Financial Regulation 3

Economics of Financial Regulation
Session 3: Enforcing Regulation

- Bank Supervision and Resolution -
Prof. Jean-Edouard Colliard, HEC Paris
2023
J.E. Colliard (HEC Paris) Economics of Financial Regulation - 3 January 3, 2023 1 / 44

Introduction
First-best regulation: we edict some rules and market

participants follow them.
Reality: someone needs to enforce these rules:
I Check that regulated market participants apply them.
I Punish them when they don’t.
Giving the enforcers the right incentives may be difficult.

Example of bank supervision and resolution.

Road map
1 What is bank supervision?
2 Supervisory failures
3 Resolution and bail-outs
4 Conclusion

Example: the fall of Dexia - 1
Dexia rescued by a 94 bln EUR package from the French and

Belgian governments on 10 Oct 2011.
Had ranked 12th/90 in the July 2011 EBA stress-tests.
Evolution of capital ratios (De Groen, 2011):
2006 2007 2008 2009 2010

Core Tier 1 Ratio 8.7% 8.2% 9.6% 11.3% 12.1%
Capital adequacy ratio 10.3% 9.6% 11.8% 14.1% 14.7%
Unweighted ratio 3.2% 2.6% 0.9% 2.0% 1.9%

Dexia always complied with the regulation, yet it failed.

High capital adequacy ratio but high leverage
⇒ low risk-weighted assets.
Only two possible explanations:
I Dexia’s assets were very safe.
I The risk-weights did not reflect the risk.




Enforcement was inadequate, not the regulation itself.

The role of supervisors
Ensure that banks comply with

regulation: check the numbers,
validate internal models...
Discretionary power to ask for
additional changes, increases in
capital etc.
Penalties: from monetary fines to
withdrawal of the banking license.
Place a bank into resolution.

Exercise
Supervisory interventions
[See Exercises Sheet #4]

The picture so far
Banks supervisors:
I Check that regulation is enforced.
I Can intervene in a discretionary way.
I Can trigger the resolution of a bank.

Who is the supervisor? - U.S.

Who is the supervisor? - Example
Bank of the West, a FDIC-insured State non Member bank?

Wells Fargo, a national bank (automatically member)?
JP Morgan, a bank holding company?
State Street Bank & Trust Company, a FDIC-insured State
Member bank in Boston?
Naugatuck Valley Savings and Loans?

Who is the supervisor? - E.U.
Separation between regulation and supervision
E.U. Euro Area France U.K. Sweden

Bank supervisor - ECB ACPR (∈ SSM) PRA Finansinspektionen (∈
/ SSM)
Bank regulator EBA EBA EBA PRA EBA
Central Bank - ECB BdF (∈ ESCB) BoE (∈

/ ESCB) Sv. Riksbank (∈
/ ESCB)

Example of a Euro Area country: France
Supervision: French banks supervised by the Autorite de

Controle Prudentiel et de Resolution (ACPR). In addition,
France is in the Euro area, its banks are supervised by the
European Central Bank (ECB). ACPR and ECB operate
together under the Single Supervisory Mechanism (SSM).
Regulation: France is in the E.U., its banks abide with E.U.
regulations edicted by the European Banking Authority (EBA).
Central bank: The central bank of France is Banque de France
(BdF). France is part of the Euro Area, hence BdF is part of the
European System of Central Banks (ESCB), headed by the ECB.

Example of an E.U. but non Euro Area country:
Sweden
Supervision: Swedish banks supervised by the

Finansinspektionen. Sweden is not part of the Euro Area, no
involvement of the ECB.
Regulation: Sweden is in the E.U., its banks abide with E.U.
regulations edicted by the EBA.
Central bank: The central bank of Sweden is Sveriges Riksbank.
Sweden is not part of the Euro Area, no involvement of the ECB.

