Economics of Financial Regulation

Session 4: International Coordination

- Basel Agreements / European Banking Union -
Prof. Jean-Edouard Colliard, HEC Paris
2023

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Introduction

Financial markets and institutions are global.

Regulation at the national level unlikely to be sufficient.
Many examples of supranational regulations / regulatory
authorities.
Why are they necessary? What do they do?

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Road map

1 The race to the bottom

2 Supervisory failures

3 The European Banking Union

4 Conclusion

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Externalities

Cross-border externalities of capital requirements:

I Favor foreign banks competing with domestic banks.
I Give banks incentives to locate more activities abroad.
I Less contagion from home to foreign banks.

⇒ uncoordinated capital requirements typically too low.

Problem more acute when banks/funds are more internationally
mobile. 极度的

Rationale for regulatory unions.

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Historical evolution
US Bank Equity/Assets Ratio 1834-2017 (Walter, 2019)

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Game

The race to the bottom

[See Games Sheet #3]

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Outcome

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The picture so far
Uncoordinated regulators let banks take too much risk (race to
the bottom).

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Regulatory unions

Why not a global regulation then?

Dell’Ariccia and Marquez (2006): trade-off between
harmonization and national preferences.
Second-best capital requirements different in each country:
I Economic importance of the banking sector.
I Risk aversion (eg. soundness of public finances).
I Substitutes to bank credit...

Different countries thus target different levels of capital

requirements: 4, 5, 8, 10% etc.

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Why join?

Unions are formed on a voluntary basis.

A country will not join a union with capital requirements far
from its preferred level.
Unions will be formed following a cost-benefit analysis:
I Benefit: if externalities are high.
I Cost: heterogeneity of preferences.

⇒ Unions in relatively homogeneous and integrated areas.

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The Basel agreements - Origins

混乱
1974: turmoil in forex markets (end of Bretton Woods), failure
of Herstatt and international contagion.
Central bank governors of G-10 countries establish a committee,
soon called Basel Committee on Banking Supervision (BCBS),
hosted by the BIS.
Forum of cooperation ⇒ agreements not binding, no legal force
until transposed into national law.

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The Bank for International Settlements (BIS)

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The Basel agreements - After Basel I

Basel I (1988): seen as a huge success (first time such an

agreement is reached).
Many non G-10 countries adopted Basel I, then Basel II: way to
commit to a stable banking system and attract funding.
Huge influence of the BCBS, becomes setter of international
standards in banking regulation.
Pressure from the industry to draft “better” rules: 1996 market
risk amendment, 2004 Basel II, 2010 Basel III.
修正案

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Basel III adoption outside BCBS countries
From Jones and Zeitz (2017).

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The picture so far
Uncoordinated regulators let banks take too much risk (race to
the bottom).
To solve this problem, regulatory unions form with relatively
homogeneous countries.

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Limits

Very heterogeneous regulatory union.

Standards developed for countries with sophisticated banks and
regulators (e.g. Basel II).
Difficult transition from forum to international lawmaker: no
permanent staff, no research etc. (Goodhart, 2011).
Growing confusion: is the objective to solve the race to the
bottom, or to design global regulatory standards?
Outdated governance structure?
Authority too big compared to checks and balances in place?
Intense lobbying. Example: weighted vs. unweighted ratios.

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Example - Ratios with RWAs
Barclays study (2012).

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Example - Unweighted ratios

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Consequences

Huge push for less model discretion.

Unsurprisingly, supported by U.S. banks!
Three interpretations:
I EU banks cheat.
I EU and US banks have adapted to different regulations.
I EU banks have better assets.

Then back to Basel I? Answer next time.

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The picture so far
Uncoordinated regulators let banks take too much risk (race to
the bottom).
To solve this problem, regulatory unions form with relatively
homogeneous countries.
Governance of a regulatory union challenging: political
bargaining, lobbying, etc.

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Road map

1 The race to the bottom

2 Supervisory failures

3 The European Banking Union

4 Conclusion

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Enforcement

Basel risk models: pb. is not so much the rules as discretion in

the enforcement.
宽松的
Supervisors may be too lenient with their banks, especially if
regulation is coordinated (Acharya, 2003).
Two possible problems:
I Coordination between different supervisors of a multinational
bank (e.g., Dexia).
I Competition between supervisors protecting national champions
(e.g., France vs. Germany).

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Supervision

Remember the example on supervision: the bank is reluctant to

liquidate problem loans.
Not liquidating is called evergreening: renew the loans and hope
that they will be repaid.
Role of the supervisor: make sure losses are properly recognized,
force liquidation if necessary.
Liquidation is good for debtholders/the deposit insurance fund,
bad for shareholders.
Wrong incentives: Cyprus, Iceland.

