Lecture 3: Deposit Insurance

Deposit insurance or deposit protection is a measure implemented in many countries to protect bank
depositors, in full or in part, from losses caused by a bank's inability to pay its debts when due. Deposit
insurance systems are one component of a financial system safety net that promotes financial stability.

History
• 1924 : First central government sponsored deposit insurance in Czechoslovakia
• 1934: Federal Deposit Insurance in the US
• 2004: 83 countries out of 181 have explicit deposit insurance. The rest have implicit
insurance.

Purpose
• Reduce probability of bank failure, for instance caused by a bank run. (bank run= when
many clients withdraw their money)
o Specifically, reduce bank run on a single bank that can be ill-founded.
o In addition, reduce banks runs involving more banks based on informational spill-
overs that can also be ill-founded.
• Reduce cost of bank failure in the form of
o Losses to depositors, especially small depositors
o Reductions in funding of economic activity
o Losses to government in case of bailouts of distressed banks

• What is special about banks?

o They provide a large share of financing in the economy
o They operate the payment system
o They act as transmitters of monetary policy to the economy. Specifically, the
central bank sets policy interest rate that affects bank lending and hence
economic activity.
o Hence, banking crisis is macroeconomic crisis.

Banking crisis is more costly than failure of other firm of comparable size. Are banks also more
fragile?
• Banks have a high proportion of demandable and other short-term debt. This makes
banks susceptible to bank runs.
• Average maturity of assets tends to be larger than average maturity of liabilities. Loans,
for instance, have a higher maturity than demandable, zero-maturity deposits. Hence,
there is a maturity mismatch.
• This makes bank susceptible (rentan) to ‘fire sales’, i.e. they may have to sell long-
maturity assets quickly at reduced prices.
• Banks have small proportion of cash relative to assets. This may also force banks to sell
illiquid assets on short notice.
• Banks have high leverage. Hence, there is little capital to be depleted before a bank is
bankrupt
Current structure of US deposit insurance
• Both ex ante and ex post deposit insurance premiums.
o Ex ante premium is regular insurance premium
o Ex post premiums: banks that survive have to pay for banks that went under.
o Hence, the US Federal Deposit Insurance Corporation (FDIC) is effectively backed
by the capital of the entire banking industry. If banking system runs out of
capital, then the U.S. Treasury will have to pay.
• Insurance premium is risk-based, i.e. premium depends on riskiness of bank assets.
Risk-based deposit insurance is insurance with premiums that reflect how prudently banks act
when investing their customers' deposits.
• Should premium be risk-based?
o This reduces incentives for banks to take risk. Bank become reluctant to take
risks
• However, risk-based premiums would not be necessary if banks that are losing capital
are closed or sold in time before deposit insurance funds need to be paid out.
o Thus, as important bank risk is regulatory risk, meaning that regulators do not
intervene promptly if a bank is heading towards bankruptcy.
o In the US, regulators have to close or otherwise deal with banks that have
equity-to-assets ratios below 0.02 within 9 months. This is the requirement of
‘prompt and corrective action’.

Deposit insurance in the EU

• In the EU, there is a Deposit Insurance Directive since 1994 that requires countries to
have explicit deposit insurance.
• In the crisis, minimum coverage was increased from Euro 20,000 to Euro 100,000.
• The possibility of ‘co-insurance’ of up to 10% of deposits by depositors was eliminated.

Market discipline
• Market discipline exists if the cost of bank funding reflects the riskiness of a bank’s asset
portfolio. If so, it potentially constrains bank risk taking.
• To illustrate, we first consider a two-period model of how market discipline affects the
asset risk choice of banks.
• A subsequent question will be whether deposit insurance reduces market discipline.

A two period model of market discipline

• Period 1 balance sheet of a bank:

•
• Here, 𝑎 is assets, 𝑙 is liabilities, and 𝑒 is equity. 𝑣 is the value of assets 𝑎 in the second
period. 𝑣 is a random variable on the interval [ 0, ∞ >.
• Payouts to equity and liability holders in the second period are also random:
• 𝑃𝑒 = 𝑣 – 𝑙 if 𝑣 − 𝑙 ≥ 0, 𝑃𝑙 = 𝑙 if 𝑣 − 𝑙 ≥ 0
• 𝑃𝑒 = 0 if 𝑣 − 𝑙 < 0, 𝑃𝑙 = 𝑣 if 𝑣 − 𝑙 < 0
• In the first period, the bank has to select a distributions of 𝑣: 𝑔(𝑣) 𝑜𝑟 𝑓(𝑣)
• They have the same expected value: 𝐸𝑔 (𝑣) = 𝐸𝑓 (𝑣) > 𝑙
• But distribution 𝑓 is relatively risky as it has fatter tails:

•
• Return to liability holders under 2 strategies:

• We can subtract l from all outcomes of v to find:

because in the picture 𝑓(𝑣) > 𝑔(𝑣) for all 𝑣 < 𝑙.

• Thus, liability holders achieve a higher expected return if the bank chooses distribution
𝑔 rather than 𝑓.
• This implies that equity holders prefer 𝑓, as there is fixed pie given by 𝐸(𝑣) to be
divided between liability holders and equity holders.
• Thus

• To compensate liability holders in case distribution 𝑓 (more risky) is chosen, they will
demand a higher interest rate. Hence, they exercise market discipline.
• This eliminates the incentive for the bank to choose distribution 𝑓.
Empirical evidence on market discipline
• Flannery and Sorescu (1996) find that debenture yields (hasil obligasi) reflect a bank’s
default risk as represented by financial ratios based on accounting data.
• Effective market discipline entails that investors monitor banks affecting bank liability
and equity prices, and that these prices affect firm behaviour. Firm behaviour can be
affected in two ways:
o directly, through actions of the firm
o indirectly, through actions of the supervisor

Does deposit insurance reduce market discipline? Basically the answer is YES
• Deposit insurance makes deposit interest rate in theory less dependent on bank risk.
Hence, it potentially undermines market discipline
• Empirical study of the effect of deposit insurance on extent of market discipline by
Demirguc-Kunt and Huizinga (2004).
• Deposit insurance reduces market discipline if it reduces the sensitivity of bank interest
expenses to indicators of bank risk.

•
• We expect:
𝜃 < 0 : higher value of 𝑅𝑖,𝑡−1 means lower risk, reducing interest expenses
𝛿 < 0 : deposit insurance leads to lower interest expenses
𝜑 > 0 : deposit insurance reduces sensitivity of interest expenses to bank risk, implying
less market discipline
• The estimating equation implies:

• If φ > 0, then sensitivity of 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡𝑖,𝑡 to 𝑅𝑖,𝑡−1is reduced if 𝐷𝑗,𝑡 = 1

• Example:

• From regression 1:
o 𝜃 = −0.597
 o 𝛿 = −0.015
o 𝜑 = 0.609
• Hence,

• Thus, there is a reduced sensitivity of interest expenses to the equity variable in case
there is explicit deposit insurance as evidence of lower market discipline.

Does deposit insurance affect market discipline through deposit growth?

• We expect the growth rate of deposits to be higher at a safe bank.
• The sensitivity of deposit growth to bank risk may be reduced by deposit insurance. This
would mean that deposit insurance weakens market discipline.
• Regression equation:

o where 𝐺𝑖,𝑡 is the growth rate of deposits at a bank.

• We expect:
o 𝜃 > 0 : safer banks can attract more deposits
o 𝛿 > 0 : banks subject to deposit insurance can attract more deposits
o 𝜑 < 0 : deposit insurance reduces sensitivity of deposit growth rate to bank risk,
implying less market discipline
o The estimating equation implies:

o If φ < 0, then sensitivity of 𝐺𝑖,𝑡 to 𝑅𝑖,𝑡−1is reduced if 𝐷𝑗,𝑡 = 1

 • Example:

• From Regression 1
o 𝜃 = 1.787
o 𝛿 = 0.114
o 𝜑 = −1.502
• Hence:

• Thus, there is a reduced sensitivity of the deposit growth rate to the equity variable in
case there is explicit deposit insurance as evidence of lower market discipline

How does deposit insurance affect bank stability?

• This is theoretically ambiguous.
• Deposit insurance increases stability as it prevents self-fulfilling bank runs by banks.
• Deposit insurance reduces stability as it potentially reduces market discipline.
• Hence, this is an empirical issue considered by the paper of Demirguc-Kunt and
Detragiache (2002).
• This paper examines:
o 61 countries during 1980-1997
o 40 systemic banking crises
• Definition of systemic crisis: Situation in which significant segments of the banking
system become insolvent and illiquid, and cannot continue to operate without special
assistance from the monetary and supervisory authorities.
• Banking crisis is characterized by
o bank holiday, deposit freezes
o blanket guarantee to depositors and other creditors
o large-scale bank nationalization
• Econometric Model

o
o The authors estimate a multivariate logit model.
o β > 0 implies that explicit deposit insurance makes a crisis more likely
• Example:
 • Thus, explicit deposit insurance increases the probability of a banking crisis. Liat dari
beta nya kalo lebih dari 0 berarti increase

Deposit insurance design feature

• D is a categorical variable to signal explicit deposit insurance.
o Alternatively, it is replaced by a variable that represents not only the existence of
explicit deposit insurance but also the extent of coverage.
• Example: Variable dealing with co-insurance. Co-insurance exists if a certain percentage
of deposits is not covered by deposit insurance:
No coinsurance = 0 if implicit insurance
= 1 if explicit insurance with co-insurance
= 2 if explicit with no co-insurance
• EU Deposit Insurance Directive of 1994 gave countries the choice to have co-insurance
up to 10%
• Example:
 • From regression 1:
o No coinsurance receives a positive estimated coefficient of 0.397
o This suggests that the absence of coinsurance increases the probability of a
banking crisis

Deposit insurance may not reduce financial stability much if there is good bank supervision.
• With good bank supervision, bank is not allowed to pursue risky strategies despite the
presence of deposit insurance.
• Let 𝑄 be quality of supervision, or more generally the quality of legal and other public
institutions in a country.
• Econometric Model:

• This model implies:

 o If β > 0 and γ < 0, then a higher quality of supervision mitigates the positive
relationship between the probability of a crisis and explicit deposit insurance.
• Example:

o In all these regressions, we find β > 0 and γ < 0.

o Thus, a higher quality of institutions, as a proxy for a higher quality of
supervision, is estimated to mitigate the positive relationship between the
probability of a crisis and explicit deposit insurance

Lecture 4: Large Banks: Are They Too Big to Fail or Too Big to Save?
The value of TBTF subsidy to financial institutions
• Claimants to TBTF financial institutions receive transfers from tax payers when
governments are forced into bailouts.
o These claimants can include depositors and bank bondholders.
• Subsidies implicit in bailouts lower funding costs to TBTF institutions
• Implications:
o TBTF institutions have incentive to take on more risk: moral hazard, (krn mereka
lowkey tau kalo ada apa2 bakal di bail-out government, jadi mereka malah
berani buat take more risk unwisely)
o Incentive to be become large and complex, e.g. through M&As
o Distortion of competition with other firms that do not enjoy TBTF subsidy. This
enables TBTF banks to can gain market share and additional profits at the
expense of smaller firms that are not TBTF.

