Excessive Risk-Taking by Banks

Risk-taking by banks played a critical role in the global crisis and Eurozone crisis. This column introduces a new eReport that focuses on four aspects of excessive risk-taking by banks, highlighting the causes and the cures. The eReport applies the best available theory and data, bringing together the main insights and views that have emerged from the crisis.

For many, the global crisis was caused by the interlinked fragilities that arose in the banking and financial sectors; these themselves were created by mindless deregulation and permissive monetary policy. By the late 2000s, the system was so precarious that shocks from many directions could have triggered the economic conflagration we witnessed.

The actual trigger was the bursting in fall 2007 of the US housing bubble – a bubble that was created by banks’ excessive risk-taking. The hallmark of this risk-taking was the subprime mortgage – for example the infamous loans to NINJA customers (No Income No Job or Assets). But such excessive risk-taking by banks is far from rare. Ireland went bust in 2010 due to risky loans made by national banks; Iceland suffered a similar fate in 2008, and Spain is flirting with a comparable outcome due to excessive risk-taking in property lending by its banks.

CEPR eReport on bank risk-taking

A new eReport released by CEPR – edited by Mathias Dewatripont and Xavier Freixas – explores the origins of excessive risk-taking by banks. The book comprises four substantial chapters (in addition to the introduction that nicely summarises these four and puts the analysis into a broader context).

• Corporate governance, by Hamid Mehran, Alan Morrison, and Joel Shapiro

In principle, banks do what their managers decide and managers, in turn, are controlled by a board of directors. Excessive risk-taking must therefore involve a breakdown in control, or desire on the part of the board to encourage such activity. For example, strategic decisions by managers may be motived by consideration of their own bonuses, short-term stock price movements, or shareholders’ short-run interests (rather than stakeholders’ long-run ones). This line of reasoning directs attention to the structure of financial institutions’ corporate governance as one source of excessively risky behaviour.

Mehran, Morrison, and Shapiro argue that corporate governance may be especially weak due to the multiplicity of stakeholders (insured and uninsured depositors, the deposit insurance company, bond holders, subordinate debt-holders and hybrid securities holders), and the complexity of banks’ operations. Moreover the moral hazard created by the too-big-to-fail situation may have led boards to encourage risk-taking as they knew that big losses would be paid largely by taxpayers rather than stakeholders. The authors also look at banks’ executive compensation schemes and the composition of boards.

• Procyclicality, by Rafael Repullo and Jesus Saurina

The boom-bust cycles in banking are at least in part caused by the procyclical availability of cheap funding and capital. In boom-times, funding is cheap and easy to get; in bust-times it is dear and scarce. This obviously procyclical nature of bank lending in the years before, during, and after the crisis has produced a consensus that banks should face anticyclical capital buffers to both reduce the size of the next boom and mitigate the damage during the next bust. The authors focus on one aspect of this, namely the question of whether and how much additional capital should be required during excessive credit growth phases, and how these excessive credit growth phases are to be identified. They study how the Basel III regulatory framework proposes to tackle the issue and the extent to which the rules accomplish their objectives.

The Basel III countercyclical provisions require higher capital-to-loan ratios when the credit-to-GDP ratio deviates from its trend. Their analysis, however, shows this works the wrong way for a majority of nations; the deviations are negatively correlated with GDP growth. In short, banks that follow the deviation from trend rule may actually be pursuing a procyclical rather than a countercyclical capital policy. The authors propose a simpler rule – the credit growth rate.

• Disclosure, transparency and market discipline, by Xavier Freixas and Christian Laux

Prior to the crisis, market discipline was thought to be the perfect complement to supervision – channelling funds to sound institutions while penalising excessive risk-takers. The crisis has changed that view; most regulators and academics now see market discipline as a weak force. The authors of this chapter consider various theoretical aspects of how imperfections could gum up the information transmission – the key ingredient of market discipline. In addition to systemic problems, the situation worsens during a crisis because both firms and issuers have incentives to hide bad information.

The market’s main sources of information are firms’ financial reports and credit rating agencies and the authors address a number of reproaches levelled at both. On the financial reporting, the use of fair value analysis has come in for strong criticisms as it caused firms to write down asset falls as the markets collapsed with this leading to eroded capital and heightened uncertainty. The authors however argue that fair value is not much to blame as it only affects banks’ trading portfolios and there is substantial discretion for banks to suspend it if the losses are considered temporary. They are more critical when it comes to credit rating agencies, concluding that these profit-maximising firms are in an institutional setting that inadequately deals with conflicts of interests. They call for more regulation of credit rating agencies to redress this.

• The banking resolution regime, by Xavier Freixas and Mathias Dewatripont

The last chapter addresses systems for taking banks into bankruptcy since beliefs about what happens when all goes wrong do affect risk-taking. If distressed bank are bailed out, risk-taking is never too risky for the bank. Banks are bailed out to avoid the high social costs of such failures. The first objective of regulation is therefore to reduce the cost of bankruptcies; this is the main focus of the last chapter.

Banking resolution, according to the authors, should be thought of as a bargaining game between shareholders and regulators. Shareholders want to maximise the value of their shares while regulatory authorities’ main objective is to preserve financial stability at the lowest possible cost. Given this, time plays against the regulatory authority. The authors thus argue for bankruptcy rules that are specially crafted for the banking sector (and different from those applying to non-financial corporations).

The authors also argue that time is of the essence, even with the perfectly efficient bankruptcy procedure. Banks in distress should be quickly closed or quickly bailed out. The chapter’s examination of banking crises in different countries shows great variety in the procedures followed and conclude that theory has no clear-cut recommendations to offer.

Plainly the design of the bank resolution mechanisms is critical. One proposal is to add a layer of capital to prevent future crises, but the authors defend the possibilities opened by contingent capital (like contingent convertibles and capital insurance). They argue that these types of mechanisms would preserve the best characteristics of debt and therefore limit moral hazard. The authors conclude by considering cross-country resolution and the challenges it implies and discuss the recent changes in the European banking resolution framework.

Reference

Dewatripont, Mathias and Xavier Freixas, eds (2012), The Crisis Aftermath: New Regulatory Paradigms, London: Centre for Economic Policy Research.