Why Are There So Many Banking Crises?: The Politics and Policy of Bank Regulation

by Jean-Charles Rochet

Overview

Almost every country in the world has sophisticated systems to prevent banking crises. Yet such crises—and the massive financial and social damage they can cause—remain common throughout the world. Does deposit insurance encourage depositors and bankers to take excessive risks? Are banking regulations poorly designed? Or are banking regulators incompetent? Jean-Charles Rochet, one of the world's leading authorities on banking regulation, argues that the answer in each case is "no." In Why Are There So Many Banking Crises?, he makes the case that, although many banking crises are precipitated by financial deregulation and globalization, political interference often causes—and almost always exacerbates—banking crises. If, for example, political authorities are allowed to pressure banking regulators into bailing out banks that should be allowed to fail, then regulation will lack credibility and market discipline won't work. Only by insuring the independence of banking regulators, Rochet says, can market forces work and banking crises be prevented and minimized. In this important collection of essays, Rochet examines the causes of banking crises around the world in recent decades, focusing on the lender of last resort; prudential regulation and the management of risk; and solvency regulations. His proposals for reforms that could limit the frequency and severity of banking crises should interest a wide range of academic economists and those working for central and private banks and financial services authorities.

Product Details

ISBN-13:	9780691131467
Publisher:	Princeton University Press
Publication date:	01/23/2008
Pages:	320
Product dimensions:	6.00(w) x 9.25(h) x (d)

About the Author

Jean-Charles Rochet is professor of mathematics and economics at the University of Toulouse and a visiting professor at the London School of Economics and Political Science. His books include (with Xavier Freixas) Microeconomics of Banking and (with Guillaume Plantin) When Insurers Go Bust (Princeton).

Read an Excerpt

Why Are There So Many Banking Crises?

---

By Jean-Charles Rochet Princeton University Press
Copyright © 2008 Princeton University Press
All right reserved.
ISBN: 978-0-691-13146-7

---

Chapter One General Introduction and Outline of the Book

The recent episode of the Northern Rock bank panic in the United Kingdom, with depositors queuing from 4 a.m. in order to get their money out, reminds us that banking crises are a recurrent phenomenon. An interesting IMF study back in 1997 identified 112 systemic banking crises in 93 countries and 51 borderline crises in 46 countries between 1975 and 1995, including the Savings and Loan crisis in the United States in the late 1980s, which cost more than $150 billion to the American taxpayers. Since then, Argentina, Russia, Indonesia, Turkey, South Korea, and many other countries have also experienced systemic banking crises.

The object of this book is to try and explain why these crises have occurred and whether they could be avoided in the future. It is fair to say that, in almost every country in the world, public authorities already intervene a great deal in the functioning of the banking sector. The two main components of this public intervention are on the one hand the financial safety nets (composed essentially of deposit insurance systems and emergency liquidity assistance provided to commercial banks by the central bank) and on the other hand the prudential regulation systems, consisting mainly of capital adequacy (and liquidity)requirements, and exit rules, establishing what supervisory authorities should do when they close down a commercial bank.

This book suggests several ways for reforming the different components of the regulatory-supervisory system: the lender of last resort (part 2), prudential supervision and the management of systemic risk (part 3), and solvency regulations (part 4) so that future banking crises can be avoided, or at least their frequency and cost can be reduced significantly.

Why Are There So Many Banking Crises? Part 1 contains a nontechnical presentation of these banking crises and a first, easily accessible, discussion of how the regulatory-supervisory system could be reformed to limit the frequency and the cost of these crises. The main conclusions of this part are the following:

Although many banking crises have been initiated by financial deregulation and globalization, these crises were amplified largely by political interference.

Public intervention in the banking sector faces a fundamental commitment problem, analogous to the time consistency problem confronted by monetary policy.

The key to successful reform is independence and accountability of banking supervisors.