Deposit insurance and wealth effects: The value of being “Too Big To Fail”
• In September 1984, the Comptroller of the Currency testified before Congress that some
banks are simply ‘too big to fail’ and that for those banks total liability insurance would
be provided. This policy would apply to the 11 largest banks, while names were not
given. [Comptroller of the Currency is the head of a U.S bank regulatory agency.]
• Empirical question: Does this provide wealth effects for bank shareholders that are
positive for the top 11 banks, and negative for other smaller banks?

Why positive wealth effects (they feel richer even though they have the same amount of
income beforw) for TBTF banks?
 • Total liability insurance renders bank liabilities riskless. This reduces banks’ cost of
funds. Normally, only $ 100,000 is fully insured by deposit insurance.
• Banks can take on more risk, as their liabilities have become riskless
• Wealth effects could be negative for smaller banks that are not TBTF
• Wealth effects are investigated for sample of 64 banks with stock market listing,
including 11 largest banks.
• Example:

• Most of the largest 11 banks experienced a positive stock return on September 20,
1984. Continental Illinois was already bankrupt at the time, which explains its zero stock
return.
• Positive stock returns of banks on September 20, 1984 could reflect that the overall
stock market went up that day.
• To control for the movement of the overall stock market, we next consider excess stock
returns for banks. i.e. stock returns for banks that are adjusted for the movement of the
overall market.

Excess return analysis

• Daily expected returns for bank 𝑗 at time 𝑡 are estimated in market model of Fama
(1985):

o where 𝑅𝑚,𝑡 is the return for the overall stock market at time t, and where 𝛼 ̂ 𝑗
and 𝛽𝑗 ̂ are estimated for each bank for days -55 to -6 relative to September 20,
1984
• Excess return for bank 𝑗 at time 𝑡:
• Example:

•
• Excess returns are positive on day 0 for Wall Street Journal (WSJ) sample of 10 banks (11
banks excluding Continental Illinois that had gone bankrupt and already had been bailed
out).

Which bank characteristics matter for determining excess return?

• Consider two samples of banks:
o WSJ 10 largest banks
o Other 53 banks
• Two characteristics:
o Size measured as log of assets
o Solvency ratio
!"#$%&'"&()#* ,--%.-/0,.)# 1(%&)2,# 3%4.
o 5""6 7,89% "' -:,&%:"83%&- ! %;9).<
𝑥 100
o This is index for insolvency
• Example:
 •
• Looking at Spearman rank correlation, we see that
o in group of 10 large banks, larger and relatively insolvent banks gained
(0.73330)
o in group of 53 small banks, larger and relatively insolvent banks lost (-0.24133)

How to measure the size of Too Big To Fail subsidy?

• Difficulties regarding measurement:
o There is some uncertainty about any future bailout: ‘constructive ambiguity’
o Beneficiaries are not only bank shareholders, but potentially also bank
customers (loan recipients, depositors), bank bondholders, and bank employees
o Expectation of bailout may change over time
• Measure of subsidy by Ueda and Weder di Mauro (2010): Reduction in interest cost of
bank bonds (pengurangan biaya bunga obligasi bank) that occurs because bank can
obtain state support in case of distress.
• Procedure to estimate this reduction in interest cost:
o Step 1: See how credit rating depends on variable that represents likelihood of
state support. A greater likelihood of support should give rise to a better credit
rating.
o Step 2: Calculate change in credit rating if state support is increased from small
to high.
o Step 3: Translate change in credit rating into change in interest rate on bank
liabilities.
• Step 1 involves rating information. Estimating equation:
 o Where:
§ 𝑅𝑎𝑡𝑖𝑛𝑔𝑠𝑖 ∶ overall credit rating from 1 (best) to 9 (worst): 1 = AAA; 2 =
AA; 3 = A, etc.
§ 𝐹𝑆𝑅𝑖 ∶ bank’s financial strength rating from 1 (best) to 9 (worst).
This is a credit rating in the absence of possibility of state support.
§ 𝐹𝑜𝑟𝑒𝑖𝑔𝑛𝑖 : dummy for a firm having a foreign parent
§ 𝑆𝑢𝑝𝑝𝑜𝑟𝑡𝑖 : state support ranging from 1 to 5, with 1 being the strongest.
This reflects the probability of the state bailing out the bank, conditional
on the bank being in distress.
o Sample: 10 largest banks in G20 countries and in Spain and Switzerland

In regression 1, Support receives positive coefficient of 0.676.

Hence, higher likelihood of state support leads to a better overall credit rating.
*credit rating: A credit rating is an evaluation of the credit risk of a prospective debtor, predicting their
ability to pay back the debt, and an implicit forecast of the likelihood of the debtor defaulting.

• Step 2: Improvement in Support by 4 points, from 5 to 1 would reduce the Ratings

variable by 4 * 0.68 = 2.72 or about 3 notches in 2007.
• Step 3: Assume that state support improves credit rating by 3 notches. Impact on bank
cost of funds:
o 5-8 basis points (bp) for A-rated banks (from A to AAA)
o 23 bp for BBB-rated banks (from BBB to AAA)
o 61 bp for BB-rated banks (from BB to AA)
o 128 bp for B-rated banks (from B to A)
How to deal with existence of TBTF subsidies?
• Public policy responses:
o Corrective taxation
§ Impose tax on bank liabilities equal to the subsidy that would take away
advantage of TBTF institutions
§ Tax on bank liabilities is called bank levy.
§ Tax base would be bank liabilities minus insured deposits.
§ “Tax” on insured deposit is deposit insurance premium
*Examples of liabilities for a bank include mortgage payments for the building, distribution
payments to customers from stock, and interest paid to customers for savings and certificates of
deposit.
o Higher capital requirements for Global Systemically Important Banks (G-SIBs).
§ List of G-SIBs is determined by Financial Stability Board in consultation
with Basel Committee.
§ Criteria: size, interconnectedness, complexity.
§ There are about 30 G-SIBs. The number of banks that is TBTF is much
larger. Hence, higher capital requirements for TBTF banks should also be
imposed by national supervisors beyond the Basel Committee.
• Bank regulation:
o Force large banks to split up or downsize. Alternatively, use merger policy to
prevent the emergence of banks through M&As that are TBTF. In US, the Dodd-
Frank Act of 2010 prevents emergence of a bank that will have more than 10% of
the bank liabilities of all banking institutions in the US.
o Regulation to make splitting up a bank in case of distress easier. “Living will”:
plan for how a large bank is to be split into smaller parts if distress occurs. Ex
ante, there can be organization of the bank into a commercial bank that would
need to be bailed out, and other investment banking arms that can be allowed to
go bankrupt.

Are banks too big to fail or too big to save?

• Too Big To Fail: bank failure creates large negative externalities and government is able
to bail out bank
• Too Big To Save: bank failure creates large negative externalities but government is
unable to bail out bank
• Bank managers have incentive to reach TBTF status, but not TBTS status
• However, the financial crisis of 2008-2009 led to a deterioration of public finances.
Hence, in practice banks may have become TBTS.

Empirical evidence on whether banks are TBTF/TBTS

• Measures of size:
o Absolute bank size: log of assets
!"#$"%"&"'(
o Systemic or relative bank size:
)*+
• We also consider systemic size, as possibly banks only become TBTS if they are big
relative to national economies.
• Example:

o The Liabilities variable measures a bank’s total liabilities relative the GDP of its
country of location.
•
o Note that 13 of these 20 countries are European

•
o Thus, for 85.8% of bank observations the ratio of total bank liabilities to GDP is
less than 0.05, while for 0.9% this ratio exceeds 1.
 •
o This figure shows that the average bank-level ratio of total bank liabilities to GDP
fell sharply in the financial crisis year 2008
• Dependent variables in empirical analysis to determine whether banks are TBTF or TBTS:
o Market value of the bank relative to book value:

This variable reflects the impact of TBTF or TBTS on shareholders.

o Credit Default Swap (CDS) spread
This is insurance against credit losses on bank debt. Seller of CDS contract takes
on an obligation to purchase specified bank liabilities at par (face value) in case
of a credit event. CDS spread gives indication of expected credit losses. This
variable reflects the impact of TBTF or TBTS on bank liability holders.
*A credit default swap (CDS) is a financial derivative or contract that allows an investor to "swap" or offset his or
her credit risk with that of another investor. For example, if a lender is worried that a borrower is going
to default on a loan, the lender could use a CDS to offset or swap that risk.

To swap the risk of default, the lender buys a CDS from another investor who agrees to reimburse the lender in the
case the borrower defaults. Most CDS contracts are maintained via an ongoing premium payment similar to the
regular premiums due on an insurance policy.

• We relate MV/BV and the CDS spread to measures of bank size to test for TBTF or TBTS:
 o Estimating equations:

o If CDS spread declines, this means lower liability insurance premium, and hence
a safer bank.
• Sample:

o Note: The sample includes banks around the world during 1991-2008
o In regression 1, MV/BV is negatively and significantly related to Assets and to
Liabilities (which is bank liabilities relative to GDP): This is evidence consistent
with TBTS.
o In regression 3, MV/BV is negatively and significantly related to Other liabilities
(which is the sum of other banks’ liabilities relative to GDP): This is evidence
consistent with TBTS.
 o In regression 8, the CDS spread is positively and significantly related to Other
liabilities (which is the sum of other banks’ liabilities relative to GDP): This is
evidence consistent with TBTS.
o Thus, the evidence points in the direction banks being TBTS
• Evidence of a negative relationship between MV/BV and bank size suggests that banks
have grown too large.
In particular, bank growth has not been in the interest of bank shareholders.
• Why did banks grow to be so large?
o Executive compensation increases with size
o Prestige and power of bank executive rise with size
• This suggests that the problem is one of corporate governance: how to make sure that
manager does what is in the interest of shareholders.