Example of a non E.U. and non Euro Area country:
United Kingdom
Supervision: British banks supervised by the Prudential

Regulatory Authority (PRA). UK is not part of the Euro Area,
no involvement of the ECB.
Regulation: UK is no longer in the E.U., its banks won’t have to
comply with EBA regulations (probably PRA only).
Central bank: The central bank of the UK is the Bank of
England (BoE). UK is not part of the Euro Area, no involvement
of the ECB.

Some additional E.U. acronyms
European Securities Markets Authority (ESMA): regulatory

authority for securities markets.
European Insurance and Occupational Pensions Authority
(EIOPA): regulatory authority for insurance companies.
European Systemic Risk Board (ESRB): macroprudential
oversight (see session 6). Hosted by the ECB.
European System of Financial Supervisors (ESFS): collection of
EBA, ESMA, EIOPA, ESRB.

The picture so far
Banks supervisors:
Many different regulatory architectures exist.

Road map
4 Conclusion

The S&L Crisis
See e.g. Kane (1992).

Savings and Loans are small banks financing long-term loans
with deposits.
1979-1981: interest rates double from 11% to 20% (Volcker).
S&Ls still have mortgages paying 4%, but borrow at 20%.
Interest rate risk was not hedged.
S&Ls basically bankrupt in 1981!

What did the supervisor do?
The Federal Savings and Loans Insurance Corporation (FSLIC)

realized it did not have enough to cover all deposits.
Admitting the problem put everybody’s careers at risk.
Hide the problem and help banks to “grow out of the crisis”:
I Increase DI coverage from 50 to 100 k USD.
I Change accounting principles.
I Count some forms of debt as capital.
I Turn a blind eye on gambling for resurrection...

Outcome
From Congressional Budget Office.
1,043/3,234 U.S. Savings & Loans resolved during 1986-1995.

Federal government reimburses depositors. Massive bail-out.
Typical example of a supervisory failure.
FSLIC dissolved.
The picture so far
Banks supervisors:

Supervisors can fail to do their job.

The picture so far
Banks supervisors:

Supervisors can fail to do their job. Why?

Supervisory competition
Importantly, banks choose their charter.

Most supervisors (except Fed) are financed with bank
examination fees.
2004: HSBC USA and JP Morgan Chase Bank give up their
New York Start charter for a national charter (OCC).
NY Banking Department loses 30% of its 80 mln USD budget.
Concern for fees may make supervisor too lenient (Kisin and
Manela, 2017).

Forbearance 耐⼼
Can we find empirical evidence of supervisory forbearance?

Agarwal, Lucca, Seru and Trebbi (2014): use exogenous rotation
between State and Federal supervisor for State banks.
Comparison of CAMELS ratings - if no bias we should have
50 − 50. Instead:
I Member banks: FRB does 43% of upgrades, 76% of
downgrades.
I Non-Member banks: FDIC does 57% of upgrades, 65% of
downgrades.
State supervisors significantly more forbearant than Federal ones.

The picture so far
Banks supervisors:

Regulatory architecture matters.

Road map
4 Conclusion

Bank resolution in the first-best
Consider the ultimate bank supervision decision: closing a bank.

In principle, standard bankruptcy procedure:
I Assets are liquidated.
I Proceeds distributed to depositors and other creditors.
I The deposit insurance fund compensates depositors for their
losses, which is why it collected fees ex ante.
This mechanism incentivizes shareholders and creditors to
monitor the bank’s management (like for any other company).
Necessary condition: the bank supervisor does close the bank,
the government does not intervene.

Too big to fail
Huge externalities when a large/connected/systemic bank

defaults: contagion, real activity etc.
If the bank defaults, the market expects a bail-out ex post.
Creditors thus ask for lower interest rates
⇒ similar to the effect of deposit insurance.
Loss of market discipline.
Temporal inconsistency:
ex ante the regulator wants the market to believe there will be
no bail-out, but wants a bail-out ex post.

Not so good alternatives
Bail-out: US TARP 2008-2009, around USD 400 bln.

