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
Hans Gersbach 02 April 2011
When banks failed, the government paid up. But the bankers responsible kept their bonuses from the years of excess. This column argues for “crisis contracts”. Such contracts require that, in the event of a crisis, bank managers forfeit a portion of their past earnings to rescue the banking system.
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).
Financial markets Global crisis International finance
moral hazard, financial regulation, Bankers’ bonuses
Deposit insurance without commitment: Wall Street vs. Main Street
Russell Cooper, Hubert Kempf 18 February 2011
Before the surprising 2007 collapse of Northern Rock, it was taken for granted that bank runs were things of the past. But their return and the modifications of deposit insurance schemes lead many to question the credibility of the government’s commitment. What makes a run on a bank? And when should the government intervene? This column provides some answers.
The events which followed the subprime crisis, which started in August 2007, were shocking news to many economists. Bank runs were back!
Financial markets Global crisis International finance
moral hazard, financial regulation, bank runs
Titian, Veronese, Caravaggio and their rivals: Evidence of competition in the market for altarpieces of the 17th century
Federico Etro 04 November 2010
Looking at the contracts for large oil paintings in Italy (1550-1750), this column finds evidence of strong competition between painters. Contracts were structured to address moral hazard problems, and prices closely reflected demand and supply conditions in an integrated market.
Art is often perceived, and sometimes defined, as handmade work that is valuable independently of its objective features and is the fruit of pure talent and inspiration independent from monetary and contractual incentives. This emphasis on the invaluable is even more pronounced for religious paintings by old masters as Titian, Veronese, or Caravaggio. At the same time, the pricing of a unique art object is often perceived as highly subjective and largely dependent on the tastes, wealth and prestige of buyers, with little regard for factors affecting demand and supply.
Frontiers of economic research Labour markets
Labour Markets, moral hazard, art, paintings, contract theory