The Lender of Last Resort Part 2 explores the concept of lender of last resort (LLR), which was elaborated in the nineteenth century by Thornton (1802) and Bagehot (1873). The essential point of the "classical" doctrine associated with Bagehot asserts that the LLR role is to lend to "solvent but illiquid" banks under certain conditions. More precisely, the LLR should lend freely against good collateral, valued at precrisis levels, and at a penalty rate. These conditions can be found in Bagehot (1873) and are also presented, for instance, in Humphrey (1975) and Freixas et al. (1999).

This policy was clearly effective: traditional banking panics were eliminated with the LLR facility and deposit insurance by the end of the nineteenth century in Europe, after the crisis of the 1930s in the United States and, by and large, in emerging economies, even though they have suffered numerous crises until today. Modern liquidity crises associated with securitized money or capital markets have also required the intervention of the LLR. Indeed, the Federal Reserve intervened in the crises provoked by the failure of Penn Central in the U.S. commercial paper market in 1970, by the stock market crash of October 1987, and by Russia's default in 1997 and subsequent collapse of LTCM (in the latter case a "lifeboat" was arranged by the New York Fed). For example, in October 1987 the Federal Reserve supplied liquidity to banks through the discount window.

The LLR's function of providing emergency liquidity assistance has been criticized for provoking moral hazard on the banks' side. Perhaps more importantly, Goodfriend and King (1988) (see also Bordo 1990; Kaufman 1991; Schwartz 1992) remark that Bagehot's doctrine was elaborated at a time when financial markets were underdeveloped. They argue that, whereas central bank intervention on aggregate liquidity (monetary policy) is still warranted, individual interventions (banking policy) are not anymore: with sophisticated interbank markets, banking policy has become redundant. Goodfriend and Lacker (1999) suggest that commercial banks could instead provide each other with multilateral credit lines, remunerated ex ante by commitment fees.

Part 2 contains two articles. Chapter 2, written with Xavier Vives, provides a theoretical foundation for Bagehot's doctrine in a model that fits the modern context of sophisticated and presumably efficient financial markets. Our approach bridges a gap between the "panic" and "fundamental" views of crises by linking the probability of occurrence of a crisis to the fundamentals. We show that in the absence of intervention by the central bank, some solvent banks may be forced to liquidate if too large a proportion of wholesale deposits are not renewed.

The second article, chapter 3, written with Xavier Freixas and Bruno Parigi, formalizes two common criticisms of the Bagehot doctrine of the LLR: that it may be difficult to distinguish between illiquid and insolvent banks (Goodhart 1995) and that LLR policies may generate moral hazard. They find that when interbank markets are efficient, there is still a potential role for an LLR but only during crisis periods, when market spreads are too high. In "normal" times, liquidity provision by interbank markets is sufficient.

Prudential Regulation and the Management of Systemic Risk Part 3 is dedicated to prudential regulation and the management of systemic risk. Although the topic is still debated in the academic literature (see Bhattacharya and Thakor (1993), Freixas and Rochet (1995), and Santos (2000) for extended surveys), a large consensus seems to have emerged on the rationale behind bank prudential regulation. It is now widely accepted that it has essentially two purposes:

To protect small depositors, by limiting the frequency and cost of individual bank failures. This is often referred to as microprudential policy.

To protect the banking system as a whole, by limiting the frequency and cost of systemic banking crises. This is often referred to as macroprudential policy.

Notice that, from the point of view of economic analysis, these two types of policies have very different justifications:

Microprudential policy is justified by the (presumed) inability of small depositors to control the use of their money by bankers. This is why most countries have organized deposit insurance funds (DIFs) that guarantee small deposits against the risk of failure of their bank. The role of bank supervisors is then to represent the interests of depositors (or rather of the DIF) vis-à-vis banks' managers and shareholders. Macroprudential policy is justified by the (partial) failure of the market to deal with aggregate risks, and by the public good component of financial stability. As for other public goods, the total (declared) willingness to pay of individual banks (or more generally of investors) for financial stability is less that the social value of this financial stability. This is because each individual (bank or investor) free-rides on the willingness of others to pay for financial stability.