Distressed merger/takeover: Fortis 2008.
⇒ increased concentration, vicious circle.
Nationalization: Northern Rock 2008.

The picture so far
Banks supervisors:

Too big to fail implies forbearance and bail-outs.
保释

Game
Too big to fail
[See Games Sheet #2]
Tsesmelidakis and Merton (2015): TBTF guarantees represent a

transfer of 129 bln USD to US bank shareholders, 236 to creditors.

TBTF over time
From Barth and Sau (2014).

TBTF over time

The picture so far
Banks supervisors:

Bail-outs incentivize more risk-taking.

Better alternatives?
⾃我救助
New emphasis on bail-ins after the crisis bail-outs: make
shareholders and creditors pay before taxpayers.
This was already supposed to be the case!
Two possibilities: reduce ∆ or create commitment.
Some recent tools:
I New authorities to organize an orderly liquidation: Orderly
Liquidation Authority (U.S.), Single Resolution Mechanism
(E.U.).
I Banks have to show ex ante that they can resolved without
endangering the market: living wills/resolution plans.
I Part of the debt has to be clearly earmarked for bail-ins.
I E.U.: No public funds can be used before sufficient bail-in
(Bank Recovery and Resolution Directive).
TLAC and MREL
Total Loss Absorbing Capital (TLAC):
I Rules proposed by the Financial Stability Board for global
systemic banks.
I Equity + debt that can be written down/converted by the
supervisor without triggering default are considered bail-inable
liabilities, or TLAC.
I From 1 January 2022: TLAC 18% of RWAs, 6.75% of total
assets.
Minimum Requirement for own funds and Eligible Liabilities

(MREL):
I Rule for all E.U. banks (BRRD).
I Minimum level of capital + bail-inable liabilities specific to each
institution, depending on the resolution plan.
Summary, E.U.
From Farina, Krahnen, Mecatti, Pelizzon, Schlegel, and Troeger
(2022):

Assessment
Ignatowski and Korte (2014): OLA reduces risk-taking, but not

for the largest banks.
Cetorelli and Traina (2018): Living wills increase cost of capital
by 22bps, stronger for systemic banks.
Steinruecke (2017), Bang and Wilken (2018): bail-in of Banco
Popular increased credibility of resolution for all other banks,
bail-out of Monte dei Paschi did the opposite.
Some (U.S.) evidence that TBTF has decreased since 2008:
Atkeson, d’Avernas, Eisfeldt, and Weill (2018); Berndt, Duffie,
and Zhu (2020).

Is TBTF over?

Conclusion
Regulators very active on this topic but, for the moment...

Bank bail-outs continue (Monte dei Paschi Dec. 2016, NordLB
Dec. 2019).
Distressed mergers during crises ⇒ banks only get bigger e.g.
Merrill Lynch & Bank of America, BNP Paribas and Fortis.
No breaking up of banks in good times. Today renewed support
for bank mega-mergers among European regulators.
I think the jury is still out...

Road map
4 Conclusion

Take-Away Points
Banks supervisors:

Bail-outs incentivize more risk-taking.
Possible solutions:
I Reduce the negative impact of bank failure.
I Improve commitment.
Thank you!
Suggested additional readings:

Ampudia, Beck, Beyer, Colliard, Leonello, Maddaloni, and
Marques-Ibanez (2019).
Komai and Richardson (2011).
White (2009).
Kane (1988).

Financial Regulation 3

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Economics of Financial Regulation

Session 3: Enforcing Regulation

J.E. Colliard (HEC Paris) Economics of Financial Regulation - 3 January 3, 2023 1 / 44

First-best regulation: we edict some rules and market

Giving the enforcers the right incentives may be difficult.

J.E. Colliard (HEC Paris) Economics of Financial Regulation - 3 January 3, 2023 2 / 44

1 What is bank supervision?

3 Resolution and bail-outs

J.E. Colliard (HEC Paris) Economics of Financial Regulation - 3 January 3, 2023 3 / 44

Dexia rescued by a 94 bln EUR package from the French and

2006 2007 2008 2009 2010

J.E. Colliard (HEC Paris) Economics of Financial Regulation - 3 January 3, 2023 4 / 44

Dexia always complied with the regulation, yet it failed.

