Chapter 1: Literature review

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BLACK SWAN OR BROKEN SYSTEM?

The impact of national forms of banking regulation on state aid to banks during the 2008-2013 financial crisis

ABSTRACT

The latest financial crisis (2008-2013) has had devastating effects and resulted in immense public debts for most Western countries after authorities had to save many banks from bankruptcy. Popular discourse currently discusses stricter regulation of the banking sector to prevent a new financial crisis and to make sure taxpayers do not have to pay for bankers’ mistakes. This thesis shows that stricter forms of regulation do not necessarily result in lower costs for authorities to save banks.

Master’s Thesis International Relations (International Political Economy)

University of Groningen Author: Jesse Siegers Student number: 1815083 Phone number: +31 6 15239406 Supervisors: dr. F. Giumelli and

prof.. dr. H.W. Hoen

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Master Thesis International Political Economy

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Acknowledgements

Nobody writes alone. This thesis has been no exception. I am extremely grateful for the support I have had from my family, my friends and my supervisor Francesco Giumelli. The countless hours of discussing my thesis (I am sorry) have been of tremendous value.

My beloved family, thanks for everything. I know discussing financial regulation is not the best subject to discuss at dinners, we can change the subject now.

Maaike, you helped me focus on my thesis when all we wanted was go outside and see the sea. Todá rabá.

Francesco, thank you for all your help, your tips and the countless times you have helped me finding answers and providing guidance.

I like to express my gratitude to all authors, researchers and scholars on which this research is based. This thesis could not have been written without the excellent work provided by all others.

My friends, thank you for spending so much time and energy in helping me. I know how much I have asked from you and for that I am grateful. I could count on you no matter what.

As always.

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Introduction

‘La crise actuelle doit nous inciter à refonder le capitalisme. Le refonder sur une éthique, celle de l’effort et celle du travail. Il nous faut trouver un nouvel équilibre entre l’état et le marché. L’autorégulation pour régler tous les problèmes c’est fini. Le laisser-faire, c’est fini.

Le marché tout-puissant qui a toujours rais, c’est fini.’¹ - Nicolas Sarkozy, former President of France

On September 14, 2007, long queues emerged before the fifth largest bank in the United Kingdom (UK), Northern Rock, after it admitted it had requested emergency funding from the Bank of England. The bank run, the first in over a hundred years in the country, sent shock waves to banks all over the world. It resulted in a global financial crisis, with several bank failures and massive bank bailouts by national governments. The immense bailout programmes resulted in widespread critique. A commenter on the financial news website Bloomberg argued: ‘This is not the first time Wall Street has made a huge financial mess and received taxpayer funded bailout to fix it. If we keep rescuing banks from their own greed, who is to say that the Street won’t come to rely on taxpayers to be an insurance policy with no limits and manage to make an even bigger mess next time?’²

This argument of ‘rescuing banks from their own greed’, is epitomized in the public choice theory of regulation. This theory holds that markets are imperfect, and that regulators are capable, willing and necessary to correct free-market inefficiencies.³ Bankers ought to be regulated because otherwise they would keep making a mess of their own banks, after which the public has to save them. Or, in a more elegant way: there are ‘externalities generated by financial market activity, which are not easily capable of being addressed by private sector

1 Nicolas Sarkozy, Speech at Toulon, September 25, 2008.

2 Greg Fish, ‘Taxpayers shouldn’t fund Wall Street’s bailout’, BloombergBusiness, September 25, 2008, (http://www.businessweek.com/debateroom/archives/2008/09/taxpayers_shouldnt_fund_wall_streets_bailout.ht ml), accessed on April 28, 2015.

3 James R. Barth, Gerard Caprio, jr., Ross Levine, Rethinking Bank Regulation, Till Angels Govern (Cambridge University Press, Cambridge, 2006), p. 34-35.

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actors.’⁴ It suggests that if (inter)national regulation of financial institutions would increase, banks would be more stable. Where the public demands stable markets, it requires its government to intervene.⁵

Public choice theory is contrasted by the private interest view of regulation, which emphasizes regulatory capture, and holds that the main goal of regulation is to ‘maximize the welfare of the regulator, the politician or the bureaucrat.’⁶ According to the private interest view, regulation does not necessarily result in a better situation for the public, but is beneficial to only a small group of individuals who have either captured regulation (i.e. interest groups) or who have been assigned to regulate (i.e. bureaucrats, regulators etc.). Where public choice theory thus predicts that increasing regulation results in more stable (financial) markets, private interest theory does not necessarily predict such.