Lecture 5: International Banking

Key issue:
• Countries may have lower incentives to bail out international banks than purely
domestic banks. This affects the operation of international banks.
• Large financial conglomerates combine various financial functions: i) banks, ii) securities
firms, and iii) insurance.
• Reasons for becoming large and complex:
o Economies of scale
o Economies of scope (benefits of providing diverse products)
o Attempt to become TBTF or Too Complex of Fail (TCTF)

•
 • Hence, Global Systemically Important Banks (G-SIBs) are large (by total assets),
international (by % of foreign assets), and complex (by total subsidiaries and number of
countries).
• Of the 28 G-SIBs, 16 are in Europe, 8 in the US, 3 in Japan and 1 in China

What explains (international) corporate structure of financial firm?

Corporate structure refers to legal organization into parent firm and subsidiaries.
• Informational frictions:
o Regarding information: there may be asymmetric information between
business-line managers and overall managers. By putting some activities in a
separate subsidiary, the parent firm obtains less noisy signal of profitability. This
helps to better reward management and to prevent wasteful expenditure by
managers.
o Also, customers may require information and legal firewalls between activities to
avoid conflict of interest at bank. For instance, if a bank engages in both
underwriting and providing investment advice, then he underwriting customer
may not want its information to be used by the advisory unit of the bank as this
could negatively affect its share price
*In investment banking, underwriting is the process where a bank raises capital for a
client (corporation, institution, or government) from investors in the form of equity or
debt securities. Contohnya kayak sells stocks and bonds to investors in the form of
Initial Public Offering (IPO)
• Regulation directly related to corporate structure: Regulation may dictate a certain
corporate, legal form.
• Three are three main regulatory models
a. Complete Integration: one corporate entity, as in universal banking model

Bank
Underwriting
Insurance
b. Parent bank with non-bank operating subsidiaries

Parent
bank

Under writing Insurance

i.
c. Holding company with bank and non-bank affiliates
 Holding
company

under insurance
bank
writing

This model is dominant in the US

• Cihak (2012) provides information on regulatory models from a survey of 193 countries:
o 93% permit banks to engage in some securities activities, 43% of these impose
some form of corporate separateness
o 83% permit banks to engage in the insurance business, 78% of these impose
some form of corporate separateness

Corporate complexity and the safety and soundness of the financial system
Potential sources of conflict among national supervisors of banks that affect financial
stability:
• International exchange of relevant information: Information may be withheld by one
regulator
• When to intervene: Principal supervisor may wish to postpone intervention if costs of
intervention are primarily domestic. In the US, intervention is required if the ratio of
equity to assets is less than 0.02 by doctrine of ‘prompt and corrective action’.
• Which country’s law and bankruptcy proceedings to use?
• There are possibly different views internationally on whether a bank is systemically
important, and hence needs to be bailed out.
• Who pays for bailout? There is a potential problem of burden sharing

Recapitalization of bank in international context Recapitalization, inject money to increase liquidity of the bank
• Recapitalization carries the benefit of keeping the payments system afloat and the cost
of public bailout moneys.
• In domestic context, the benefits and cost of recapitalization are for a single country.
Then recapitalization decisions will be efficient, i.e. there will be recapitalization if
benefits exceed costs, and only then.
• In international context, benefits of recapitalization are collective, but contributing to
the bailout remains a national cost. Then recapitalization decisions may be inefficient,
because of a coordination problem.
• Contributing to recapitalization is a public good. There may be underprovision of this
public good in an international context.
• Model based on Freixas (2003) in paper on ‘Crisis Management in Europe’
• Domestic setting:
o 𝛩: benefit of recapitalization, i.e. keeping distressed bank afloat
o 𝐶: bailout cost
• Decision:
o Recapitalize if 𝜃 − 𝐶 > 0 (positive)
o Let bank fail if 𝜃 − 𝐶 < 0 (negative)
o Decision is efficient

• International setting with n countries

o Let θ and C be collective benefit and cost of recapitalization
o 𝜃𝑗 : benefit for country

o 𝑃𝑗 : contribution by country j towards cost

o Let us assume
1. 𝜃 − 𝐶 > 0
This means that recapitalization is collectively efficient
2. 𝜃𝑗 − 𝐶 < 0 for all 𝑗
No country can benefit from recapitalizing the bank individually.
o Will bank be recapitalized? For this we need two condition to be satisfied:
i. 𝑃 = 𝐶 [sufficient contributions]
ii. 𝜃𝑗 ≥ 𝑃𝑗 [each country benefits from recapitalization]
o Can recapitalization be a non-cooperative equilibrium?
§ Consider that countries apply the following payment rule:

Each country now gains. Specifically, the gain for country j is

=
Hence, each country gets a share # of the collective gains 𝜃 − 𝐶 from
recapitalization. This means that condition ii) is satisfied, each countries
benefits from recapitalization
§ Are aggregate payments sufficient?
 Yes, aggregate payments are sufficient. Hence, condition i) is satisfied,
§Thus, payments according to the given payment rule can be
noncooperative equilibrium outcome. It is rational for country 𝑗 to apply
this rule if all other countries are doing this.
§ Recapitalization occurs even though countries do not explicitly
cooperate. They just believe (correctly) that other countries make
payments according to the given rule.
o Can absence of recapitalization also be an equilibrium?
§ In particular, can 𝑃𝑗 = 0 for all 𝑗 be noncooperative equilibrium?
§ 𝑃> = 0 is optimal policy for country 𝑗 given 𝑃?> = 0 for other countries than
country 𝑗. –
§ This reflects that country 𝑗 will not recapitalize the bank by itself given
that no other country contributes.
§ Hence, there are multiple equilibria, as both recapitalization and no
recapitalization can be equilibria.

Is the financial safety net a barrier to cross-border banking?

In banking,' safety nets' refer to government guarantees provided to depositors and sometimes to all
bank creditors. ... Because they do not fear losing their funds, depositors and possibly other creditors do
not monitor banks as carefully as otherwise
• This is the case if a generous bailout of international banks is less likely on account of
international supervision and the need to coordinate internationally to bail out an
international bank.
• This can imply that international banks face a higher cost of funds.
• This is an empirical issue to be explored.
)#.%&%-. %@$%#-%-
• Variable of interest: 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 = )#.%&%-. 4%,&)#* 8),4)8).)%-
• Indices of Internationalization
o Foreign liabilities share: Ratio of the sum of all foreign subsidiaries’ liabilities
(weighted by the parent bank’s subsidiary ownership share) to the consolidated
liabilities of the parent firm.
o Concentration: Herfindahl index of liability concentration internationally given by

where 𝑠) is the liability share in country i:

𝐶𝑂𝑁 = 1 for domestic bank

𝐶𝑂𝑁 < 1for international bank
• Example
 This graph shows data for banks that have at least one foreign subsidiary. For these
banks, the mean foreign liabilities share is 5.4%

The mean value of the liability concentration variable is 0.966. Thus, most banks have
liabilities in only 1 or very few countries
• Estimating equation to examine the impact of the foreign liabilities share (FLS) on
interest expenses:

o For bank I in country j at time t

 § 𝑃𝑟𝑜𝑓𝑖𝑡)>.?= : the ratio of profits to assets, lagged one period
§ 𝐵𝑎𝑛𝑘)>. : set of bank-level variables including lagged profit
§ 𝐶𝑜𝑢𝑛𝑡𝑟𝑦)>. : set of country-level variables
o A firm with low profits is more likely to experience distress and to need to
access the financial safety net.
o Specifically, the estimating equation implies:

o We expect to find:
§ 𝛽1 > 0 , as more international banks (measured by a higher FLS) may
need to pay higher interest rates as the prospect of a bailout is less
certain.
§ 𝛽2 < 0 , as more profitable banks are less likely to require a bailout.
Hence, the relation between interest expenses and the degree of bank
internationalization is expected to be weaker for more profitable banks.
• Alternatively, we can replace FLS by CON in the estimating equation to get:

o Note that

o We expect to find:
§ 𝛽1 < 0 , as more international banks (measured by a lower CON) may
need to pay higher interest rates as the prospect of a bailout is less
certain
§ 𝛽2 > 0 , as more profitable banks are less likely to require a bailout.
Hence, the relation between interest expenses and the degree of bank
internationalization is expected to be weaker for more profitable banks.
•
o In regression 2 including FLS, we find 𝛽1 = 0.042 > 0 and 𝛽2 -1.740 < 0 (ini yg
lagged). This provides evidence that banks with a high foreign liabilities share
have higher interest expenses, especially if they have lower profitability.
o In regression 4 including Concentration (CON), we find 𝛽1 = −0.021 < 0 and 𝛽2 =
0.882 > 0 (lagged). This provides evidence that banks with a high foreign
liabilities concentration have lower interest expenses, especially if they have
lower profitability.
o Overall, the evidence suggests that more international banks face higher
interest expenses, consistent with reduced chances of generous bailouts for
these banks.
• World GDP growth rate is index of global economic health. This can substitute for the
profits rate as an index of bank-level financial health.
o Estimating equation:

where 𝑊𝐺𝑅𝑡 is the rate of growth of world GDP in year t.

o The estimating equation implies:

o We expect to find:
 § 𝛽1 > 0 , as more international banks (measured by a higher FLS) may
need to pay higher interest rates as the prospect of a bailout is less
certain.
§ 𝛽2 < 0 , as more profitable banks are less likely to require a bailout. Banks
tend to be more profitable at times of high world GDP growth. Hence, the
relation between interest expenses and the degree of bank
internationalization is expected to be weaker at times of high world GDP
growth.
• Example

This figure shows that international banks faced only slightly higher interest expenses
than domestic banks in years such as 2000 and 2006-2007 of high world GDP growth.
The year 2000 preceded the bursting of the internet stock market bubble in 2001, and
the years 2006-2007 preceded the financial crisis of 2008-2009
• Interaction of the foreign liabilities share with world GDP growth

The interaction of the foreign liabilities share with world GDP growth receives a negative
coefficient of -0.944. This implies that interest expenses rise less with the foreign
liabilities share at times of higher world GDP growth.
 • A country is more likely to be able to bail out a bank if it has plentiful public resources.
o This is more likely to be the case if the country experiences a fiscal balance
surplus.
o To consider this, we construct the Fiscal balance variable which is given by the
ratio of the fiscal balance to GDP.
• To consider the role of the Fiscal balance variable, we split the sample into two
subsamples with:
i. Fiscal balance > 0 (there is a fiscal surplus)
ii. Fiscal balance < 0 (there is a fiscal deficit).
• We expect the relation between a bank’s interest expenses and its degree of
internationalization to be weaker if the fiscal balance is positive, as then a country may
have sufficient resources to bail out all banks, including international banks.
• Example: Sample split for interest expense regressions by fiscal balance

o In case there is a fiscal deficit, we see that a bank’s interest expenses are
positively related to the foreign liabilities share (in regression 3) 0.032, and
negatively to Concentration (in regression 4) -0.026.
o This shows that bank internationalization has a more positive impact on
interest expenses in countries experiencing a fiscal deficit.
Conclusion
• International banks have relatively high interest expenses.
• Depositors exercise market discipline on especially international banks.
• This suggests that the financial safety discriminates against international banks, which
are then at a competitive disadvantage.
• Possible solution: Bailout decisions can be taken at an international level. This is the
case in the euro area after the establishment of the Single Resolution Mechanism.
(SRM)
Lecture 6: Financial Sector Taxation
In 2010, the IMF published a report entitled: ‘A Fair and Substantial Contribution by the
Financial Sector’ Objectives:
• To ensure domestic financial institutions bear the burden (menanggung beban) of any
extraordinary government interventions fairly and efficiently. Efficiently means without
endangering real economy. Fairly means that beneficiaries of prior bailouts should pay
the most. It means that banks are asked to pay higher bailout by higher taxation.
• To address banks’ excessive risks today (for instance, through overleveraging) to reduce
the probability and costliness of crises.

