Overstating Moral Hazard: Lessons from Two Decades of Banking Crises

Over the past two decades a variety of banking system rescue approaches have been used, including in the 1997 Asian financial crisis, the 2008 global financial crisis, and the 2010 European debt crisis. By analysing the resolution of these crises as well as the approach to addressing bad loans in the People’s Republic of China, this paper provides a new perspective on the common belief that bailouts are invariably harmful to public funds or excessively conducive to moral hazard. Depending on the form of bailout, bank restructuring, and fiscal backstop, resolutions can be an effective means to restore a banking system. This paper argues that in a systemic financial crisis, a combination of balance sheet restructuring and the use of asset management companies to deal with non-performing loans is often the best choice. However, a fully-fledged resolution that triggers the bail-in procedure remains the best approach for non-systemically important financial institution failures which take place outside of systemic crises, namely when the failure is idiosyncratic.postprin

Market Discipline and EU Corporate Governance Reform in the Banking Sector: Merits, Fallacies, and Cognitive Boundaries

Much contemporary analysis has concluded that the recent financial crisis and bank failures were, inter alia, the result of a breakdown in corporate governance regimes and market discipline. New EU regulations strongly advocate market-based remedies such as tighter investor monitoring and greater control over executives' remuneration, in order to safeguard financial stability. We argue that this approach largely ignores three very important aspects of modern financial markets that cannot be constrained through market discipline: (a) socio-psychological phenomena; (b) the epistemological properties of financial market innovation; and (c) the inherent inability of market participants to predict uncertain risk correlations. Therefore, this article argues that excessive EU focus on corporate governance reforms, as a means to improve financial stability, detracts attention from much more significant concerns, chiefly the issue of optimal bank structure

Bank resolution 10 years from the global financial crisis: a systematic reappraisal

Since 2010 most Group of Twenty (G20) jurisdictions have introduced new recovery and resolution regimes to deal with bank failures. The common objective of these regimes is, first, to facilitate the orderly failure of financial institutions and, second, to redirect the bulk of losses to the private sector, thereby eliminating the need for public bailouts. Stringent creditor monitoring of bank risk is presumed to constrain excessive leverage because otherwise shareholders and managers will increase leverage to maximize returns on equity (ROE). Thus, the threat of a creditor bail-in should eliminate the TBTF subsidy and should also contain the governance costs that accompany excessive leverage curtailing managerial rents. Despite significant progress to meet resolution objectives, concerns remain on whether the present arrangements will work effectively in a systemic crisis. Such skepticism centres on whether bailing in the creditors of a cross-border institution, including the conversion of pre-funded liabilities such a TLAC and MREL, would prove sufficient to prevent the bailout of a global systemically important financial institution (G-SIFI). There are also concerns about the possibly undesirable consequences of bank bail-ins when the failure is systemic rather than idiosyncratic. Finally, it is not known to what extent resolution regimes are sufficient to mitigate moral hazard, especially in the absence of an ex post penalty regime for bank managers. This paper discusses these issues in context and tries to articulate the normative values attached to resolution regimes highlighting the prevalent lack of clarity and the overlapping and sometimes conflicting nature of resolution objectives under present frameworks. Then the paper focuses on the implications of draconian creditor bail-in regimes and advocates a more relaxed approach to the provision of liquidity in resolution to avoid fire sales

Bank Leverage Ratios and Financial Stability: A Micro- and Macroprudential Perspective

Bank leverage ratios have made an impressive and largely unopposed return; they are mostly used alongside risk-weighted capital requirements. The reasons for this return are manifold, and they are not limited to the fact that bank equity levels in the wake of the global financial crisis (GFC) were exceptionally thin, necessitating a string of costly bailouts. A number of other factors have been equally important; these include, among others, the world's revulsion with debt following the GFC and the eurozone crisis, and the universal acceptance of Hyman Minsky's insights into the nature of the financial system and its role in the real economy. The best examples of the causal link between excessive debt, asset bubbles, and financial instability are the Spanish and Irish banking crises, which resulted from nothing more sophisticated than straightforward real estate loans. Bank leverage ratios are primarily seen as a microprudential measure that intends to increase bank resilience. Yet in today's environment of excessive liquidity due to very low interest rates and quantitative easing, bank leverage ratios should also be viewed as a key part of the macroprudential framework. In this context, this paper discusses the role of leverage ratios as both microprudential and macroprudential measures. As such, it explains the role of the leverage cycle in causing financial instability and sheds light on the impact of leverage restraints on good bank governance and allocative efficiency