This thesis argues that there are three fundamental weaknesses in banking: risk, uncertainty and contagion. Risk and uncertainty make banks vulnerable. As a result of contagion, a bank in crisis often leads to a banking crisis. These three factors contribute to the instability of the banking system and are regarded to be at the root of its failing. With such failures banks produce disservices to other persons, of such a sort that payment cannot be exacted from the benefited parties or compensation enforced on behalf of the injured parties. These disservices, or negative externalities contribute to the legitimization of banking regulation. However, there are also side-effects related to regulation, such as decreased efficiency, increasing fragility and lower profitability. These raise questions whether the end justifies the means.

With the destructive global effects of the latest financial crisis and its colossal impact on government deficits fresh in our minds, it is important to complement the theoretical discussion between public choice- and private interest theory with empirical research. This thesis uses the latest financial crisis to test whether the degree of regulation is related to the costs for authorities

4 Howard Davies and David Green, Global Financial Regulation, The Essential Guide (Polity Press, Cambridge, 2008), 12-13.

5 Richard A. Posner, ‘Theories of Economic Regulation, Working Paper no 41’, Centre for Economic Analysis of Human Behaviour and Social Institutions, May 1974.

6 Barth, Caprio, & Levine, Rethinking Bank Regulation, p. 34-35.

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Public choice theory holds that banks would fail less frequently in countries with a strictly regulated banking sector than in countries with a weakly regulated banking system. As a result, governments of such countries with a strictly regulated banking sector would have to spend less on saving banks. To test public choice theory, the hypothesis of this thesis is as follows:

‘If regulation of the banking sector in a given country increases then, ceteris paribus, the costs for public intervention in that country during banking crises decreases.’

Using World Bank (WB) data, I identified which European countries with a developed banking system had the weakest form of banking regulation and which countries were the most strictly regulated.⁷ As the differences should be most evident between the most regulated countries and the least regulated countries, I identified two groups of countries: five countries with the strictest regulated banking systems and five countries with the weakest regulated banking systems. Subsequently, using European Commission (EC) figures, the financial aid provided by the respective authorities to their banking sector between 2008 and 2013 was measured and taken as a percentage of the size of their banking sector.⁸

After this group comparison I took a closer look at the regulatory measures in effect in the ten countries and identified a relation between actual risk based capital ratios and the amount of public aid and bailouts. As the regulatory minimum – i.e. the capital ratio banks are required to keep – is the same for almost all countries, I tested other possible explanations for the differences in the actual risk based capital ratios held by banks in different countries: banking competition, banking concentration and pre-crisis profitability.

The debate this thesis aims to contribute to is not mere theory. The effects of the financial crisis have been all too real for so many people all over the world. The financial crisis, and the related economic crisis, have been dubbed the Great Recession as a (not very) subtle reference to the 1929 Great Depression. When it comes to the fall in global stock markets and destroying trade, the effects of the current financial crisis are even bigger than during the

7 See appendix 1.

8 See appendix 2.

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Great Depression.⁹ As national governments bailed out banks, to prevent even worse, the public debts of many states grew to unprecedented heights. But the effects of the financial crisis were also felt on an individual level with numerous layoffs, decreasing disposable income and growing economic uncertainty. If we aim to limit the negative side-effects of financial interdependence and instability, we should have a better understanding of the effects of regulation. It matters to know whether regulation matters.

Obviously, there are some limitations to this thesis. A first limitation is the complexity of the financial market. Not only are there many different (and often complex) financial instruments, there are also numerous regulatory bodies involved. Such complexity of the subject poses a challenge to me as a researcher as well as to the research itself. A second limitation is the discrepancy between the formal procedures and its actual execution. It is difficult to assess whether a regulatory body effectively monitors its regulation, and punishes those who do not conform. It is even harder to examine whether a banks effectively complies with the regulation. A third limitation is the global interconnectedness of banks. As more and more banks operate on a truly global scale, with branches in many countries, the effects of national forms of regulation might become more limited. Countries which are more closely connected to the world economy are logically also more vulnerable to global financial shocks. Domestic regulation might then only be of fractional importance. A fourth limitation is that a genuine relationship between regulation and the effects of the financial crisis is hard to establish.

