How insurers differ from banks: Implications for systemic regulation
Christian Thimann 17 October 2014
Having completed the regulatory framework for systemically important banks, the Financial Stability Board is turning to insurance companies. The emerging framework for insurers closely resembles that for banks, culminating in the design and calibration of capital surcharges. This column argues that the contrasting business models and balance sheet structures of insurers and banks – and the different roles of capital, leverage, and risk absorption in the two sectors – mean that the banking model of capital cannot be applied to insurance. Tools other than capital surcharges may be more appropriate to address possible concerns of systemic risk.
Regulation of the insurance industry is entering a new era. The global regulatory community under the auspices of the Financial Stability Board (FSB) is contemplating regulatory standards for insurance groups that it deems to be of systemic importance. Nine insurance groups received this FSB classification in 2013, and the design of systemic regulation for these groups is now in progress.
insurance, reinsurance, banking, financial intermediation, regulation, systemic risk, maturity transformation, BASEL III, investment, capital, capital requirements, bail-in, loss absorption
EU bank deleveraging
Pierluigi Bologna, Arianna Miglietta, Marianna Caccavaio 14 October 2014
Following the financial crisis, European banks have taken steps to revise unsustainable business models by deleveraging. By this metric they have made substantial progress – but this column argues that improper management of the deleveraging process may threaten the recovery. The authors find that equity increases played a much larger role than asset decreases, and recommend increasing the disposal of bad assets.
Ever since the global financial crisis made it apparent that financial institutions had increased their leverage substantially (Figure 1), bank leverage has faced intense scrutiny. In the run-up to the crisis, the ballooning of banks’ balance sheets was primarily driven by both a significant increase in lending activities and an abundance of cheap funding. Many banks expanded dramatically, becoming too highly leveraged and ‘too-big-to-fail’, while at the same time accumulating substantial risks.
EU policies Financial markets Global crisis
deleveraging, leverage ratios, bank-sovereign link, EU banks, banking, credit, Eurozone crisis
Corporate governance of banks: Risk appetite as a pre-commitment mechanism
Patricia Jackson 13 October 2014
Following the Global Crisis the focus has been on how to make banks safer. Capital and liquidity requirements have been tightened, but attention now needs to shift to corporate governance and risk culture. This column argues that in opaque organisations, formal risk-appetite frameworks can provide a pre-commitment mechanism that tightens risk governance, but a focus on the wider risk culture is also important.
Since the Global Crisis the authorities have been focusing on how to make banks safer, with changes to capital and liquidity requirements. Corporate governance of banks and the wider risk culture are also in the frame. Laeven and Ratnovski (2014) look at governance and raise three aspects: better risk management, regulation of pay, and enhanced market discipline. Another lens is to consider the effectiveness of the board and in particular its independence. However, several papers (e.g. Erkens et al. 2012 and Adams 2012) have found that this is negatively related to outcomes in the Crisis.
Financial markets Global crisis
global crisis, banking, capital requirements, liquidity requirements, risk management, corporate governance, Culture
Finance sector wages: explaining their high level and growth
Joanne Lindley, Steven McIntosh 21 September 2014
Individuals who work in the finance sector enjoy a significant wage advantage. This column considers three explanations: rent sharing, skill intensity, and task-biased technological change. The UK evidence suggests that rent sharing is the key. The rising premium could then be due to changes in regulation and the increasing complexity of financial products creating more asymmetric information.
Individuals who work in the finance sector enjoy a significant wage advantage. This wage premium has received increasing attention from researchers following the financial crisis, with focus being put onto wages at the top of the distribution in general, and finance sector wages in particular (see Bell and Van Reenen 2010, 2013 for discussion in the UK context). Policymakers have also targeted this wage premium, with the recent implementation of the Capital Requirements Directive capping bankers’ bonuses at a maximum of one year of salary from 2014.
Financial markets Microeconomic regulation
Bankers’ bonuses, banking, wages, Inequality, UK, regulation, asymmetric information, Executive compensation, Finance, task-biased technological change, ICT
Shadow banking and the economy
Alan Moreira, Alexi Savov 16 September 2014
The prevailing view of shadow banking is that it is all about regulatory arbitrage – evading capital requirements and exploiting ‘too big to fail’. This column focuses instead on the tradeoff between economic growth and financial stability. Shadow banking transforms risky, illiquid assets into securities that are – in good times, at least – treated like money. This alleviates the shortage of safe assets, thereby stimulating growth. However, this process builds up fragility, and can exacerbate the depth of the bust when the liquidity of shadow banking securities evaporates.
Shadow banking, what is it good for? At the epicentre of the global financial crisis, shadow banking has become the focus of intense regulatory scrutiny. All reform proposals implicitly take a stance on its economic value.
According to the prevailing regulatory arbitrage and neglected risks views, it doesn’t have any – shadow banking is about evading capital requirements, exploiting ‘too big to fail’, and marketing risky securities as safe to unwitting investors. The right response is to bring shadow banking into the regulatory and supervisory regime that covers insured banks.
Financial markets Global crisis Macroeconomic policy
shadow banking, banking, financial crisis, global crisis, regulatory arbitrage, liquidity transformation, financial stability, externalities, collateral, business cycle, financial regulation, financial fragility, liquidity, liquidity crunch
Compliance with risk targets – will the Volcker Rule be effective?