Public support provided and measures to recover it in recent crisis: money from taxation can be
used for
• Capital injections
• Lending to banks by treasuries, the ministry provide loans
• Asset purchases and protection schemes.
o For instance, the government can sell put for certain bank assets to banks with a
particular exercise price
• Guarantees of bank liabilities,
• Provision of liquidity and other support by central banks, central banks lend money to
commercial banks
• Expanded deposit insurance (coverage increased from € 20,000 to €100,000 in the EU
after the crisis), $250,000 (US)

Cost of Direct support consist of capital injections, purchase of assets, and lending by the
treasury
Taxation and regulation to address adverse (negative) externalities from the financial sector in
case of bank failure
• In a simple textbook world, tax and regulations could be equivalent. Consider the
problem of capital adequacy:

• , A asset, L liabilities, C capital, Capital adequacy:

minimal amount of capital relatively to asset, gamma (minimum capital ratio)
• This can be achieved by:
o Tax τ with revenues τL. If L depends negatively on τ (tax rates), then the tax rate
should be set at a level 𝜏∗ so that

for a given value of A.

Revenue would be 𝑅 = 𝜏∗ 𝐿(𝜏∗ ).
o Alternatively, there can be regulation to set 𝐶/𝐴 ≥ 𝛾 combined with a lump sum
tax T equal to T = 𝜏∗ 𝐿(𝜏∗).
o Theoretically, these two approaches can be equivalent.
However, there tend to be differences in practice.

How taxation and regulation can be different

• If regulation is not accompanied by lump sum taxation, then buffer is accumulating in
the banking sector, not the public sector.
A lump-sum tax is a special way of taxation, based on a fixed amount, rather than on the real
circumstance of the taxed entity. In contrast with a per unit tax, lump-sum tax does not increase in
size as the output increases
• The role of uncertainty: if u allow Taxation, bank have wider room to respond. For
instance, if a great investment opportunity arises for a bank, then the bank could
temporarily borrow funds in case of a taxation regime to customer, increasing leverage
(temporarily) for a given capital stock C. This is not possible in case of capital
regulation. Taxation allow flexibility in raising funding and temporarily reduce the
actual capitalization of the bank
• Institutional considerations
o Regulation (capital) can be made dependent on ‘soft’ information, e.g. on
riskiness of loan portfolio. In reality, capital regulation dependent on asset risk.
 o Regulation provides for possibly more discretion (keleluasaan) to the supervisors
in terms of applying the regulation, which can give rise to regulatory capture.

New tax instrument proposed:

• Bank levies: taxes on bank liabilities,
• Financial Transactions Taxes (FTTs), e.g. tax on equity transactions, tax in financial
instruments
• Financial Activities Tax (FAT): tax on combined profits and wage bill in financial sector

Bank Levies
• Purposes: cover net fiscal cost of direct public support (bailouts), and help reduce
excessive risk taking (generate new revenue).
• Revenue (if it paid to government) could go into special fund. In that case, the bank levy
could lead to moral hazard, if fund is seen to make future bailouts more likely., bcs they
are guaranteed bank tend to start taking more risk unwisely
• Base of levy would be balance sheet measure. It could be broad measure of liabilities of
a bank, giving rise to a relatively low rate.
• To be excluded from the tax (bank levy) base:
o Equity, to encourage capital
o Insured deposits, to avoid double taxation
o Intracompany debt to bcs we want the bank levy to be neutral to company
structure. Equivalently, just liabilities of consolidated firm could be taxed.
• Alternatively, tax base could be risky component of funding such as
o Wholesale funding (short-term funding from capital market), risky funding for
banks
o Foreign funding
Disadvantage: narrow base requires high rate, which can lead to distortions
• Rate of the levy
o Could depend on risk of the institution
o How high should the rate be?
The ratio of liabilities to GDP can be taken to be (equal to 2 times) 2. With a rate of
0.1%, revenues will be 0.2% of GDP per year. After 10 years, revenue will be 2% of
GDP, and after 20 years 4% of GDP. This corresponds to the cost of a crisis, which
tends to be in the 2-4% of GDP range.

Financial Transaction Taxes (FTTs)

Tax on the sale and/or purchase of a security like stocks and bonds
• Examples:
o Currency transactions tax (Tobin tax) -> Tobin the one who proposed the tax
o Capital levy for businesses
o Bank transactions tax, people who use bank account debit
o Securities transactions tax (STT) covering transactions in debt, equity and their
derivatives.
 • A securities transactions tax (STT) could generate substantial revenue, relatively easy to
collect
A tax of 1 basis point if levied globally on stock, bond and derivative transactions could
raise $ 200 billion annually. This tax is easy to collect if collection is through central
clearing mechanisms.
• Is an FTT a good tax to meet the general objectives of increased financial taxation?
o FTT is not the best way to finance a resolution mechanism, as there is no clear
connection between trading volume and a bank’s need to rely on the financial
safety net.
o Specifically, FTT does not target determinants of financial risk such as size,
interconnectedness, and financial firm leverage.
o FTT may be easy to avoid by doing transactions abroad or by financial
engineering.
o The incidence of an FTT is unclear. Is it on holders of securities such as equities?
The problem with FTT
It can harm the individuals investors such as in their retirement savings, education savings
because it could add up quickly, why? Because can be levied multiple times on every
investments. Some people says that FTT isn’t worth the cost.

Financial Activities Tax (FAT)

• Tax base is the sum of profits and labour remuneration of banks
• This tax base corresponds to the value added in the financial sector. Hence, the FAT
could correct for the exemption of financial services from VAT.
• A FAT does not directly distort transactions of financial firms, as transactions are (not
targeted with this tax) discouraged. Generally, profits from various activities are taxed
equally.
• Could raise significant revenue at relatively low rate.
• FAT should help to reduce the size of the financial sector

In 2011, the European Commission proposed a directive for a common system of financial
transactions tax.
• With EU-wide tax rate of 0.1% on bond and equity transactions and a rate of 0.01% on
derivative transactions
• Estimated revenue per year is € 57 billion,
• Proposal was for revenue to be divided between EU and member states
• Proposal was not accepted by member states
• 2013 new proposal, not all eu countries participate only 11 countries

FAT does not exist

• This makes it difficult to see what would be its impact on banking. To get some idea, one
can study the impact of the corporate income tax on banking. The corporate income
tax is similar: it taxes profits (but not wages). A study of the impact of the corporate
income tax on banking has the advantage that there is a lot of variation in corporate tax
rates internationally. Corporate tax generally depends both on:
 o Parent country
o Subsidiary country

Empirical evidence on international taxation and cross border banking (FAT)

• Cross-border banks can be subject to discriminatory taxation
o Non-resident dividend withholding tax in the subsidiary country
o Corporate income tax on repatriated dividends in the parent country
• This may affect performance and structure of international banking market:
o Performance: interest spreads (differences between lending and deposit rates)
o Structure: volume of international banking activity, in particular FDI in banking.

International Taxation
• Tax rate variables:
o 𝑡𝑖 is the corporate tax in subsidiary country i
o 𝑡𝑝 is the corporate tax in parent country i
o 𝑤𝑖 is the non-resident withholding tax in subsidiary country i on income
repatriated to country p
o Let 𝜏𝑖𝑝 𝜏)$ be additional international tax.
𝜏)$ = [total tax on income flowing from country i to country p] – 𝑡)
• Calculation of additional international tax depends on the pertinent convention of
double tax relief.
• Examples of double tax relief conventions:
 •

Summary statistic for foreign ownership of banks by country of residence

•
The national share of foreign ownership is the share of the assets of foreign-owned
banks in total assets of banks located in a country.
Mean values of tax related variables for banks by country of residence

• Host country corporate tax is corporate income tax rate in the bank’s country of
residence. Dividend double tax is the double tax rate on repatriated dividend income

Impact of additional tax on bank interest margin

• Bank that is subject to taxation tries to pass the burden of taxation on to its customers
• This could mean:
o Lower deposit interest rate
o Higher lending interest rate
• Both increase net interest income of the bank
• Measure of the bank interest margin:

This variable has a mean of 2.8%.

• Sensitivity of this margin reflects the extent to which taxation is passed on to bank
customers.
• Estimating equation

Estimate of 𝛽 is 0.035 F

Result of net interest revenue regression

• What is the implied incidence of higher international tax on bank and on bank
customers?
• Additional variables:
o n: net-of-tax, net interest margin
o b: pre-tax, gross net interest margin
o t: total corporate tax, including the international double tax 𝜏)$
o r : tax revenue per dollar of lending and depositing
 •
Impact of additional international tax on FDI (foreign direct investment) in banking
• Does taxation of banks lead to reduction in activity of affected firms?
• This would be evidence that taxation not only affects the pricing of financial services,
but also distorts the volume of activity
• Relevant volume of activity in case of international taxation is FDI in financial services
• A measure of FDI: Volume of total assets of foreign-owned banks (with majority foreign
ownership) on bilateral basis for any two countries.
• Regression analysis yields the result that the semi-elasticity of 𝐹𝐷𝐼AB with respect to 𝜏𝑖𝑝,

i.e. is estimated to be -7.191. Interpretation: if 𝜏)$ goes up by 1%, then

of 𝐹𝐷𝐼AB goes down by 7.2%.
• Hence, financial sector taxation is potentially highly distortive, as it reduces the taxed
activity sharply in case of international double taxation.
• Similarly, to corporate income taxation, an FAT is potentially also mostly borne
(ditanggung) by banking customers and it could significantly reduce financial activity.

