8L1PlnklnC llnAnClAL

8LCuLA1lCn
!ean Charles 8ocheL
AnLrluvorlesung, 30 Aprll 2012
ueparLmenL of 8anklng and llnance
unlverslLy of Zurlch.
1
ln18CuuC1lCn
Subprlme crlsls of 2007-2009 has shown Lhe necesslLy
Lo reform hnanc|a| regu|anon.
So far lL was enurely focused on |nd|v|dua| banks
(m|cro-prudenna| approach).
8uL Lhere ls also a need Lo guaranLee Lhe stab|||ty of
the bank|ng and hnanc|a| system as a whole.
1hls presenLauon summarlzes my recenL research
and my fuLure pro[ecLs on Lhls new, macro-prudenna|
(or system|c) approach, Lo nanclal sLablllLy.
2
A llule hlsLory of banklng crlses (1)
Commerc|a| banks are frag||e:
1hey largely nanced by small deposlLors, who do
noL have Lhe experuse Lo monlLor bank managers,
and who can wlLhdraw Lhelr money easlly.
1he uS free banklng era (1837-1864): very
frequenL bank panlcs (bad crops, recesslons,.)
Cverend and Cuerney (1866) ln Lhe uk.
CreaL uepresslon (1929-1934).

A safety net was esLabllshed ln order Lo avold Lhese
banklng crlses.
3
A llule hlsLory of banklng crlses (2)
1he Uk approach to avo|d cr|ses:
Lhe 8ank of Lngland was lnsLrucLed Lo acL as a
Lender of Last kesort (8agehoL 1873) lf a so|vent
bank becomes ||||qu|d.
uocLrlne was rsL puL lnLo appllcauon durlng Lhe
rsL 8arlngs crlsls (1890).
As a resulL: no bank runs ln Lhe uk for 109 years
(unul norLhern 8ock).
lor example: worked perfecLly well durlng Lhe
second 8arlngs crlsls (1993).
4
A llule hlsLory of banklng crlses (3)
1he US approach to avo|d|ng cr|ses:
Creauon of Lhe Iedera| keserve (1913), who can also acL
as a Lender of LasL 8esorL (d|scount w|ndow).
Creauon of Lhe Iedera| Depos|t Insurance Corporanon
and lederal Savlngs and Loans lnsurance Corporauon
(1934): lnsure deposlLors agalnsL Lhe fallure of Lhelr bank.
Worked well unul Lhe Sav|ngs and Loans Cr|s|s (1980).

ln facL Lhe safety net was adopLed ln many counLrles buL lL
d|d not succeed to e||m|nate bank|ng cr|ses.
3
8anklng crlsls
SlgnlcanL banklng
problems
no banklng problem
or no lnformauon
Why are Lhere so many banklng crlses?
7
8ecause Lhe safeLy neL encourages banks Lo
borrow a loL and Lake excesslve rlsk (moral
hazard)
AsseLs
100
ueposlLs
96



LqulLy
4
AsseLs
92
ueposlLs
96


LqulLy
0

ubllc
funds 4

Losses
(8)

Calns
(8) AsseLs
108
ueposlLs
96


LqulLy
12
8
1hls ls why banks' equlLy rauos have decreased
dramaucally over Lhe lasL 170 years
1he [usucauon for
mlcro-prudenual regulauon
9
Let me summar|ze the reasons for pub||c |ntervennon:

Commerclal banks are largely nanced by small deposlLors,
who do noL have Lhe experuse Lo monlLor bank managers,
and who can wlLhdraw Lhelr money easlly.
8ank-runs can only be avolded lf Lhese reLall deposlLs are
compleLely and credlbly lnsured.
8uL Lhls lnsurance may creaLe a moral hazard problem:
bankers musL be prevenLed from Laklng excesslve rlsks wlLh
Lhelr deposlLors' money.