Jussi Keppo, Josef Korte 07 September 2014
Four years ago, the Volcker Rule was codified as part of the Dodd–Frank Act in an attempt to separate allegedly risky trading activities from commercial banking. This column presents new evidence finding that those banks most affected by the Volcker Rule have indeed reduced their trading books much more than others. However, there are no corresponding effects on risk-taking – if anything, affected banks take more risks and use their trading accounts less for hedging.
The Volcker Rule, passed as part of the Dodd–Frank Act in July 2010, has been appraised as one of the most important changes to banking regulation since the global financial crisis. By restricting banks’ business models and prohibiting allegedly risky activities, the rule ultimately aims at increasing resolvability and reducing imprudent risk-taking by banks, and therefore at increasing financial stability. This is done by banning banks from proprietary trading and limiting their investments in hedge funds and private equity.
Financial markets Microeconomic regulation
banking, regulation, Volcker rule, Dodd–Frank, banking regulation, proprietary trading, risk, hedging, financial stability
Banks, government bonds, and default: What do the data say?
Nicola Gennaioli, Alberto Martin, Stefano Rossi 19 July 2014
There is growing concern – but little systematic evidence – about the relationship between sovereign default and banking crises. This column documents the link between public default, bank bondholdings, and bank loans. Banks hold many public bonds in normal times (on average 9% of their assets), particularly in less financially developed countries. During sovereign defaults, banks increase their exposure to public bonds – especially large banks, and when expected bond returns are high. At the bank level, bondholdings correlate negatively with subsequent lending during sovereign defaults.
Recent events in Europe have illustrated how government defaults can jeopardise domestic bank stability. Growing concerns of public insolvency since 2010 caused great stress in the European banking sector, which was loaded with Euro-area debt (Andritzky 2012). Problems were particularly severe for banks in troubled countries, which entered the crisis holding a sizeable share of their assets in their governments’ bonds – roughly 5% in Portugal and Spain, 7% in Italy, and 16% in Greece (2010 EU Stress Test).
sovereign debt, financial crises, banking, banks, bonds, sovereign default, credit, bank lending, risk-weighting
Are banks too large?
Lev Ratnovski, Luc Laeven, Hui Tong 31 May 2014
Large banks have grown and become more involved in market-based activities since the late 1990s. This column presents evidence that large banks receive too-big-to-fail subsidies and create systemic risk, whereas economies of scale in banking are modest. Hence, some large banks may be ‘too large’ from a social perspective. Since the optimal bank size is unknown, the best policies are capital surcharges and better bank resolution and governance.
Large banks have grown significantly in size and become more involved in market-based activities since the late 1990s. Figure 1 shows how the balance-sheet size of the world’s largest banks increased two- to four-fold in the ten years prior to the crisis. Figure 2 illustrates how banks shifted from traditional lending towards market-oriented activities.
regulation, economies of scale, bank regulation, banking, Too big to fail, systemic risk, BASEL III, bank resolution, bank capital
Spillovers from systemic bank defaults
Mark Mink, Jakob de Haan 24 May 2014
To date, much uncertainty exists about how large the spillovers would be from the default of a systemically important bank. This column shows evidence that the market values of US and EU banks hardly respond to changes in the default risk of banks that the Financial Stability Board considers globally systemically important (G-SIBs). However, changes in all G-SIBs’ default risk explain a substantial part of changes in bank market values. These findings have implications for financial-crisis management and prevention policies.
Financial-crisis management and prevention policies often focus on mitigating spillovers from the default of systemically important banks. During the recent crisis, governments avoided large bank failures by insuring and purchasing intermediaries’ troubled assets, by providing them with capital injections, and even by outright nationalisations. After the crisis, financial regulators designed additional requirements for those institutions that the Financial Stability Board designated as globally systemically important banks (G-SIBs).
financial stability, spillovers, regulation, banking, banks, systemic risk
The two faces of cross-border banking flows: An investigation into the links between global risk, arms-length funding, and internal capital markets
Dennis Reinhardt, Steven Riddiough 07 May 2014
Cross-border funding between banks collapsed following the bankruptcy of Lehman Brothers, but the withdrawal of funding was not uniform across countries. This column argues that the composition of cross-border bank-to-bank funding can help to explain why. Interbank funding between unrelated banks is particularly vulnerable to global shocks, but intragroup funding between related banks can act as a stabilising force, particularly for advanced economies with a high share of global parent banks. Policymakers should look at disaggregated cross-border bank-to-bank flows, as doing otherwise could result in a misleading assessment of financial stability risks.
Following the collapse of Lehman Brothers in September 2008, global risk spiked and the world witnessed a collapse in cross-border funding between banks. On closer inspection, however, not all countries’ banking systems experienced a withdrawal of cross-border finance. In fact, a number actually enjoyed an inflow of funding from banks overseas (Figure 1).
Figure 1 Cross-border bank-to-bank flows following the collapse of Lehman Brothers
Financial markets International finance
financial stability, banking, Wholesale funding, interbank lending, Cross-border lending, cross-border banking