These differences imply in particular that, while microprudential policy (and supervision) can in principle be dealt with at a purely private level (it amounts to a collective representation problem for depositors), macroprudential policy has intrinsically a public good component. This being said, governments have traditionally controlled both dimensions of prudential policy, which may be the source of serious time consistency problems8 (this is because democratic governments cannot commit on long-run decisions that will be made by their successors) leading to political pressure on supervisors, regulatory forbearance, and mismanagement of banking crises.

The first article in part 3, chapter 4, builds a simple model of the banking industry where both micro and macro aspects of prudential policies can be integrated. This model shows that the main cause behind the poor management of banking crises may not be the "safety net" per se as argued by many economists, but instead the lack of commitment power of banking authorities, who are typically subject to political pressure. However, the model also shows that the use of private monitors (market discipline) is a very imperfect means of solving this commitment problem. Instead, I argue in favor of establishing independent and accountable banking supervisors, as has been done for monetary authorities. I also suggest a differential regulatory treatment of banks according to the costs and benefits of a potential bailout. In particular, I argue that independent banking authorities should make it clear from the start (in a credible fashion) that certain banks with an excessive exposure to macroshocks should be denied the access to emergency liquidity assistance by the central bank. By contrast, banks that have access to the LLR either because they have a reasonable exposure to macroshocks or because they are too big to fail should face a special regulatory treatment, with increased capital ratio and deposit insurance premium (or liquidity requirements).

The three other articles in part 3 study the mechanisms of propagation of failure from one bank to other banks, or even to the banking system as a whole.

Chapter 5, written with Jean Tirole, shows that "peer-monitoring," i.e., the notion that banks should monitor each other, as a complement to centralized monitoring by a public supervisor, is central to the risk of propagation of bank failures through interbank markets.

Chapter 6, also written with Jean Tirole, studies the risk of propagation of bank failures through large-value interbank payment systems.

Finally, chapter 7, written with Xavier Freixas and Bruno Parigi, shows that the architecture of the financial system, and in particular the matrix of interbank relations has a large impact on the resilience of the banking system and its ability to absorb systemic shocks. This paper is related to several important papers on the sources of fragility of the banking system, notably Allen and Gale (1998), Diamond and Rajan (2001), and Goodhart et al. (2006).

Solvency Regulations Part 4 contains three articles, which are all concerned with the regulation of banks' solvency, and more precisely with the first and second Basel Accords. The first Basel Accord, elaborated in July 1988 by the Basel Committee on Banking Supervision (BCBS), required internationally active banks from the G10 countries to hold a minimum total capital equal to 8% of risk-adjusted assets. It was later amended to cover market risks. It has been revised by the BCBS, which has released for comment several proposals of amendment, commonly referred to as Basel II (Basel Committee 1999, 2001, 2003).

The first article, chapter 8, is mainly concerned with the possibilities of regulatory arbitrage implied by this first accord. It shows that improperly chosen risk weights induce banks to select inefficient portfolios and to undertake regulatory arbitrage activities which might paradoxically result in increased risk taking.

This article belongs to a strand of the theoretical literature (e.g., Furlong and Keeley 1990; Kim and Santomero 1988; Koehn and Santomero 1980; Thakor 1996) focusing on the distortion of the allocation of the banks' assets that could be generated by the wedge between market assessment of asset risks and its regulatory counterpart in Basel I.

Hellman et al. (2000) argue in favor of reintroducing interest rate ceilings on deposits as a complementary instrument to capital requirements for mitigating moral hazard. By introducing these ceilings, the regulator increases the franchise value of the banks (even if they are not currently binding) which relaxes the moral hazard constraint. Similar ideas are put forward in Caminal and Matutes (2002).

The empirical literature (e.g., Bernanke and Lown (1991); see also Thakor (1996), Jackson et al. (1999), and the references therein) has tried to relate these theoretical arguments to the spectacular (yet apparently transitory) substitution of commercial and industrial loans by investment in government securities in U.S. banks in the early 1990s, shortly after the implementation of the Basel Accord and the Federal Deposit Insurance Corporation Improvement Act (FDICIA).