1he docLrlne for
mlcro-prudenual regulauon (1)
10

Mode of |ntervennon:
deslgn prudenual regulauons almed aL llmlung banks' rlsk
Laklng (8asel Commluee recommendauons, nauonal
leglslauon , Luropean ulrecuves).
esLabllsh a banklng supervlsor (or a nanclal servlce
auLhorlLy) ln charge of represenung Lhe lnLeresLs of small
deposlLors (and lnvesLors, or lnsurance pollcy holders).
ln SwlLzerland Lhls supervlsor ls llnMA, creaLed ln 2009 by
merger of Lhree speclallzed auLhorlues (banks, lnsurance,
money launderlng).

1he docLrlne for
mlcro-prudenual regulauon(2)
11

Cb[ecnve of regu|anon (for banks): mlnlmlze expecLed
cosL of lndlvldual bank fallures.

Instruments: Lhe 3 plllars of 8asel 2 (mlnlmum caplLal
requlremenL, pro-acuve supervlslon, markeL dlsclpllne)
modled by 8asel 3, LhaL lnLroduced ||qu|d|ty
requ|rements, as well as spec|a| reso|unon procedures.

SwlLzerland has Laken Lhe lead ln Lhls domaln:
addluonal caplLal requlremenLs for 1oo 8|g 1o Ia||
banks, contra-cyc||ca| cap|ta| buers.

1he docLrlne for
mlcro-prudenual regulauon(3)
12
Cost of regu|anon and potenna| prob|ems:
8lsk of regulaLory capLure by Lhe lndusLry (e.g.
adopuon of value aL 8lsk crlLerlon by 8asel
Commluee).
8lsk of supervlsory forbearance under pollucal
pressure (e.g. un[usued ball-ouLs pald by Lax-
payers)

osslblllues of dlsLoruons of compeuuon (e.g.
lnadequaLe rlsk welghLs for caplLal requlremenLs).
Why do we need Lo reform
llnanclal 8egulauon?
13
Consensus: mlcro-prudenual regulauon ls lnsumclenL!

Several reasons for Lhls:

1. 1he hnanc|a| system has changed dramanca||y:
8anks have become much b|gger, much more comp|ex
New hnanc|a| markets (fuLures, opuons, swaps, CuSs,..)
have appeared and become huge.
New |ntermed|ar|es have appeared, and some are very
opaque (hedge funds)
8anks and markeLs are compleLely |nterconnected.



.


uS llnanclal SysLem, 1980
($1rllllon, 2010 value)
14
Loans
2.3
8onds
1
ueposlLs
3
LqulLy
0.3
8orrowers
lnvesLors
SLocks 1.6
8onds 1.3
8anks
MarkeLs
uS llnanclal SysLem, 2010 ($ 1rllllon)
13
Loans
10
Securlues
6
ueposlLs
8
Securlues
6.3
LqulLy
1.3
8orrowers
lnvesLors
uerlvauves 19
SLocks 17
8onds 14
8anks
MarkeLs
MuLual lunds 11
enslon lunds 7
Pedge lunds ?
C balance sheeL
Why do we need Lo reform
llnanclal 8egulauon (2)?
16
AnoLher reason for adopung a sysLemlc regulauon ls LhaL
bank fallures Lyplcally happen LogeLher (bank|ng cr|ses).
1hls ls because a|| banks |nvest |n s|m||ar assets
(rea| estate, stock markets , government bonds, SMLs,.).

1hus Lhey are a|| h|t by the same macro-shocks
( crash on asset markets, sovere|gn defau|t, recess|on, .) .

8anklng crlses have a huge soc|a| cost (noL only scal cosL,
buL more lmporLanLly perslsLenL ouLpuL loss).



.