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Exercise

National bias in supervision.

Loosely based on Beck, Todorov, and Wagner (2012), and Colliard
(2014).

[See Exercises Sheet #5]

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Evidence
Beck, Todorov and Wagner (2012) - supervisor is more prompt
to force liquidation when:
I The bank has more foreign shareholders.
I The bank has more domestic creditors.
I The bank has more foreign assets.

Empirics: regress log CDS spread 3 days before failure over

these items.
Low CDS spread before failure = supervisor intervened early.
Results:
I + 1pp foreign ownership ⇒ −60% CDS spread.
I + 1pp foreign deposits ⇒ +150% CDS spread.

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The picture so far
Uncoordinated regulators let banks take too much risk (race to
the bottom).
To solve this problem, regulatory unions form with relatively
homogeneous countries.
Governance of a regulatory union challenging: political
bargaining, lobbying, etc.
With common regulation, the race to the bottom moves to bank
supervision.

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Road map

1 The race to the bottom

2 Supervisory failures

3 The European Banking Union

4 Conclusion

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The market failure

Summer 2012, peak of the euro area crisis.

联系
Fear of a bank-sovereign nexus: weaker banks ⇒ bail-out
expectations ⇒ higher deficits ⇒ losses for banks holding
sovereign debt ⇒ weaker banks etc. (e.g. Leonello, 2014).
Two objectives:
I Make it sure and credible that banks are safe (vs. forbearant
national supervisors).
I Make it credible that troubled banks won’t be bailed out.

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The bank-sovereign nexus
From Breckenfelder and Schwaab (2015).

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Components

Single Supervisory Mechanism. Common supervision by the ECB

since November 2014.
Single Resolution Mechanism. Common authority to resolve
distressed banks. Since 1 January 2016.
Single Deposit Insurance. Not foreseen yet, only harmonization
of DI thresholds.

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SSM - Functioning

ECB directly responsible for the 113 most significant banks of

the Euro area (82% of banking assets).
Sends “joint supervisory teams” for onsite supervision, takes all
decisions at the central level.
General oversight of the 3,500 other banks.
National supervisors remain primary supervisor of the less
significant banks.
Very labor-intensive function: 1,000 new employees (i.e. +50%
staff for the ECB).

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The picture so far
Uncoordinated regulators let banks take too much risk (race to
the bottom).
To solve this problem, regulatory unions form with relatively
homogeneous countries.
Governance of a regulatory union challenging: political
bargaining, lobbying, etc.
With common regulation, the race to the bottom moves to bank
supervision.
SSM is in principle a solution to this problem in the Euro area.

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Is the coverage optimal?

Direct supervision only for the most significant institutions.

But externalities matter, not size per se.
Neglect of small banks systemic as a herd e.g. cajas.
Political obstacles, e.g., German Landesbanken.
Danger of a dichotomous system: largest banks become
increasingly large and interconnected, smaller banks more
marginal or taken over.

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Other challenges

Higher stakes ⇒ higher reputation risk ⇒ more difficult to

recognize problems (Morrison and White, 2013): optimal
forbearance.
Interaction with monetary policy.
Staff loyalty: secondment vs. permanent positions.
Cooperation with the European Banking Authority and “out”
countries unclear.
Imbalance larger without the U.K.
Entry of Bulgaria Oct. 2020. Next Denmark?

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2020Q2 Figures.

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Politics
Total assets 24, 431 bln EUR (2020 Q2).
France alone has 35% of the total.
SSM governance:
I Supervisory board with 6 ECB + 20 national supervisors.
I Steering committee with 3 ECB + 5 national supervisors.

How should we appoint the 5 national representatives?

I Difficult not to have France and/or Germany.
I With proportionality, Cyprus would have a representative 1% of
the time.
I Complicated rotation mechanism, bargaining and political
appointments.
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Road map

1 The race to the bottom

2 Supervisory failures

3 The European Banking Union

4 Conclusion

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Take-away points
Uncoordinated regulators let banks take too much risk (race to
the bottom).
To solve this problem, regulatory unions form with relatively
homogeneous countries.
Governance of a regulatory union challenging: political
bargaining, lobbying, etc.
With common regulation, the race to the bottom moves to bank
supervision.
SSM is in principle a solution to this problem in the Euro area.
Governance is again challenging, especially due to the
heterogeneity of member countries.
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 Thank you!

Suggested additional readings:

Goodhart (2011).
Beck (ed.) (2012).

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