Hancock et al. (1995) study the dynamic response to shocks in the capital of U.S. banks using a vector autoregressive framework. They show that U.S. banks seem to adjust their capital ratios much faster than they adjust their loan portfolios. Furfine (2001) extends this line of research by building a structural dynamic model of banks' behavior, which is calibrated on data from a panel of large U.S. banks for the period 1990-97. He suggests that the credit crunch cannot be explained by demand effects but rather by the rise in capital requirements and/or the increase in regulatory monitoring. He also uses his calibrated model to simulate the effects of Basel II and suggests that its implementation would not provoke a second credit crunch, given that average risk weights on good quality commercial loans will decrease if Basel II is implemented.

The other two articles in part 4 focus on the reform of the Basel Accord (nicknamed Basel II), which relies on three "pillars": capital adequacy requirements, supervisory review, and market discipline. Yet, as shown in chapter 9, the interaction between these three instruments is far from being clear. The recourse to market discipline is rightly justified by common sense arguments about the increasing complexity of banking activities and the impossibility for banking supervisors to monitor in detail these activities. It is therefore legitimate to encourage monitoring of banks by professional investors and financial analysts as a complement to banking supervision. Similarly, a notion of gradualism in regulatory intervention is introduced (in the spirit of the reform of U.S. banking regulation, following the FDIC Improvement Act of 1991). It is suggested that commercial banks should, under "normal circumstances," maintain economic capital way above the regulatory minimum and that supervisors could intervene if this is not the case. Yet, and somewhat contradictorily, while the proposed reform states very precisely the complex refinements of the risk weights to be used in the computation of this regulatory minimum, it remains silent on the other intervention thresholds.

The third article, chapter 10, written with Jean-Paul Décamps and Benoît Roger, analyzes formally the interaction between the three pillars of Basel II in a dynamic model. It also suggests that regulators should put more emphasis on implementation issues and institutional reforms.

Market Discipline versus Regulatory Intervention Let me conclude this introductory chapter by discussing an important topic that is absent from the papers collected here, namely the respective roles of market discipline and regulatory intervention. Conceptually, market discipline can be used by banking authorities in two different ways:

Direct market discipline, which aims at inducing market investors to influence the behavior of bank managers, and works as a substitute for prudential supervision.

Indirect market discipline, which aims at inducing market investors to monitor the behavior of bank managers, and works as a complement to prudential supervision. The idea is that indirect market discipline provides new, objective information that can be used by supervisors not only to improve their control on problem banks but also to implement prompt corrective action (PCA) measures that limit forbearance.

(Continues...)

---

Excerpted from Why Are There So Many Banking Crises? by Jean-Charles Rochet
Copyright © 2008 by Princeton University Press. Excerpted by permission.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

---

Table of Contents

Preface and Acknowledgments ix
General Introduction and Outline of the Book 1
References 14

PART 1. WHY ARE THERE SO MANY BANKING CRISES? 19

Chapter 1: Why Are There So Many Banking Crises? by Jean-Charles Rochet 21
1.1 Introduction 21
1.2 The Sources of Banking Fragility 23
1.3 The Lender of Last Resort 24
1.4 Deposit Insurance and Solvency Regulations 27
1.5 Lessons from Recent Crises 28
1.6 The Future of Banking Supervision 30
References 33

PART 2. THE LENDER OF LAST RESORT 35

Chapter 2: Coordination Failures and the Lender of Last Resort: Was Bagehot Right After All? by Jean-Charles Rochet and Xavier Vives 37
2.1 Introduction 37
2.2 The Model 41
2.3 Runs and Solvency 44
2.4 Equilibrium of the Investors' Game 47
2.5 Coordination Failure and Prudential Regulation 53
2.6 Coordination Failure and LLR Policy 55
2.7 Endogenizing the Liability Structure and Crisis Resolution 58
2.8 An International LLR 63
2.9 Concluding Remarks 66
References 67