Although I have tried to rule out other possible explanations for the results, no social or economic research could ever be performed in a total sterile environment. Many factors play a role in this complex material, and therefore regulation always will be only a part of the answer.

As said, in this thesis I only take developed countries into account. While doing so, I am aware that I neglect a large part of our world. However, I believe that such a focus is necessary because of the abovementioned interconnectedness of globally operating banks.

9 Barry Eichengreen and Kevin O’Rourke, ‘A Tale of Two Depressions: What do the new data tell us’, VoxEU, March 8, 2010 (http://www.voxeu.org/article/tale-two-depressions-what-do-new-data-tell-us-february-2010- update), accessed on April 28, 2015.

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Taking countries into account where banks operate merely on a national level could seriously distort the results.

This thesis is composed of three parts. The first part of this thesis will start with a review of the literature on the roots of banking crisis, regulation and public aid, or aid provided by authorities to banks. The literature review is necessary not only to understand the relation between the three variables, but also serves as a foundation for the hypothesis and the model which will be elaborated upon the in the second part. This second chapter includes the theory and methodology used by this thesis. The third part will include the empirical research itself.

Chapter 1: Literature review

“Die Lage auf den internationalen Finanzmärkte ist ernst. Sie ist in dieser Form noch nie da gewesen […]. Es is die Stunde über den Tag hinaus zu denken, zu bewerten und zu entscheiden, das heißt, eine neue Systematik für das Zusammen-wirken aller im Finanzsektor Tätigen zu entwickeln, also eine Zukunftsperspektive zu gestalten und präventiv zu handeln.”¹⁰

- Angela Merkel, Chancellor of Germany.

Much has been written about banking, its (intrinsic) weaknesses and regulation of the sector.

This first chapter starts with the ideas of uncertainty, risk and contagion which are key to understand the weaknesses of the banking sector and are major contributors to the instability of the sector. Regulation in turn is ought to mitigate such weaknesses, resulting in less instability and thus less negative externalities. However, the literature does not unanimously agree whether regulation indeed results in less negative externalities; i.e. whether the costs for authorities for saving banks decline if regulation increases. While public choice theory argues it does, private interest theory argues that regulation primarily benefits the regulator and has had, at best, very limited positive effects on the stability of the banking sector. This chapter will round up with the discussion on the effects of regulation and thus its legitimization.

10 Angela Merkel, government statement for the German Bundestag, October 7, 2008, Bulletin 104-1, (http://www.bundesregierung.de/Content/DE/Bulletin/2008/10/104-1-bkin-bt-regerkl.html), accessed on accessed on April 28, 2015.

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Uncertainty, risk & contagion In 1763, at the end of the Seven Years’ War (1754-1763), unrest erupted in Northern European banks and trade houses. The years before witnessed the first usage of acceptance loans which could be exchanged for other acceptance loans. This financial innovation, referred to as wisselruiterij, was invented by the Dutch banker Leendert Pieter de Neufville.

It was used on a huge scale in Europe and brought considerable, though short-lived, success.

When in 1763, at the end of the war, the accounts were settled, investors became aware that the bank did not have enough reserves to clear all debts. On July 25, De Neufville’s bank went bankrupt, taking 50 other Amsterdam banks with it in its fall, together with dozens of banking houses in Hamburg, Stockholm and Berlin.¹¹ In total, over one hundred banks were hit by the crisis. It was the first European banking crisis.

After this crisis, regulation of the financial sector came to fruition.¹² In fact, all major reforms in regulation took place after serious banking distress, such as the 1933 Banking Act in the US after the bank failures of 1931, 1932 and 1933, and the 1979 Banking Act in the UK after the failures of 1973-1975.¹³ To understand the purpose of regulation, therefore, we first need to understand the weaknesses of banking.