Lecture 7: Integration of Banks and Markets,

Accelerating Integration
• Literature overview by Boot and Thakor (2015),
• Deregulation (less rules) and liberalization (provide more opportunities) of the
financial sector
• Interbank competition (banks competition for customers) within domestic markets as
well as across national borders
• Competition for banks from financial markets (bonds and stocks, derivatives)
• Transformation of boundary between financial institutions and markets (starting to
compete with respect of their products offered)
Intertwined (Terjalin) Nature
• Increasingly intertwined nature of banks and financial markets
• Financial crisis of 2007(bank stop lending money to each other)-2009 shows that
systemic risks may have become more prevalent (more common)
*Systemic risk refers to the risk of a breakdown of an entire system rather than simply the
failure of individual part.
• Potential complementarities and conflicts of interest between intermediated
relationship banking activities (lending money to cust) and financial market activities
(issue of bond stocks, transferring risk) (such as securitization (selling portfolio of loans
to other parties it means the risk is transferred) and underwriting (guarantee))
• Multiple dimensions of bank dependence on markets generate both risk reduction and
risk elevation possibilities (for financing/transfer risk, create opportunities of reduction
or increase)
• Hedging can reduce risk, for like different currencies. A hedge is an investment that is
made with the intention of reducing the risk of adverse price movements in an asset.
Normally, a hedge consists of taking an offsetting or opposite position in a related
security.
• Proprietary trading (bank buy stock on balance sheet), liquidity guarantees for
securitized debt and positions in credit default swaps CDS (assume some of the credit
risk linked to a portfolio) can increase risk
• Increasing interactions between banks and markets affect financial system fragility
(vulnerable), increase the chance to unlikely event/crisis

Banks as Information Processing Intermediaries, to make risky loans they have to make
judgement from their customer information
• Banks absorb risk to transform liquidity and credit risk characteristics of assets
(qualitative asset transformation)
• Banks invest in illiquid loans (loans for a house for like 30 years) and finance them with
liquid demandable deposits
• Banks invest in risky loans (loans after recession) but finance them with riskless deposits
(there’s deposit insurance to reduce the risk)

Bank Lending vs Direct Funding by Financial Markets

• Insight of modern financial intermediation theory: banks are better than markets at
resolving informational asymmetries
• Banks have a closer proximity to and better information on borrowers
• Borrowers may reveal proprietary information to banks but not to markets (stock
market)
• Banks may have better incentives to invest in information acquisition and a banking
relationship

Relationship Banking
 • Substantial contractual flexibility based on the generation of hard and soft proprietary
information during a banking relationship
• Write discretionary contracts ex ante (before the law created) that leave room for ex
post adjustments
• Timely intervention: when the bank loan has sufficiently high priority, the bank could
threaten to call back the loan

Lending by Financial Markets

• Bondholders are subject to more severe information asymmetries; they know less about
the company to which they lend money
• Bondholders are generally more dispersed, there are thousands of bondholders
• Bondholders, therefore, are ill-suited for an early intervention task (time intervention)

Relationship Banking and Competition

• Competition may encourage borrowers to switch to other banks, shortening the
expected lifespan of the relationship and reducing banks’ incentives to invest in it, if the
lifespan is long, this cost compensated
• Competition may elevate the importance of a relationship-orientation as a distinct
competitive edge,
• Orientation of relationship banking adapts to competition so higher competition does
not drive out relationship banking

Competition between Banking and Markets

• Banks and markets compete at the expense of each other (Europe is more bank-based
and the US more market-based)
• Still, potential complementarities between bank lending and capital market funding
• Prioritized bank debt may facilitate timely intervention (also valuable to bondholders)
• Increasing importance of securitization: assets are removed from a bank’s balance sheet

Bank as Liquidity Creators

• Banks make loans (illiquid assets) but finance themselves largely with highly liquid
demand deposits (deposit yang bisa di withdraw kapan aja oleh depositornya), thereby
creating liquidity in the economy
• Banks expose themselves to withdrawal risk and become fragile (bank run on Northern
Rock in September 2007)
• Also, problems on interbank market led to LOLR (Lender of last resort) liquidity support
by central banks as from August 2007

Implication of Integration
• Greater competition is inducing banks to follow their customers to the capital market.
Providing Risk mitigation products like liquidity guarantee, underwriting, for their own
risk management too,
• Banks themselves are using the financial market increasingly for their own risk
management example CDS credit default swap, securitization
 • More difficult to isolate banking risks from financial market risks, become active on
capital market
• Bail out of uninsured investors, thereby increasing moral hazard

Securitization,
• Prior to 2007-2009 crisis banks securitized an increasingly wide range of assets, such as
mortgage loans, take (grant) hundreds of mortgage loans and sell them to financial
markets
• Changing role of banks from “originate and hold” to “originate, repackage and sell”

Credit Risk Transfer

• Not only securitization, but also other credit risk transfer techniques have expanded
tremendously, such as credit default swaps
• Globalization of financial markets
• Improvements in information technology, make process faster
• Sophisticated pricing models
• Wider trend of financial innovation toward commodization and trading of credit risk

Traditional Securitization
• Pooling of credit risky assets, such as residential mortgage loans
• Subsequent sale to special purpose vehicle
• SPV issues securities
*Special Purpose Vehicles Work. The SPV itself acts as an affiliate of a parent corporation,
which sells assets off of its own balance sheet to the SPV. The SPV becomes an indirect
source of financing for the original corporation by attracting independent equity investors to
help purchase debt obligations.
• Securities are sold to investors where the principal and interest depend on the cash
flows produced by the pool of underlying financial assets (MBS)

Motivations for Securitization

• Securitization grew in Europe and the US from around $ 550 billion in 2000 to more than
$ 2,800 billion in 2006
• For originators (banks or lenders): raise funding, reduce financing costs, and diversify
sources of financing
• For investors: pooling of assets generates diversification benefits which cannot be
obtained via outright loans sales or syndication of loans

Financial Crisis 2007-2009, mostly bcs of housing loans

• Incentive problems
• Investors’ overreliance on credit ratings
• Increased levels of complexity and opacity, and related valuation difficulties
• Crisis started with strongly rising delinquencies in US subprime mortgage markets which
led to concern about the valuation of all credit transfer instruments
• General repricing of credit risk,
Lecture 8: Market Discipline, correction provided by market
Restoring Confidence in The Banking System
• Substantial increase of bank capital requirements (Basel 3), how much capital bank need
to have sufficient liquidity
• Contingent capital as a bail-in mechanism (helped by internal system of the bank)
• Resolution schemes: impose losses on bond holders through prompt corrective action
schemes, get equity by issuing shares and stocks, by retaining profits
• Longer-term compensation schemes

Evolution of Bank Capital/Asset Ratios (1874-2001)

f
Evolution of Non-Financial Capital/Asset Ratios (1978-2002)
Reduction in Bank Capital/Asset Ratios
• Moral hazard in the banking system due to existence of explicit and implicit guarantees
(too big to fail), too costly to let big banks fail, may create losses to other banks, millions
accounts will lose their access to their money or debt, government need to rescue the
bank, it will create expectation to the investor, like will be rescued by government, new
equity capital will be injected, for the bondholder higher equity capital buffer enable
bank to guarantee losses
• Perverse incentives for taking more risk and reducing bank capital
• Bond holders have no incentive for proper risk monitoring and disciplining of the bank
• Short-term bonus schemes

Market Discipline
Market discipline is the onus (tanggung jawab) on banks, financial institutions, sovereigns, and
other major players in the financial industry to conduct business while considering the risks to
their stakeholders. Market discipline is a market-based promotion of the transparency and
disclosure of the risks associated with a business or entity. It works in concert with regulatory
systems to increase the safety and soundness of the market.
https://www.investopedia.com/terms/m/market-discipline.asp
• Flannery: market discipline entails two components, namely monitoring and influencing
• First, if investors accurately monitor their bank’s condition, security prices and the
bank’s liability choices will reflect that market information
• Second, investors’ reactions to a bank’s credit developments must influence how the
firm behaves
• if bank taking too much risk and bank equity capital ratio does not increase the investors
will require higher risk premium on their debt means higher discount rate and higher
market price
Through the support of disclosures and clear financial reporting systems, market discipline
increases the information available to the public and encourages the release of timely data on a
company's assets, liabilities, income, net profit or loss, cash flows, and other financial
information. In addition, qualitative information surrounding a company’s goals, management,
and any legal pressures also becomes more readily available. This data helps reduce
uncertainty, increase accountability, and promote the function of the market as an exchange
between lenders and borrowers.

An example of market discipline is public support for raising capital requirements. Banks and
other depository institutions must have liquidity for a certain level of assets. While regulatory
agencies like the Bank for International Settlements, the Federal Deposit Insurance Corporation
(FDIC) or the Federal Reserve Board set standards for capital requirements, market discipline
pushes banks to uphold and even expand them. In turn, this can increase the public’s confidence
in their banks.

Market Discipline and Government Guarantees

Market discipline requires that both depositors have access to information on bank risk and
anticipate bearing cost in the event of bank insolvency.
• Explicit deposit insurance and implicit guarantees distort market discipline
• Insured banks’ funding basosts do not fully reflect their risk exposures
• Shareholders may go for short-term upside potential
• Proposals for contingent capital and bail-in debt intend to increase market discipline
• Bank supervisors can use market information as a second information channel

Relatively High Capital

• Relatively high regulatory capital requirement
• Increase buffers which can absorb unexpected losses before taxpayer has to intervene
• Higher buffers will decrease moral hazard in the banking system
A capital buffer are required reserves held by financial institutions put in place by regulators.
Capital buffers were mandated under the Basel III regulatory reforms, which were implemented
following the 2007-2008 financial crisis. Capital buffers help to ensure a more resilient global
banking system.