Chapter 3: The Lender of Last Resort: A Twenty-First-Century Approach by Xavier Freixas, Bruno M. Parigi, and Jean-Charles Rochet 71
3.1 Introduction 71
3.2 The Model 75
3.3 Efficient Supervision: Detection and Closure of Insolvent Banks 81
3.4 Efficient Closure 85
3.5 Central Bank Lending 89
3.6 Efficient Allocation in the Presence of Gambling for Resurrection 95
3.7 Policy Implications and Conclusions 97
3.8 Appendix 98
References 101

PART 3. PRUDENTIAL REGULATION AND THE MANAGEMENT OF SYSTEMIC RISK 103

Chapter 4: Macroeconomic Shocks and Banking Supervision by Jean-Charles Rochet 105
4.1 Introduction 105
4.2 A Brief Survey of the Literature 106
4.3 A Simple Model of Prudential Regulation without Macroeconomic Shocks 108
4.4 How to Deal with Macroeconomic Shocks? 112
4.5 Is Market Discipline Useful? 118
4.6 Policy Recommendations for Macroprudential Regulation 121
References 123

Chapter 5: Interbank Lending and Systemic Risk by Jean-Charles Rochet and Jean Tirole 126
5.1 Benchmark: No Interbank Lending 132
5.2 Date-0 Monitoring and Optimal Interbank Loans 139
5.3 Date-1 Monitoring, Too Big to Fail, and Bank Failure Propagations 148
5.4 Conclusion 153
5.5 Appendix: Solution of Program (P) 155
References 157

Chapter 6: Controlling Risk in Payment Systems by Jean-Charles Rochet and Jean Tirole 159
6.1 Taxonomy of Payment Systems 161
6.2 Three Illustrations 166
6.3 An Economic Approach to Payment Systems 173
6.4 Centralization versus Decentralization 181
6.5 An Analytical Framework 184
6.6 Conclusion 191
References 192

Chapter 7: Systemic Risk, Interbank Relations, and the Central Bank by Xavier Freixas, Bruno M. Parigi, and Jean-Charles Rochet 195
7.1 The Model 199
7.2 Pure Coordination Problems 205
7.3 Resiliency and Market Discipline in the Interbank System 207
7.4 Closure-Triggered Contagion Risk 210
7.5 Too-Big-to-Fail and Money Center Banks 213
7.6 Discussions and Conclusions 215
7.7 Appendix: Proof of Proposition 7.1 217
References 222

PART 4. SOLVENCY REGULATIONS 225

Chapter 8: Capital Requirements and the Behavior of Commercial Banks by Jean-Charles Rochet 227
8.1 Introduction 227
8.2 The Model 230
8.3 The Behavior of Banks in the Complete Markets Setup 231
8.4 The Portfolio Model 238
8.5 The Behavior of Banks in the Portfolio Model without Capital Requirements 240
8.6 Introducing Capital Requirements into the Portfolio Model 244
8.7 Introducing Limited Liability into the Portfolio Model 246
8.8 Conclusion 249
8.9 Appendix 250
8.10 An Example of an Increase in the Default Probability Consecutive to the Adoption of the Capital Requirement 256
References 257

Chapter 9: Rebalancing the Three Pillars of Basel II by Jean-Charles Rochet 258
9.1 Introduction 258
9.2 The Three Pillars in the Academic Literature 259
9.3 A Formal Model 260
9.4 Justifying the Minimum Capital Ratio 266
9.5 Market Discipline and Subordinated Debt 268
9.6 Market Discipline and Supervisory Action 269
9.7 Conclusion 272
9.8 Mathematical Appendix 274
References 277

Chapter 10: The Three Pillars of Basel II: Optimizing the Mix by Jean-Paul Décamps, Jean-Charles Rochet, and Benoît Roger 281
10.1 Introduction 281
10.2 Related Literature 284
10.3 The Model 287
10.4 The Justification of Solvency Requirements 292
10.5 Market Discipline 294
10.6 Supervisory Action 298
10.7 Concluding Remarks 302
10.8 Appendix: Proof of Proposition 9.2 303
10.9 Appendix: Optimal Recapitalization by Public Funds Is Infinitesimal (Liquidity Assistance) 303
10.10 Appendix: Proof of Proposition 9.3 304