Alan Greenspan, former Chairman of the Federal Reserve of the United States, argued at the beginning of the latest financial crisis that ‘it is risk that causes instability, and it was the underpricing of risk that caused the crisis.’¹⁴ Not everybody agreed. Opponents stated that taking only calculable risk into account leaves us in an oversimplified world, ignorant of uncertainty. ‘There is a difference between insurance companies, who deal mostly with risk, and investors in asset markets, who not only deal with risk, but also in uncertainty because of massive, unpredicted swings in market sentiment’, the renowned scholars Stephen Nelson and

11 P.J. Blok, Geschiedenis van het Nederlandse volk, deel 3, (Leiden, 1925), p. 520.

12 Centre for Financial and Management Studies, ‘Bank Regulation & Resolution of Banking Crises’, SOAS, University of London, 2009, p. 2.

13 CFMS, ‘Bank Regulation & Resolution of Banking Crises’, p. 4-5.

14 Alan Greenspan, The age of turbulence: adventures in a new world, (Penguin Press, New York, 2007), p. 507.

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Peter Katzenstein wrote.¹⁵ This thesis follows this line of argumentation and argues that risk and uncertainty are at the basis of banking instability.

Risk and uncertainty in common discourse are often used interchangeably. There is, however, an important difference between the two. ‘The main difference between risk and uncertainty is that the first is measurable while the latter is not’, the famous economist John Maynard Keynes argued.¹⁶ ‘By “uncertain” knowledge I do not mean merely to distinguish what is known for certain from what is only probable’, he wrote. ‘The game of roulette is not subject, in this sense, to uncertainty. […] The sense in which I am using the term is that in which the prospect of a European war is uncertain. […] About these matters there [is] no scientific basis on which to form any calculable probability whatever. We simply do not know.’¹⁷ In other words, for risk we do not know the outcome, but we do know the distribution of probabilities, whereas with uncertainty we neither know the outcome, nor the distribution of probabilities.

Nassim Nicholas Taleb has dubbed such ‘highly improbable high impact’ events Black Swans.¹⁸ Banking crises and many of their causes can be regarded as such Black Swans.

Taleb argues that there is a scientific ‘blindness with respect to randomness, particularly the large deviations.’¹⁹ The blindness to such events explains the failure of risk-management models used in the run-up to the 2008 financial crisis. Banks tend to underestimate the high impact of events which are highly unlikely. According to traditional models, based on a normal distribution of risk, the chances of the events leading to the financial crisis should, occur only ‘once every 14 universes.’²⁰ The numerous financial and banking crisis in the past century are prove of the incorrectness of such predictions. Although Black Swans cannot be predicted, banks do control their exposure to risk and uncertainty. The more banks engage in high risk (but highly profitable) endeavours, the more likely chances are that they encounter a Black Swan and run into trouble.

15 Stephen C. Nelson and Peter J Katzenstein, ‘Uncertainty, Risk and the Financial Crisis of 2008’, International Organization, 68:02, 2014, 361-392, p. 366.

16 Robert Skidelsky, Keynes: the return of the master, (Public Affairs, New York, 2010), p. 83.

17 Skidelsky, Keynes, (Public Affairs, New York, 2010), p. 84-85.

18 Nassim Nicholas Taleb, The Black Swan, the impact of the highly improbable, (Random House, New York, 2007).

19 Taleb, The Black Swan, the impact of the highly improbable, xix.

20 Jon Danielson, ‘Blame the models’, Journal of Financial Stability, 4:4, 2008, 321-328, p.322.

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Besides uncertainty and risk, there is another important feature of banking crises: the infectivity of banking distress. This phenomenon has been discussed by a great number of scholars, among whom the economic historian Charles P. Kindleberger. ‘Boom and panic in one country seem to induce boom and panic in others, often through purely psychological channels’, Kindleberger wrote.²¹ This type of contagion is caused by so called ‘irrational phenomena’, including financial panics, herd behaviour, loss of confidence and increased risk aversion.²² The Russian crisis in 1998, which was a result of a loss in confidence in emerging markets after the East Asian financial crisis a year earlier, is an example of such. Such crises are the result of information asymmetries and coordination problems, and can be remedied through, among others, deposit insurance schemes.