Basel 1 (1988)
• Capital requirements for assets divided into credit risk buckets
• Also capital requirements for off-balance sheet (OBS) exposures
• OBS exposures are converted into on-balance sheet credit equivalents
• Guarantees for securities issued by special purpose vehicles (SPV) investing in subprime
mortgage loans

Basel 2 (2004)
• Basel 2 addresses regulatory capital arbitrage problem of Basel 1
• Increased risk differentiation by allowing banks to design internal ratings based systems
• Potentially perverse incentives for underestimating, deliberately or undeliberately,
credit risk profile and capital need
 • Lack of market discipline as a counterbalance

From Basel 2 to Basel 3

• Basel 2 was implemented in Europe early 2008 when the financial crisis had already
started
• The global meltdown after Lehman Brothers made clear that bank capital levels had
been inadequate
• Basel Committee on the course of a substantial increase of bank capital

Basel 3 (2010)
Basel III introduced new requirements with respect to regulatory capital with which large banks
can endure cyclical changes on their balance sheets. During periods of credit expansion, banks
must set aside additional capital. During times of credit contraction, capital requirements can be
relaxed.

The new guidelines also introduced the bucketing method, in which banks are grouped according
to their size, complexity, and importance to the overall economy. Systematically important banks
are subject to higher capital requirements.

• Basel 3 increases core equity ratio to 7%

• Additional counter-cyclical capital requirements
• Narrower definition of qualifying regulatory capital
• Higher capital requirements for Systemically Important Financial Institutions (SiFis)

Contingen Capital
• Mandatorily convertible bonds referred to as CoCos (Credit Suisse) or bonds with
mandatory loss clause (Rabo)
• Could make the increase of bank capital easier: not only shares but also debt capital
• Markets for contingent capital need to be developed with adequate risk-return trade off
• Promising signals from Asia and the Middle East

(Contingent) Capital for SiFis

• Switzerland is the front runner with a proposed capital requirement of 19%
• Regulators initially focus on global SiFis comprising of about 30 of the world´s biggest
banks with an additional capital charge of up to 3%
• Possibly problematic distinction between global SiFis, non-global SiFis and non-SiFis

Resolution Schemes and Prompt Corrective Action

• Establishment of capital/asset zones
• Highest zone (e.g., above 10%): limited overall supervision
• Falling below 10%: greater supervision and requirement to submit business plan
• Falling below 8%: direct monitoring and supervision
• Falling below 2%: take over and restructure financially the bank by wiping out
shareholders and imposing losses on bond holders (hair cut)
PCA (Prompt Corrective Action) Provides Legal Basis
• Legal basis for intervention and resolution
• Resolution is problematic with respect to large international banks
• Requiring banks to draw up living wills (surat wasiat??) in order to facilitate resolution

Compensation Schemes
• Change incentive schemes of management by defining longer-term targets
• Introduce claw back clauses
• Maximize bonus part of compensation package
• Banks have a special role in society which requires a social responsibility of bankers in
order to regain confidence

Lecture 9: Basel 3
Financial Crisis 2007-2009
• Financial crisis has many causes (such as monetary policy providing cheap liquidity, lack
of well-regulated markets for securitized mortgages)
• Financial crisis clearly demonstrates fragility of bank balance sheets and inadequacy of
bank capital levels
• Very soon after the first problems emerged in August 2007 banks stopped lending to
each other
• Unprecedented injections of liquidity, capital support and guarantees, exposing
taxpayers to large losses

Restoring Confidence in Banking System

• Substantial increase of bank capital requirements (Basel 3)
• Contingent capital as a bail-in mechanism
• Resolution schemes: impose losses on bond holders through prompt corrective action
schemes (PCA)
• Longer-term compensation schemes

Relatively High Capital

• Relatively high regulatory capital requirement
• Increase buffers which can absorb unexpected losses before taxpayer has to intervene
• Higher buffers will decrease moral hazard in the banking system

From Basel 2 to Basel 3

The second Basel Accord, called the Revised Capital Framework but better known as Basel II,
served as an update of the original accord. It focused on three main areas: minimum capital
requirements, supervisory review of an institution's capital adequacy and internal assessment
process, and the effective use of disclosure as a lever to strengthen market discipline and
encourage sound banking practices including supervisory review. Together, these areas of focus
are known as the three pillars.
 • Basel 2 was implemented in Europe early 2008 when the financial crisis had already
started
• The global meltdown after Lehman Brothers made clear that bank capital levels had
been inadequate: “The global banking system entered the crisis with an insufficient level
of high quality capital” (Basel Committee 2010)
• Basel Committee on the course of a substantial increase of bank capital

Critique of Basel 2
• Complexity and regulatory burden
• Supervisory burden given information disadvantage
• Gaming, manipulation and risk arbitrage
• Insufficient attention to market discipline
• Reduction of regulatory capital contrary to initial aim
• Procyclicality
• Focus on individual banking institution (microprudential)
• No focus on stability of the whole banking system or systemic risk (macroprudential)
• Excessive on-and off-balance sheet leverage
• Lack of high-quality capital for absorbing losses
• No focus on bank liquidity

Basel 3: Capital Requirements

Basel III seeks to strengthen the resilience of individual banks in order to reduce the risk of
system-wide shocks and prevent future economic meltdowns.
• Raising quality, consistency and transparency of bank capital base
• Reducing procyclicality by establishing conservation and countercyclical buffers
• Supplementing risk-based capital requirement with leverage ratio
• Enhancing risk coverage
• Addressing systemic risk and interconnectedness

Bank Capital
• Financial crisis demonstrated that
o not all bank capital was available for absorbing losses
o inconsistency in the definition of capital across jurisdictions and lack of
disclosure
• Focus on Tier 1 capital (“going-concern capital”) within total capital requirement; Tier 2
capital (“gone-concern capital”) counts only for max. 2%
• Moreover, predominant form of Tier 1 capital must be common shares and retained
earnings

Tier 1 Capital
Tier 1 capital is a bank's core capital and includes disclosed reserves—that appears on the
bank's financial statements—and equity capital. This money is the funds a bank uses to function
on a regular basis and forms the basis of a financial institution's strength. These funds come
into play when a bank must absorb losses without ceasing business operations. Tier 1 capital is
the primary funding source of the bank.
https://www.investopedia.com/ask/answers/043015/what-difference-between-tier-1-capital-
and-tier-2-capital.asp

• Common equity Tier 1 capital consists of common shares and retained earnings plus
items such as stocks surplus (share premium)
• Additional Tier 1 capital is
o subordinated to depositors, general creditors and subordinated debt
o perpetual or may be callable at the initiative of the issuer only after a minimum
of five years under the condition that it is replaced by capital of the same or
better quality, or the bank demonstrates that the capital position is above the
minimum
• Additional Tier 1 capital includes contingent capital instruments classified as liabilities
for accounting purposes but having principal loss absorption through
o conversion to common shares at an objective pre-specified trigger point, or
o a write-down mechanism which allocates losses to the instrument at a pre-
specified trigger point

Contingent Capital
• Mandatorily convertible bonds referred to as CoCos (Credit Suisse) or bonds with
mandatory loss clause (Rabo)
• Could make the increase of bank capital easier, but the Basel Committee only allows
limited application as part of Tier 1 capital
• Markets for contingent capital need to be developed with adequate risk-return trade off
but signals from Asia and the Middle East are promising

Tier 2 Capital
Tier 2 capital includes undisclosed funds that do not appear on a bank's financial statements,
revaluation reserves, hybrid capital instruments, subordinated term debt—also known as junior
debt securities—and general loan-loss, or uncollected, reserves. Revalued reserves is an
accounting method that recalculates the current value of a holding that is higher than what it
was originally recorded as such as with real estate. Hybrid capital instruments are securities
such as convertible bonds that have both equity and debt qualities.

Tier 2 capital is supplementary capital because it is less reliable than tier 1 capital. It is more
difficult to accurately measure due to its composition of assets that are difficult to liquidate.
Often banks will split these funds into upper and lower level pools depending on the
characteristics of the individual asset.

• Tier 2 capital is
o subordinated to depositors and general creditors (e.g., subordinated debt)
 o may be callable at the initiative of the issuer only after a minimum of five years
under the condition that it is replaced by capital of the same or better quality, or
the bank demonstrates that the capital position is above the minimum

Bank Capital Ratios

• Common equity Tier 1 must be at least 4.5% of risk-weighted assets (RWA)
• Tier 1 capital must be at least 6% of RWA
• Total capital (Tier 1 plus Tier 2 capital) must be at least 8% of RWA
• Seems similar to Basel 2 but is a much stricter capital requirement

Conservation Buffer
• The capital conservation buffer was introduced to ensure that banks have an additional
layer of usable capital that can be drawn down when losses are incurred. The buffer was
implemented in full as of 2019 and is set at 2.5% of total risk-weighted assets
• During the financial crisis many banks continued to make large distributions in the form
of dividends, share buy backs and generous compensation payments
• In case the common equity Tier 1 ratio falls below 7% the bank is required to conserve
an increasing part of its earnings in the subsequent financial year (up to 100%)

Countercyclical Buffer
Basel III introduced new requirements with respect to regulatory capital with which large banks
can endure cyclical changes on their balance sheets. During periods of credit expansion, banks
must set aside additional capital. During times of credit contraction, capital requirements can be
relaxed.

• Ensure that capital requirements take account of the macro-financial environment

• Excess aggregate credit growth in good economic times may lead to a build-up of
system-wide risk
• Countercyclical buffer 0 to 2.5% to be met with common equity Tier 1 capital only

Leverage Ratio
A leverage ratio is any one of several financial measurements that look at how much capital
comes in the form of debt (loans) or assesses the ability of a company to meet its financial
obligations. The leverage ratio category is important because companies rely on a mixture of
equity and debt to finance their operations, and knowing the amount of debt held by a company
is useful in evaluating whether it can pay off its debts as they come due.
A leverage ratio is any one of several financial measurements that assesses the ability of a
company to meet its financial obligations.
• Many banks built up excessive leverage while still showing strong risk-based capital
ratios
• During the crisis banks were forced by financial markets to reduce leverage, thereby
amplifying downward pressure on asset prices and exacerbating losses, declines in bank
capital and contraction in credit availability
 • Introduce a “simple, transparent, non-risk based leverage ratio that is calibrated to act
as a supplementary measure to the risk-based capital requirements
• Basel 3 introduces minimum Tier 1 leverage ratio of 3% of non-risk based assets plus the
on-balance sheet credit equivalent of off-balance sheet activities
• Parallel run period from January 2013 until January 2017 tracking the behaviour over
the economic cycle and relative to the risk-based requirement
• Leverage ratio used to be seen as a crude risk measure when designing Basel 2

Risk Coverage
• Strengthen the risk coverage of the Basel 2 framework
• Raise capital requirements for the trading book and complex securitization and off-
balance sheet exposures (such as SIVs)
• Increase capital requirements for counterparty risk exposures arising from banks’
derivatives, repo and securities financing activities, thereby also providing incentives to
move OTC derivative contracts to central counterparties

