Will Basel III work?
Xavier Vives 22 December 2014
Banking has recently proven much more fragile than expected. This column argues that the Basel III regulatory response overlooks the interactions between different kinds of prudential policies, and the link between prudential policy and competition policy. Capital and liquidity requirements are partially substitutable, so an increase in one requirement should generally be accompanied by a decrease in the other. Increased competitive pressure calls for tighter solvency requirements, whereas increased disclosure requirements or the introduction of public signals may require tighter liquidity requirements.
The recent financial crisis has exposed the failures of regulation. We have witnessed how the three pillars of the Basel II approach – namely capital requirements, supervision, and disclosure and market discipline – have been insufficient to prevent or contain the crisis. Banking has proved much more fragile than expected. Among the problems that have surfaced is the danger of an overexposure to wholesale financing, as demonstrated by the demises of Northern Rock and Bear Stearns.
BASEL III, capital requirements, banking, regulation, financial crisis, liquidity requirements, transparency, Competition policy, state aid, fire sales, financial fragility, coordination failure, moral hazard, contagion, solvency, liquidity, balance sheets, Information, public signals
What about increasing unemployment benefits for the young?
Claudio Michelacci, Hernán Ruffo 18 November 2014
Like any insurance mechanism, unemployment benefits involve a trade-off between risk sharing and moral hazard. Whereas previous studies have concluded that unemployment insurance is close to optimal in the US, this column argues that replacement rates should vary over the life cycle. Young people typically have little means to smooth consumption during a spell of unemployment, while the moral hazard problems are minor – regardless of replacement rates, the young want jobs to improve their lifetime career prospects and to build up human capital.
It is well known that workers suffer when they lose their job and experience an unemployment spell – surveys indicate a sharp decrease in happiness, and average consumption falls by around 20% upon job displacement. And much research has studied how to efficiently insure workers against the risk of unemployment. Like any other insurance mechanism, unemployment insurance involves a trade-off between the gains from providing liquidity and insurance to unemployed workers and the cost of the implicit problem of moral hazard.
unemployment, insurance, happiness, Unemployment insurance, unemployment benefits, moral hazard, replacement rates, human capital, life cycle
Adverse selection and moral hazard in the Japanese public credit guarantee schemes for SMEs
Kuniyoshi Saito, Daisuke Tsuruta 14 November 2014
In Japan, loans with 100% guarantees account for more than half of all loans covered by public credit guarantee schemes, but banks claim that they do not offer loans without sufficient screening and monitoring even if the loans are guaranteed. This column presents evidence of adverse selection and moral hazard in Japanese credit guarantee schemes. The problem is less severe for loans with 80% guarantees.
Credit rationing caused by capital market imperfections is widely seen as an important phenomenon in the loan market, especially for small and medium enterprises (SMEs). Among various ways of alleviating the problem, credit guarantee schemes are one of the most important policy tools in many countries. An economic rationale for such public intervention is that it can enhance efficiency by providing additional funds for SMEs that are in fact healthy but unable to secure enough loans because of the informational gap between lenders and borrowers.
credit rationing, SMEs, credit, public guarantees, Japan, capital markets, asymmetric information, moral hazard, adverse selection, loan guarantees, insurance
Bruno Biais, Jean-Charles Rochet, Paul Woolley 21 August 2014
The Global Crisis has intensified debates over the merits of financial innovation and the optimal size of the financial sector. This column presents a model in which the growth of finance is driven by the development of a financial innovation. The model can help explain the securitised mortgage debacle that triggered the latest crisis, the tech bubble in the late 1990s, and junk bonds in the 1980s. A striking implication of the model is that regulation should be toughest when finance seems most robust and when innovations are waxing strongly.
One of the curiosities of the modern economy is why the finance sector is so large. Economists have only recently sought to document and ponder this phenomenon. Empirically, Greenwood and Scharfstein (2013) find that, in the US, financial services, which accounted for 2.8% of GDP in 1950, made up 8.3% of GDP in 2006.
securitisation, financial crises, moral hazard, asymmetric information, financial innovation, global crisis, bubbles, monitoring, shirking, junk bonds, CDOs, CDSs, ETFs
Lessons for rescuing a SIFI: The Banque de France’s 1889 ‘lifeboat’
Pierre-Cyrille Hautcoeur, Angelo Riva, Eugene N. White 02 July 2014
The key challenge for lenders of last resort is to ameliorate financial crises without encouraging excessive risk-taking. This column discusses the lessons from the Banque de France’s successful handling of the crisis of 1889. Recognising its systemic importance, the Banque provided an emergency loan to the insolvent Comptoir d’Escompte. Banks that shared responsibility for the crisis were forced to guarantee the losses, which were ultimately recouped by large fines – notably on the Comptoir’s board of directors. This appears to have reduced moral hazard – there were no financial crises in France for 25 years.
