Finance: Research, Policy and Anecdotes

There are many parts of the U.S. regulatory framework under attack (or: under review, in the more bureaucratic language), even though there is no evidence that the slow-down of entrepreneurship in the U.S. is related to federal regulation.  One of the many aspects of the regulatory framework is the resolution framework for large systemically financial institutions in the Dodd-Frank Act.

The suggestion to throw out the resolution mechanism, which allows the use of taxpayer money, to thus minimize moral hazard risk and foster market discipline sounds intellectually honest and logical.  After all, if there is a chance to be bailed out if things go wrong, this provides incentives for aggressive risk-taking, an effect that is stronger the larger the bank – commonly known as too-big-to-fail effect  - and the lower the capital buffer of the bank – known as betting the bank effect.  So, increasing capital buffers further and getting rid of potential bail-outs should firmly consolidate market discipline.

However, that is where economic theory meets economic reality and political economy. In 2008, none of the European countries had a proper bank resolution framework.  The U.S. had such a regime (successfully used by the FDIC) for commercial banks, but not for investment banks and bank holding companies.  As U.S. and European supervisors and governments looked into the abyss of not only a systemic banking crisis but a complete melt-down of the financial system, they found themselves empty-handed when considering how to resolve the failing banks.  Using the regular corporate insolvency framework was not an option, as the Lehman Brothers bankruptcy had just shown.  So, the only option was a tax-payer funded bail-out of these banks.  Over the past nine years, governments have reacted, introducing bank resolution regimes that combine bail-in rules (i.e., making sure that shareholders and junior bond holders lose their shirts) with ensuring that the financial system and thus ultimately, the real economy, does not offer.  To ensure the latter, options for government support have to exist, though as last resort, not as first resort, as in 2008.  Not having such a clause would make it non-credible and result in creditor run and contagion effects at the slightest sign of trouble.

But wouldn’t scrapping any possibility for government support strengthen market discipline?  Only if it were credible, i.e., nothing short of a constitutional restriction would do, given a history of government responses to previous crises.  And it would certainly reduce the flexibility of policy makers in the eye of a crisis.  Ultimately, effective bank resolution is about a trade-off between enforcing market discipline on stakeholders in failing banks and protecting the rest of the financial system and the real economy. While tying your hands might reduce the number of bank failures by strengthening market discipline, it will not eliminate them and will make their negative effects for the real economy even worse.

But wouldn’t very high capital buffers reduce the need for a resolution regime? While capital requirements under Basel III might still not be at the level where they should be, increasing capital buffers to a level where bank failure is all but esxcluded would ultimately drive banks towards narrow banking, with the consequence that risk taking would move away from the regulated into currently less or even non-regulated segments of the financial system.  As more and more households are excluded from fixed-return passive long-term investment strategies, such as relying on a defined-benefit pension, active management of their investment portfolio, which includes maximizing a risk-adjusted return, would ultimately increase pressure on regulators to extend the financial safety net beyond narrow banking if households are pushed away by minimal interest rates in a narrow banking system.

In summary, governments have a comparative advantage in providing certainty and they are most asked to do so during systemic banking crises. Tying their hands by pretending there will never be a bail-out will leave governments with the choice between a melt-down of the financial system with terrible repercussions for the real economy or violating the no-bail-out rules, no matter how binding they were meant to be.  It is clear what a democratically elected government will do!  

So beware of easy solutions, as economic reality does not always comply with good intentions!

Overview