Systemic Risk
• Strong interconnectedness among systemically important banks (SIBs) can transmit
shocks across the financial system
• Negative externalities of institutions that are perceived as not being allowed to fail due
to their size, interconnectedness, complexity, lack of substitutability or global scope
(potentially huge moral hazard)

Global SIBs (Systemically Important Banks)

• Regulators initially focus on global SIBs comprising of 29 of the world’s largest banks
• Additional capital charge between 1% to 2.5 of RWA (with a possible top charge of 3.5%
which is not applied now) to be met with common equity Tier 1 only

Level Playing Issues for SIBs

• Level playing field issues between global SIBs, non-global SIBs and non-SIBso
• Common equity Tier 1 is the most costly form of capital for banks to raise
• Higher capital requirement for global SIBs will reduce their funding advantages that
arise from expectations of public support

Going-concern Contingent Capital and SIBs

• Going-concern contingent capital (high-trigger contingent capital) is not (yet) allowed by
the Basel Committee for meeting the additional capital charge for global SIBs
• Switzerland will have a total capital charge of 19% for SIBs with 9% in the form of
contingent capital

Adding up Capital Requirements

• Common equity Tier 1: max. 12%
o 4.5% minimum
o 2.5% conservation buffer
 o 0% - 2.5% countercyclical buffer
o 1% - 2.5% additional buffer for SIBs
• Additional Tier 1 capital: 1.5%
• Tier 2 capital: 2%
• Total capital: max. 15.5%

Assessing Basel 3 Capital Requirements

• Complexity and the regulatory and supervisory burden are not reduced
o Internal ratings based models are still in place
o New complex capital charges for countercyclical buffers and SIBs
• Bank capital levels are increased but most likely not enough looking at historical
numbers
• Basel Committee now recognizes potential benefits of leverage ratio without allowing it
to play a prominent role (cf. leverage ratio of 15% advocated by Benink and Benston in
2005)
• Market discipline is not made credible due to limited allowance for use of contingent
capital

Basel 3: Liquidity Requirements

• Strong capital requirements are a necessary condition for banking sector stability, but
are not sufficient
• Strong liquidity base reinforced through robust supervisory standards is of equal
importance
• Introduction of internationally harmonized minimum global liquidity standards

Liquidity vs Solvency
• “During the early ‘liquidity phase’ of the financial crisis, many banks – despite adequate
capital levels – still experienced difficulties because they did not manage their liquidity
in a prudent manner” (Basel Committee, 2010)
• Already in Fall 2007, one year before the fall of Lehman Brothers, the interbank market
had dried up
• Financial institution regulation used to be focused on the safety net, including
o Lender of last resort to support liquidity when markets cannot distinguish
between solvent and insolvent financial institutions
o Deposit insurance to prevent bank runs
o Capital adequacy with primary focus on solvency of individual banks

Two Complementary Liquidity Objectives

• Ensure that a banks has sufficient high quality liquid resources to survive an acute stress
scenario lasting for one month: liquid coverage ratio
• Promote resilience over a longer time horizon by requiring a bank to fund its activities
with more stable sources of funding on an ongoing structural basis: net stable funding
ratio
Assessing Basel 3 Liquidity Requirements
• Professionalization of liquidity risk management after financial crisis demonstrated
weaknesses
• Complexity and the regulatory and supervisory burden are increased further with a new
prescriptive approach for liquidity (apart from capital) requirements
• More credible market discipline may make a less prescriptive approach feasible

Lecture 10: Evaluation of Bank Systemic Risk

Bank Systemic Risk
• Systemic risk in the banking sector is of great concern due to public externalities of
banking
• After fall of Lehman Brothers academics and regulators got renewed interest in systemic
risk
• Basel II Accord (2004) still had focus on the risks at the individual bank level
• Basel III Accord (2010) aims at increasing bank capital including some charges for
contribution to systemic risk

Basel III
• Increase microprudential capital requirements, notably common equity Tier 1 of 7%
• Introduce macroprudential capital requirements, both for a cross-sectional and
temporal dimension of systemic risk
• Cross-sectional: 29 global SIBs face additional capital charge of 1%-2.5%
• Temporal: countercyclical capital requirements of 0%-2.5% in order to contain
procyclicality of financial system

Literature on Systemic Risk

• Kaufman and Scott define systemic risk as the risk or probability of breakdowns in the
entire system, as opposed to breakdowns in individual parts or components
• Systemic risk in banking is characterized by high correlation and clustering of bank
failures in a single country, several countries, or throughout the world
• Systemic risk can originate from shocks at a macro level and at a micro level
• At a macro level systemic risk refers to an event having effects on the entire banking,
financial or economic system (for instance, steep increase in the lending rate of the ECB)
• At a micro level we can identify systemic risk in two ways
o First, as the probability that the failure of an individual institution sets in motion
through contagion a series of successive losses in the rest of the financial system.
o Second, as the spillover from an initial exogenous external shock, but which does
not involve direct causation and depends on weaker and more indirect
connections through signaling (similarities in third-party risk exposures such as
subprime loans in August 2007 and the fall of Lehman Brothers in September
2008)

Assessing Bank Systemic Risk

 • New literature is emerging using market data to assess systemic linkages among
financial institutions under extreme events
• No generally accepted definition of systemic failure
• Bank supervisors need to formulate criteria for risk evaluation at the system level

Contribution of this Paper

• This paper formulates different social welfare functions (“social risk functions”)
specifying various ways how supervisors can evaluate systemic risk
• In order to investigate the relevance of each social risk function we provide estimates
using daily stock price data\(total return indexes including dividends) for 25 major banks
in the eurozone
• Data set runs from April 1992 until February 2004 and excludes recent financial crisis
period

Evaluation Criteria for Risks

• Social Risk Functions: Minimax

o Weakest link or worst-off individual bank is the only concern because all banks
are considered systemically important (risk aversion)
o Indifference curves are inversely L-shaped
• Social Risk Functions: Utilitarian

o Only considers average loss returns of banks in the system without regard to
how losses are distributed
o Indifference curves are linear
• Social Risk Functions: Minimin

o The best of the worst cases is the only concern because the survival of a single
bank is deemed sufficient for the survival of the entire system
o Indifference curves are L-shaped
 • Social Risk Functions: mixture of Utilitarian and Minimax

o Combination of the utilitarian and weakest link concern

o Indifference curves are inverse V-shaped displaying the risk aversion of society

•
Data Description
• 25 major banks – eurozone
o Source: Hartman, Straetmans, de Vries (2005)
o Selection criteria
(1) sizes measured by assets and deposits
(2) involvement in interbank lending
• Daily stock prices
o April 2, 1992 – February 27, 2004
o 3106 observations
Empirical Analysis
• Daily loss level
o Set xVaR = 0.03, 0.06, 0.09, 0.12
§ Pr{Xt > 0.03} = probability of a loss return of 3% or more in a single day
• Given loss levels reflecting approximately 5, 1, 0.2, 0.05 percentiles
o For example, 3% loss may occur once per 20 days
o 12% loss (systemically important event) ⇒ once per 8 years
 •

Risk of Individual Banks

• Table 2:
o pe (measured by empirical distribution)
§ informative only when xVaR = 0.03, 0.06
§ for extreme case xVaR = 0.12 → not informative
o pn (normal distribution)
§ only valid for xVaR = 0.03
§ severe underestimation of risk for extreme cases
o pf (fat-tailed distribution)
§ xVaR = 0.12 ⇔ extreme risk such as default risk
§ e.g., Bankgesellschaft vs. Deutsche Bank
pf = 25.26 vs. 7.84
once per 1.5 years vs. 5.1 years
Note 1.5 years ≒ 1/0.002526 * 1/250
5.1 years ≒ 1/0.000784 * 1/250
o pf (fat-tailed distribution)
§ Ordering of top 5 riskiest banks
• Sampo Leonia (once per 1.3 years)
• Bankgesellschaft (once per 1.5 years)
• ING Bank (once per 1.6 years)
• Bayerische Hypo (once per 2.3 years)
• Capitalia (once per 2.6 years)
§ The smaller value implies more frequent bank failure, i.e., riskier bank
Systemic Risk of Countries and Eurozone
• Systemic risk of
o Eurozone (25 banks)
o Germany (4), France (4), Italy (4)
o Minimax, utilitarian, minimin and mixtures

Systemic Risk: Countries

• Table 4: pf with xVaR = 0.12
o Minimax: weakest link measure
§ Germany 29.259 (once per 1.4 years)
§ Italy 29.299
o Utilitarian
§ Germany 9.535
§ Italy 5.453 (once per 7.3 years)
o Minimin: best of worst cases measure
§ Germany 3.266 (once per 12.2 years)
§ Italy 0.962
§ France 0.064
o Table 4: pf with xVaR = 0.12
Germany (4 banks) Eurozone (25 banks)
Minimax 29.26 101.32
Utilitarian 9.54 2.92
Minimin 3.27 0.00

Concluding Observations
• Supervisory social risk functions, used as input for selection and aggregation of bank loss
returns, result in very different estimated probabilities of systemically important events
(pf )
• Supervisors should specify their preferred SRF
• In case supervisors think that estimated probabilities pf are too high, they should take
remedial actions such as increasing bank capital requirements
• The question whether a supervisor thinks that estimated pf are too high crucially
depends on a more detailed and quantitative specification of its preferred SRF and
would need future research
• The contribution of our paper is to highlight the importance of the fact that different
SRFs can lead to very different estimates of the likelihood of systemically important
events
• Basel III still has predominantly a microprudential focus, trying to prevent individual
bank failures (consistent with the Minimax SRF)
• This would justify a substantial increase of bank capital requirements but, most likely,
beyond the increase currently proposed under Basel III
• It is interesting to note that Switzerland has decided to require its SIBs to hold a capital
ratio of 19% which is significantly above the ratio set by Basel III
Lecture 11: Banking Crisis
Banking Crisis
• Caprio and Honohan note that the banking crisis that broke out in August 2007 is only
the latest episode in a long series around the world
• Banks have played a central or important supporting role although some financial crises
have had their focus elsewhere (government debt, exchange rate and stock market
crises)