References 305

What People are Saying About This

Tsomocos

Jean-Charles Rochet is one of the dedicated 'audacious pioneers' who have attempted to dissect with rigor, precision, and creativity some of the most elusive issues of financial (in)stability. It is pleasing to see his work presented in a unified, clear, and well-written form. A testament to his formidable contributions and remarkable insights, this book will guide researchers and students, as well as practitioners, into the future.
— Dimitrios P. Tsomocos, Said Business School, University of Oxford

From the Publisher

"Jean-Charles Rochet is one of the dedicated 'audacious pioneers' who have attempted to dissect with rigor, precision, and creativity some of the most elusive issues of financial (in)stability. It is pleasing to see his work presented in a unified, clear, and well-written form. A testament to his formidable contributions and remarkable insights, this book will guide researchers and students, as well as practitioners, into the future."—Dimitrios P. Tsomocos, Said Business School, University of Oxford

"Why are there so many banking crises? One answer is that so few economists of Jean-Charles Rochet's caliber have worked on the problem. Combining analytical and technical abilities, institutional knowledge, clear writing, and common sense to an outstanding degree, Rochet has produced a book that will benefit everyone who reads it."—Charles Goodhart, London School of Economics and Political Science

"This collection of important papers by Jean-Charles Rochet, one of the leading theoreticians of banking, should generate great interest."—George Kaufman, Loyola University Chicago

George Kaufman

This collection of important papers by Jean-Charles Rochet, one of the leading theoreticians of banking, should generate great interest.
— George Kaufman, Loyola University Chicago

Charles Goodhart

Why are there so many banking crises? One answer is that so few economists of Jean-Charles Rochet's caliber have worked on the problem. Combining analytical and technical abilities, institutional knowledge, clear writing, and common sense to an outstanding degree, Rochet has produced a book that will benefit everyone who reads it.
— Charles Goodhart, London School of Economics and Political Science

Editorial Reviews

"Among economists' explanations are moral hazard, ill-judged capital adequacy rules and the incompetence of supervisors. Jean-Charles Rochet, a leading authority on banking, argues the real problem lies with politicians who too often insist on rescuing insolvent banks for short-term reasons of their own. [W]hatever the verdict on the policy proposals, the book makes interesting reading in current circumstances."—-John Plender, Financial Times

"The book provides an excellent introduction to the theory of banking regulation. . . . I can recommend the book to anyone interested in a formal, academic approach to banking regulation. The concise conclusions of the individual articles provide valuable ideas for changes in banking regulation."—-Bernd Brommundt, Financial Markets and Portfolio Management

From the Publisher

The book provides an excellent introduction to the theory of banking regulation. . . . I can recommend the book to anyone interested in a formal, academic approach to banking regulation. The concise conclusions of the individual articles provide valuable ideas for changes in banking regulation.

Financial Markets and Portfolio Management - Bernd Brommundt

Among economists' explanations are moral hazard, ill-judged capital adequacy rules and the incompetence of supervisors. Jean-Charles Rochet, a leading authority on banking, argues the real problem lies with politicians who too often insist on rescuing insolvent banks for short-term reasons of their own. [W]hatever the verdict on the policy proposals, the book makes interesting reading in current circumstances.

Financial Times - John Plender

The book provides an excellent introduction to the theory of banking regulation. . . . I can recommend the book to anyone interested in a formal, academic approach to banking regulation. The concise conclusions of the individual articles provide valuable ideas for changes in banking regulation.
— Bernd Brommundt

Financial Markets and Portfolio Management

Among economists' explanations are moral hazard, ill-judged capital adequacy rules and the incompetence of supervisors. Jean-Charles Rochet, a leading authority on banking, argues the real problem lies with politicians who too often insist on rescuing insolvent banks for short-term reasons of their own. [W]hatever the verdict on the policy proposals, the book makes interesting reading in current circumstances.
— John Plender

Financial Times