17
8ank fallures are clusLered
17
Why do we need Lo reform
llnanclal 8egulauon (3)?
18

llnally Lwo oLher reasons for reformlng nanclal regulauon:

3.I|nanc|a| cyc|es:
banks lend Loo much ln good umes (credlL booms)
banks lend Loo llule ln bad umes (credlL crunches)
Lhls generaLes excesslve volaullLy of credlL (pro-cycllcallLy) and
asseL prlces (bubbles and re sales splrals)
4. System|ca||y Important I|nanc|a| Insntunons (SIIIs):
some nanclal lnsuLuuons (lncludlng non-banks) are ma[or
players ln vlLal parLs of nanclal sysLem (paymenL sysLems,
money markeLs, securlues Lradlng ,derlvauves markeLs),
Lhese Sllls cannoL be closed even lf Lhey lncur large losses.



.


llnanclal Cycles ln Lhe uSA
19
A proposed docLrlne for macro-
prudenual regulauon(1)
20
Mode of |ntervennon:
1here ls no need Lo creaLe a new auLhorlLy buL raLher Lo
coordlnaLe Lhe acuons of exlsung auLhorlues ln charge of nanclal
sLablllLy.

1hls can be done Lhrough a llnanclal SLablllLy Commluee (lSC),
comprlslng represenLauves of Lhe llnanclal Servlce AuLhorlLy
(llnMA), Lhe CenLral 8ank (Sn8), and Lhe MlnlsLry of llnance, as
well as lndependenL members.

1hls Commluee would recelve a double mandaLe:
ensure Lhe conunulLy of Lhe vlLal parLs of Lhe nanclal sysLem,
llmlL sysLemlc rlsk and excesslve ucLuauons of aggregaLe credlL.



A proposed docLrlne for macro-
prudenual regulauon (2)
21

Instruments: 1he llnanclal SLablllLy Commluee would dec|de on:

Whlch lnsuLuuons are deemed sysLemlc (Sllls) and whaL speclal
measures are appllcable Lo Lhem (caplLal add-ons, addluonal
llquldlLy requlremenLs,.), based on nanclal sLablllLy models and
sLress LesLs.
Whenever quanuLauve resLrlcuons on credlL (CA8, leverage rauo,
maxlmum L1v rauo,.) should be Lhe ad[usLed, based on forecasLs
of fuLure macroeconomlc condluons, and assessmenLs of rlsks
bulld-ups.
CCnCLuSlCn: M? ACAuLMlC 8C!LC1
22
lL ls slmple yeL ambluous: deve|op |n 2r|ch a wor|d c|ass
research center on bank|ng regu|anon.
1hls cenLer wlll beneL from synergles wlLh oLher researchers:

WlLhln Lhe deparLmenL of banklng and nance (behavloral nance,
corporaLe nance, mlcroeconomlcs, economeLrlcs, maLhemaucal
nance).
WlLh oLher researchers based ln Zurlch (economlsLs aL uZP and
L1P, uSl wlLh uZP lawyers, [olnL semlnar ln Law and llnance wlLh
L1P, CClZ wlLh uZP and L1P maLhemauclans).
WlLh oLher researchers based ln SwlLzerland (Swlss llnance
lnsuLuLe, 8ank for lnLernauonal SeulemenLs, Swlss nauonal 8ank).
M? ACAuLMlC 8C!LC1 (2)
23
ubllc auLhorlues Lurn Lo us academlcs and ask: whaL
should we do? 1he problem ls LhaL we do noL know!

1he 2r|ch Center on 8ank|ng kegu|anon can contr|bute
to h|| th|s gap |n academ|c know|edge.
1he cenLer wlll organlze semlnars (Annual Zurlch
Semlnar on 8anklng") and lnLernauonal conferences
lnvolvlng Lhe world's besL speclallsLs ln banklng.

We wlll beneL from Lhe presence ln Zurlch of Lop
bankers (u8S, CS, Zk8.) regulaLors (Sn8,llnMA) and Lhe
auracuveness of Zurlch Lo organlze dlscusslons panels
wlLh lnLernauonal bankers and regulaLors.