed net asset value)  Subject to bank runs  Repercussion: in systemic crisis, financial safety net might have to be extended to them  Heavy regulatory focus on banks might push banking activities outside the prudential regulatory perimeter  Shadow banking system 24
  25. 25. Where do we stand  Regulatory reform to prevent the last crisis  Regulation focused on institutions and markets, less on product  Financial innovation (potentially welfare enhancing) to evade new regulation  Financial sector always ahead of regulators – regulatory dialectic (Kane)  How to create arbitrage-safe regulatory frameworks that escapes the feedback loop 25
  26. 26. Looking beyond the feedback loop – creating arbitrage-safe regulatory frameworks  Complexity vs. simplicity:  Fine-tune risk-weights vs. leverage ratio  Europe: sovereign exposure (risk weight, concentration limit); leverage ratio too low  Comprehensive assessment: leverage ratio not taken into account  Complement micro- with macro-prudential regulation  Both cross-sectional and time-series dimensions  Learning by doing  Europe: too limited powers on Eurozone level 26
  27. 27. Looking beyond the feedback loop – creating arbitrage-safe regulatory frameworks (2)  Focus on resolution  Knowing that you will lose your shirt in case of failure can reduce incentives to take aggressive risk  Europe: complete banking union  Dynamic approach to regulation  functional rather than institutional regulation “if it looks like frog and it quacks like a frog….”  Adjust regulatory perimeter over time  Can SSM do this? 27
  28. 28. Future research  Complexity vs. simplicity  Assess impact of new regulation  Theory and empirics  Effectiveness of different frameworks for capital requirements  General equilibrium approach, taking into account second-round effects  What works best in macro-prudential regulation?  Design features of resolution frameworks  Expand analysis of systemic risk sources beyond banking system  General equilibrium effects  Koijen and Yogo (2014): life insurance segment 28
  29. 29. Thank you Elena, Itay and Thorsten

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