In the aftermath of the 2008 financial crisis, the Dodd-Frank Act of 2010 set out to limit the authority of the Federal Reserve to rescue insolvent financial institutions. Since 1932, Section 13(3) of the Federal Reserve Act had given the agency the power to lend to “any individual partnership, or corporation” in “unusual and exigent circumstances.” The 2010 Act now compels the Fed to consult with the Secretary of the Treasury before implementing a new lending program.
Economic history Financial markets
Central Banks, financial crises, moral hazard, lender of last resort, bailout, bank runs, SIFIs, central banking, Banque de France
Gambling for resurrection in Iceland
Friðrik Már Baldursson, Richard Portes 06 January 2014
In 2008, Icelandic banks were too big to fail and too big to save. The government’s rescue attempts had devastating systemic consequences in Iceland since – as it turned out – they were too big for the state to rescue. This column discusses research that shows how this was a classic case of banks gambling for resurrection.
The demise of the three large Icelandic banks, just after the fall of Lehman Brothers, was a key event in the spread of the financial crisis. A couple of weeks before its collapse in October 2008, Kaupthing bank announced that the Qatari investor Sheikh Mohammed Bin Khalifa Bin Hamad al-Thani had bought a 5.01% stake. This briefly boosted market confidence in Kaupthing (Financial Times 2008). What market participants did not know was that Kaupthing illegally financed the deal, which was without risk to al-Thani.
Iceland, financial crisis, moral hazard, banking, banks, gambling for resurrection
Joint liability in international lending: A proposal for amending the Treaty of Lisbon
Kaushik Basu, Joseph Stiglitz 02 January 2014
The Eurozone crisis exposed weaknesses in the Eurozone’s design. This column – by Nobelist Joe Stiglitz and World Bank Chief Economist Kaushik Basu – argues that the Eurozone’s financial architecture can be improved by amending the Treaty of Lisbon to permit appropriately structured cross-country liability for sovereign debt incurred by EZ members.
The sovereign debt crisis exposed weaknesses in the Eurozone’s financial architecture that may not have been fully anticipated when the founding treaties of the Eurozone were drafted. Key among these weak spots are the provisions of the Treaty of Lisbon which regulate intergovernmental debt obligations and preclude direct financing of sovereigns by the ECB.
EU institutions International finance
eurozone, Maastricht Treaty, sovereign debt, moral hazard, Lisbon Treaty, Eurozone crisis, no-bailout clause
A game changer: The EU banking recovery and resolution directive
Thomas Huertas, María J Nieto 19 September 2013
To end moral hazard, investors, not taxpayers, should bear the loss associated with bank failures. Recently, the EU took a major step in this direction with the Banking Recovery and Resolution Directive. This column argues that this is a game changer. It assures through the introduction of the bail-in tool that investors, not taxpayers, will primarily bear the cost of bank failures, and it opens the door to resolving banks in a manner that will not significantly disrupt financial markets.
To end moral hazard and “too big to fail”, investors, not taxpayers, should bear the loss associated with bank failures. Recently, ECOFIN took a major step in this direction. It agreed a common position with respect to the Banking Recovery and Resolution Directive. If confirmed in the trialogue with the Commission and the European Parliament, the Directive will:
moral hazard, Too big to fail, banks
Coping with financial crises: Latin American answers to European questions
Eduardo Cavallo, Eduardo Fernandez-Arias 17 October 2012
The Eurozone body politic seems to be slowly learning the lessons for crisis management. This column argues that Latin America’s decades of financial crisis can provide key insights for Europe.
Many peripheral Eurozone countries are suffering from financial and competitiveness problems reminiscent of previous Latin American challenges. The analogy has been noticed many times.
In a recent paper (Cavallo and Fernandez-Arias 2012), we focus on selected areas in which the Latin American experience with crisis and recovery offers useful lessons for today’s European concerns, namely high public debt risk premium, distress in the banking system, sudden stops of capital flows, and low growth and competitiveness.
Latin America, moral hazard, Eurozone crisis
A failsafe way to end the Eurozone crisis
Charles Wyplosz 26 September 2011
Last weekend, Eurozone policymakers were shaken into admitting that something more needs to be done to save the Eurozone and avoid a major crisis that would reverberate around the world. This column proposes a three-step solution to finally end the crisis.
The annual gathering of finance ministers and central bank governors at the IMF/World Bank meetings in Washington seems to have been an epiphany for Eurozone leaders. Finally, there seems to be agreement that their July 2011 agreement was insufficient (Reuters 2011).
In a previous Vox column, I sketched a way of stopping the public debt crisis that is engulfing the Eurozone (Wyplosz 2011). Here I develop this idea into a coherent proposal that, if adopted, would immediately stop the rot.
ECB, moral hazard, Eurozone crisis, EFSF, debt guarantee