The cost of rescuing banks in several countries

Impact on Banking Crisis

• Loss of confidence in the payments system, people will lose their trust towards banks
therefore they will withdraw their money, create illiquidity crisis, solvency crisis
• Pressure on fiscal deficits (there’s confidence crisis), public debt (bail out, to buy equity
stakes), and domestic interest rates (default risk premium)
• Reduced market discipline: bank rescues may reduce private incentives to monitor the
behavior of banks in the future and may create incentives for excessive risk taking,
• Reduction in bank credit and higher interest rates, less inclined to make loans
• Worsening of information and adverse selection problems during a crisis: only the least
creditworthy borrowers are prepared to pay higher interest rates, banks end up lending
money to bad borrowers
• Constraints on the conduct of monetary policy: limits on the possibility to raise interest
rates, gov building up debt ratios, kalo banyak yg minjem central banks jd susah naikin
interest rates
Early History
• Banking crises are virtually as old as banking
• Regular ten-yearly recurrence of crises through most of the 19th century and through to
World War II
• The post-World War II era saw a period of exceptional stability due to economic growth,
regulations that restricted banking competition and product innovation, competition
was restricted
• Regulations became unsustainable as communications technology and financial
innovation (including the emergence of near-bank competitors) led to evasion
• Liberalization of banking and capital flows, together with increasingly volatile
macroeconomic conditions, went together with a return of banking crises

Bad Banking and Bad Policies

• Fraud and mismanagement (bad banking) and bad government policies have been at
the root of most banking crises, lack risk management for example in the case of abn
amro, the company is not aware that there is a money laundering scheme in one of their
customers account
• Individual traders: Barings (2005) and Societé Générale (2008) with a loss of over 7
billion US dollars, you must have a good risk management system to prevent potential
losses
• Introduction of new instruments often leads banks to take on new risks without
adequate attention to downside potential (often create new speculation)
• Liberalization and deregulation of economic policies can lead to a surge of bank failures
in countries with weaker information and governance institutions
• Liberalization of entry into banking increases competitive pressures
• Liberalized banks (and their supervisors) inherit a staff that is short on banking skills and
modern risk management techniques

Over-optimism
• Dynamic instability in widely held expectations about macroeconomic and business
prospects has played a major role in many systemic banking crises
• Over-optimism about economic growth, often manifested in a real estate price boom,
results in a rapid credit expansion
• Disaster myopia prevails (underestimating the probability of disaster)
• Chuck Prince: as long as the music is playing, you’ve got to get up and dance. You may
expect crisis but just keep stay in the game (take risk)

Norway, Sweden, and Finland (late 1980s and early 1990s)

• Major changes in the regulatory regime: regulatory balance sheet restraints were
removed, and interest rates became more market-determined
• Deregulation induced a more competitive and efficient market environment in banking
… but also led to a rapid increase in the volume of lending collateralized by property
• Rapid rise of asset and real estate prices
 • In the late 1980s and early 1990s the Nordic countries moved into recession
• Combination of tight monetary policy and falling asset prices
• Large proportion of Nordic banks had to be rescued
• Big shocks to banking systems can easily produce severe reactions that result in
substantial negative externalities

Japan (1990s)
• Bursting of real asset price bubble in early 1990s
• Banks’ non-performing loans and capital positions were addressed only after a long time
period
• Lack of sense of urgency and strong public resentment about the use of taxpayers’
money
• Compare with the current European situation

East Asia (1997-1998)

• In 1997, Thailand’s central bank floated the baht after failing to protect the currency
from speculative attack
• The move triggered a financial and economic collapse that quickly spread to other
economies in the region, notably Indonesia and South Korea
• Sharp contraction of GDP and bankruptcies of companies overexposed to foreign
currency risk
• Presence of fixed or semi-fixed exchange rates
• Large current account deficits that created downward pressure on the currencies,
thereby encouraging speculative attacks
• High domestic interest rates that had encouraged companies to borrow heavily offshore
• Weak oversight of domestic lending
• Large falls in the baht, the won and the rupiah against the US dollar
• Impossibly high debt repayments in domestic currency terms
• Capital flight exacerbated the currency depreciation
• Workout of the bad debts and disposal of the distressed assets

Lecture 12: The Eurozone Crisis and the Roadmap towards European Banking Union
Moral Hazard in The Euro Zone (19 countries that shares the same currencies)
• Moral hazard in the euro zone due to perception of guarantees and bail outs. Due to the
existence of implicit and explicit guarantees.
• Bond holders perceive the riskiness of a German bond as about equal to a Greek bond
There's a perception that if one bank in a certain country fails, the euro zone will
definitely help, because if not, they can just leave the euro zone and create new
currencies. If someone leaves the euro zone, they will leave perception to other
countries, like why did they leave the euro zone?
• Ministers of Finance had an incentive to create an image of risk equality and diminish
Germany’s anchor role
• Convergence of interest rates already before the euro was launched in 1999
Euro Zone: First Phase
*The Maastricht Treaty, known formally as the Treaty on European Union, is
the international agreement responsible for the creation of the European Union (EU)
signed in 1991 and which became effective in 1993.Creation of new currency EURO
• Maastricht Treaty and Black Monday (Dutch EU Presidency second half of 1991)
• Violation of the Growth and Stability Pact. German and France violated the rules
• High budget deficits and debt levels (the famous rule – budget deficit shouldn’t be
higher than 3% and government debt ratio shouldn’t be higher than 60%)
• Lack of enforcement of structural reforms on labour and product markets. Ur country
have to be flexible the labor market, and typically. Import are higher than export back
then (trade deficit)
• Weak starting position when financial crisis emerged as from 2007. There’s a credit
boom, been assuming a lot of debt.
• Started with Greece early 2010 government debt ratio was much higher than ….,
Portugal weak states, Ireland the government bail-out a lot of their banks. This countries
get rescue fund from the ESM

Eurozone Council June 29, 2012

• Creation of permanent European rescue fund, the European Stability Mechanism (ESM),
as successor of the temporary rescue fund, the European Financial Stability Facility
(EFSF), setelah bikin yg temporary akhirnya jd permanent rescue fund buat bail-out if
needed
• Limited size of ESM: only 500bn (no further increase foreseen either through direct
increase or by providing ESM with a banking license)
• Lack of political commitment to the euro as a single currency
• Interest rates of Spain and Italy peaked once again in July 2012 (10 year bond up to 7%),
because Italy and spain has their own debt, rescue fund tend to increase more their
debt. the larger the size of rescue fund, the lower the probability it will actually be used.
The result of this rescue fund is instability in the system. May lead to break-up of the
eurozone.

European Central Bank (ECB), ultimate creator of liquidity, they can print money
• July 26, 2012: Draghi states “whatever it takes to preserve the euro”. Market completely
feel reassured and market explode (stock, bonds, etc)
• September 6, 2012: Draghi’s “audacious gamble” with “outright monetary transactions”
• Unlimited buying scheme of existing bonds of problem countries IF they meet ESM
conditionality. To create liquidity
• Strict and effective conditionality in terms of budget cuts and economic reforms. If a
country is having a trouble, interest rates go up, it cannot refinances itself against the
very high interest rate, will lead to bankruptcy. It need to comply with a package of
condition
 • OMT (Outright Monetary Transaction) has not been used but seems successful given the
low interest rates on government bonds in Italy, Spain and Portuga. Buying government
bonds in troubled country

Euro Zone: Solutions

• Stronger enforcement of structural economic reforms, notably in France and Italy. Spain
has been more ambitious in implementing this
• Urgent action needed to prevent the euro zone from falling into a deflationary spiral.
Prices going up deflation going down, ECB want to prevent deflation. If u expect prices
to go lower u will tend to postpone your purchase, everyone will also postpone their
purchase, people are not spending prices go down, the real value of government debt
increase when prices go down, because in deflation phase it makes it harder to pay the
same loan
• Expansionary budgetary policy in countries with low budget deficits such as Germany
and the Netherlands
• January 2015: ECB announces QE of 1,140bn euros. Starting to buy up government
bonds.
• March 2020: ECB starts Pandemic Emergency Purchase Programme (PEP) currently
amounting to 1,850bn euros. Entering economic recession.
• July 2020: European Council agrees on a corona rescue fund of 750bn euros linked to
economic reforms

Unresolved Business of Unsustainable Government Debt. Government Debt Ratio increase

specifically Italy
• Modification of political dynamics in Europe
• Emphasis in the European debate has focused on mutualization of sovereign debt
• An alternative may be debt relief (ex post) made conditional on structural economic
reforms
• Alleviation of moral hazard problem associated with mutualization
• Case of Italy: low economic growth, high unemployment, high government debt ratio,
(political) costs of refugees crisis, lack of European solidarity and new populist
government

Roadmap towards a European Banking Union (2012)

Three Pillars:
• Establishment of a single supervisory mechanism (SSM).
• Establishment of a single resolution mechanism (SRM)
• Deposit guarantee schemes (DGS)
• Higher capital and liquidity requirements (Basel 3 and CRR/CRD 4) Capital Requirement
Regulation as an implementation of Basel 3 in Europe

Single Supervisory Mechanism (SSM)

• ECB acts as direct supervisor for banks with assets of more than 30 billion euro as of
November 2014 (“single supervisory mechanism”). Big banks like ABN AMRO, ING will
 be supervised directly by the ECB, the smaller banks will be supervised by Dutch Central
Bank. The ECB create their own supervisory team and also add some local
representative to the team. But like Dutch bank will not be supervised by some Dutch,
to reduce bias
• ECB will be granted overall supervisory responsibility for banks in the euro area,
including the power to require banks to take remedial action
• Active involvement of national supervisors within the SSM, still responsible of all the
smaller banks, can take action directly if there is important reason

Single Resolution Mechanism (SRM)

• Bank Recovery and Resolution Directive (BRRD), including a bail-in debt mechanism (as
from 2016) and a requirement to draw up living wills
• BRRD establishes harmonized procedures for restructuring problem banks
• SRM supplements BRRD and establishes the Single Resolution Board, ensuring a
coherent and uniform approach to the operation of the resolution rules across Europe
as from 2015. If remedial action from ECB does not solve the problem, the case will be
transferred to the Single Resolution Board
• Build-up of a Single Resolution Fund

Deposit Guarantee Schemes (DGS)

• Creation of a Single DGS is the third pillar of the European Banking Union. Actually they
already have their own national deposit insurance schemes for about 100,000 euros/
payment accounts. Who’s going to pay for it if there’s a crisis? The taxpayers and/or
other banks. If no one able to pay for the deposit insurance due to the crisis, it can
create bank run because the customer losses their trust on bank
• Single DGS will not be established for the time being: rely upon existing networks of
national DGS
• Countries such as Germany first require a clean-up of non-performing loans in problem
banks
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