J.E. Colliard (HEC Paris) Economics of Financial Regulation - 3 January 3, 2023 5 / 44

Dexia always complied with the regulation, yet it failed.

J.E. Colliard (HEC Paris) Economics of Financial Regulation - 3 January 3, 2023 5 / 44

Dexia always complied with the regulation, yet it failed.

Enforcement was inadequate, not the regulation itself.

J.E. Colliard (HEC Paris) Economics of Financial Regulation - 3 January 3, 2023 5 / 44

Ensure that banks comply with

J.E. Colliard (HEC Paris) Economics of Financial Regulation - 3 January 3, 2023 6 / 44

[See Exercises Sheet #4]

J.E. Colliard (HEC Paris) Economics of Financial Regulation - 3 January 3, 2023 7 / 44

J.E. Colliard (HEC Paris) Economics of Financial Regulation - 3 January 3, 2023 8 / 44

J.E. Colliard (HEC Paris) Economics of Financial Regulation - 3 January 3, 2023 9 / 44

Bank of the West, a FDIC-insured State non Member bank?

J.E. Colliard (HEC Paris) Economics of Financial Regulation - 3 January 3, 2023 10 / 44

Separation between regulation and supervision

E.U. Euro Area France U.K. Sweden

Bank regulator EBA EBA EBA PRA EBA

Central Bank - ECB BdF (∈ ESCB) BoE (∈

J.E. Colliard (HEC Paris) Economics of Financial Regulation - 3 January 3, 2023 11 / 44

Supervision: French banks supervised by the Autorite de

J.E. Colliard (HEC Paris) Economics of Financial Regulation - 3 January 3, 2023 12 / 44

Supervision: Swedish banks supervised by the

J.E. Colliard (HEC Paris) Economics of Financial Regulation - 3 January 3, 2023 13 / 44

Supervision: British banks supervised by the Prudential

J.E. Colliard (HEC Paris) Economics of Financial Regulation - 3 January 3, 2023 14 / 44

European Securities Markets Authority (ESMA): regulatory

J.E. Colliard (HEC Paris) Economics of Financial Regulation - 3 January 3, 2023 15 / 44

Many different regulatory architectures exist.

J.E. Colliard (HEC Paris) Economics of Financial Regulation - 3 January 3, 2023 16 / 44

1 What is bank supervision?

3 Resolution and bail-outs

J.E. Colliard (HEC Paris) Economics of Financial Regulation - 3 January 3, 2023 17 / 44

See e.g. Kane (1992).

J.E. Colliard (HEC Paris) Economics of Financial Regulation - 3 January 3, 2023 18 / 44

The Federal Savings and Loans Insurance Corporation (FSLIC)

J.E. Colliard (HEC Paris) Economics of Financial Regulation - 3 January 3, 2023 19 / 44

1,043/3,234 U.S. Savings & Loans resolved during 1986-1995.

Many different regulatory architectures exist.

J.E. Colliard (HEC Paris) Economics of Financial Regulation - 3 January 3, 2023 21 / 44

Many different regulatory architectures exist.

J.E. Colliard (HEC Paris) Economics of Financial Regulation - 3 January 3, 2023 22 / 44

Importantly, banks choose their charter.

J.E. Colliard (HEC Paris) Economics of Financial Regulation - 3 January 3, 2023 23 / 44

Can we find empirical evidence of supervisory forbearance?

J.E. Colliard (HEC Paris) Economics of Financial Regulation - 3 January 3, 2023 24 / 44

Many different regulatory architectures exist.

J.E. Colliard (HEC Paris) Economics of Financial Regulation - 3 January 3, 2023 25 / 44

1 What is bank supervision?

3 Resolution and bail-outs