Crisis contracts

Hans Gersbach, 2 April 2011

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There is anything but a dearth of proposals on how banks and bank-related financial institutions could be more stringently regulated and monitored by the government with a view to avoiding the recurrence of a crippling crisis like the one we have been labouring under for the past two years (e.g. Perotti and Suarez 2011 and Danielsson 2011 on this site). These proposals range from draconian measures (the break-up of major financial institutions, or bank testaments) to the complete overhaul of bank equity regulations.

In this column I introduce “crisis contracts” as an option that extends the existing range of proposals and represents an alternative to direct intervention in financial markets.

Crisis contracts are designed specifically for members of the bank’s management. The nature of a crisis contract is as follows:

  • Definition of a crisis: A crisis occurs when the average equity capital in the banking system (relative to the assets) falls below a critical predefined threshold.
  • When a crisis occurs, the top managers of major or highly interconnected banks contribute a portion of their earnings from the previous years to a rescue fund for the recapitalisation of the banking system.

Such crisis contracts would impose limited liability on the managements of banks for the occurrence of banking crises.

Advantages of crisis contracts

While crisis contracts would only provide a small proportion of the financial resources required to bail out banks in a crisis, they would still have a number of advantages (for the theory see my research, Gersbach (2004, 2009, and 2011).

  • First, they are designed specifically for members of bank management, in other words those people who make crucial decisions. They therefore provide an incentive for bank management members to lessen crisis probability in order to reduce the likelihood of income depletions. Possible upshots might be that an individual bank will hold on to more equity capital, cut down on high-risk investments, and keep out of vulnerable financial relations networks.
  • Second, crisis contracts produce incentives to encourage other financial institutions to behave in a similar way and thus become less crisis-prone. For example, higher collateral might be demanded of other financial institutions if they figure as debtors on the interbank market. Circumspect managers might encourage, or even force, the managements of other banks to be more cautious.
  • Third, banks would step up the intensity with which they investigate systemic risks and the potentialities for reducing them. It would, for instance, seem fair to expect banks to obtain a more detailed picture of the impact of plummeting property prices on credit risks, security prices, and refinancing options. 
  • Fourth, collective responsibility for banks and the obligation for managers to contribute to recapitalisation in the event of a crisis would appeal to ideas of fair play among the general public. If citizens have the impression that the burdens imposed by a crisis are distributed even-handedly, they will be more likely to approve the use of taxpayers’ money to alleviate that crisis.
  • Fifth, crisis contracts would not require state authorities to engage in the extremely difficult, if not impossible, assessment of systemic risks – as is currently being proposed. Nor would there be any reason to attempt the equally difficult identification of the degree to which the business activities of an individual bank exacerbate systemic risks. Of course, crisis contracts would still necessitate an assessment of basic parameters such as the proportion of bank-manager earnings to be paid into the rescue fund in the event of a crisis, or the salient features of the financial institutions for which crisis contracts would be applicable.
  • Sixth, management members of very large banks would automatically make higher contributions to dealing with the crisis because their salaries are normally higher. But there would be no direct interference with the determination of the pay for members of bank managements. It is however to be expected that if crisis contracts were introduced, there would be changes in the pay scales for these managers.

Problem points

Crisis contracts would fundamentally change the responsibilities of a bank’s management. Limited liability for crises represents a modification of the principle whereby the sole obligation of the leadership of a bank is to ensure the welfare of the enterprise. This new constitutive element in the economic system would clearly broaden the interpretation of liability that has evolved in the course of a long legal tradition.

The kind of liability proposed here is collective in nature, so account would be taken of differences in earnings but not of differences in risk behaviour by bank management members. Cautious operators would also have to contribute to the stabilisation fund. While it would be conceivable to make managers with risky bank portfolios forfeit a higher portion of their earnings, this would once again bring up measurement problems, which is precisely what crisis contracts are designed to avoid.

Collective punishment can have undesirable and unintended consequences. In small countries, a single bank might be large enough to trigger a crisis and thus moral hazard might be exacerbated. Moreover, by institutionalising the notion that managers of financial institutions are among the first to blame for financial crises, this may encourage more severe action from politicians and regulators. This reinforces the need to embed crisis contracts into an overall regulatory framework.

Conclusion

Crisis contracts are both a simple and a drastic resource for changing the institutional framework of the financial sector in an economic system. They are unlikely to make all the other measures that have been proposed superfluous, notably the call for a substantial boost in the equity capital base of banks. But crisis contracts do have the potential to become one of the pillars sustaining a new financial system.

References

Acharya. V and M Richardson (eds.) (2009), Restoring Financial Stability: How to Repair a Failed System, Wiley Finance.

Adrian, T and M Brunnermeier (2009), CoVaR, mimeo, Princeton.

Bank of England (2009), The Role of Macroprudential Policy – A Discussion Paper, November.

Borio, C and M Drehmann (2009), "Assessing the Risk of Banking Crises – Revisited", BIS Quarterly Review, March, 29-46.

Danielsson, J (2011), “Risk and Crises”, VoxEU.org, 18 February.

Gersbach, H (2004), “Financial Intermediation with Contingent Contracts and Macroeconomic Risks”, CEPR Discussion Paper 4735.

Gersbach, H (2009), "Insurance against systemic crises: The real contract between society and banks", VoxEU.org, 8 August.

Gersbach, H (2011), “Private Insurance Against Banking Crises?”, CEPR Discussion Paper 7342.

Hellwig, M (2009), "Systemic Risk in the Financial Sector: An Analysis of the Subprime-Mortgage Financial Crisis", De Economist, 157(2):129-207.

Perotti, E and J Suarez (2011), “The Simple Analytics of Systemic Liquidity Risk Regulation”, VoxEU.org, 16 March. 

Topics: Financial markets, Global crisis, International finance
Tags: Bankers’ bonuses, financial regulation, moral hazard

Professor at CER-ETH - Center of Economic Research at ETH Zurich and CEPR Research Fellow