Besides such ‘misinterpretations’ by investors or depositors, international contagion can occur through a banks’ financial linkages with other major banks or via its operations in global financial centres.²³ The globalization of banks might thus prove a vulnerability, as it results in increased fragility. In addition, financial economists Chan-Lau, Mitra and Ong found that banks’ contagion risk has risen over time.²⁴

Banks cope with uncertainty and risk, but have a tendency to underestimate both, as Danielson showed. This renders banks vulnerable. On top of that, Kindleberger argued that large banks are highly contagious because of irrational phenomena and their international financial linkages. Although these three intrinsic weaknesses legitimize regulation, there are also some (perceived) side-effects of regulation.

21 Charles P. Kindleberger, Manias, Panics and Crashes, a History of Financial Crisis (John Wiley & Sons, New York, 2000), p. 119.

22 Rudiger Dornbusch, Yung Chul Park and Stijn Claessen, ‘Contagion: understanding how it spreads’, The World Bank Research Observer, 2000: 15, 177-197, p. 180.

23 Jorge Chan-Lau, Srobona Mitra and Li Lian Ong, ´Identifying Contagion Risk in the International Banking System: an extreme value theory approach’, International Journal of Finance and economics, 2012: 17, 390- 406, p. 390.

24 Chan-Lau, Mitra and Ong, ‘Identifying Contagion Risk in the International Banking System’, p. 392.

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Regulation: legitimation and perceived side effects Legitimizing regulation A first legitimization of regulation comes from the mitigation of risk and uncertainty which are inherent in the banking sector. However, risk and uncertainty result in two very different forms of intervention. When bankers would only face risks, it could be the task of the regulator to (forcefully) improve the risk measurement systems. However, when bankers face irreducible uncertainties, i.e. they do not know the outcome nor the distribution of probabilities, measuring it is impossible. Regulators then face an additional task, protecting society against bets which eventually will go wrong. The Obama-Volcker proposal, proposed in January 2010, takes this kind of reasoning, as it prohibits commercial banks from engaging in proprietary trading, owning hedge funds and private equity firms, as well as limiting their holding of derivative instruments. The purpose, here, is to prevent the spread of contagion, reducing tax-payer liability and reducing the monopoly power of the financial sector.²⁵

One of the first legitimizations of banking regulation came from the Financial Instability hypothesis, posed by the American economist Hymin Minksy in his 1977 paper ‘A Theory of Systemic Fragility’. Here, Minsky wanted to investigate why three financial crises had occurred in the past ten years (in 1966, 1969-1970 and 1974-1975) while none had happened in the twenty years after the Second World War. He argued that these crises were caused by a

‘fragile financial structure’, which was ‘the result of the normal functioning of our particular economy.’²⁶ This starkly contrasted with the then prevailing standard economic theories, which had argued that financial crises and the big depressions of history were anomalies.²⁷ The argument of systemic instability did not imply that financial systems could not vary in different degrees of stability; periods of relative stability were alternated with regimes under which it is unstable. Minsky argued that over periods of prolonged prosperity, the economy transits from ‘financial relations that make a stable system to financial relations that make for an unstable system.’²⁸ Minsky holds that these ‘business cycles of history’ consist of both the

25 Robert Skidelsky, Keynes: the return of the master, (Public Affairs, New York, 2010), p. 171-172.

26 Hyman P. Minsky, ‘A Theory of Systemic Fragility’, Hyman P. Minsky Archive, Paper 231 (May 1977), p. 2.

27 Minsky, ‘A Theory of Systemic Fragility’, p. 17.

28 Ibidem, p. 8.

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internal dynamics of capitalist economies and the ‘system of interventions and regulations that are designed to keep the economy operating within reasonable bounds.’²⁹ In other words, were these interventions and regulations not in place, then the system could possibly self- destruct. Minsky’s emphasis on financial instability leads him to conclude that ‘policies to control and guide the evolution of finance are necessary.’³⁰

With these ideas, Minsky laid the foundations for later theories on how economic and financial cycles develop, but more importantly he legitimized the usage of regulation of the banking system to prevent it from crashing. The idea that regulation of the financial sector is necessary to prevent it from crashing is at the root of the public interest theory. Appreciation for Minsky’s thoughts seem to have benefitted from the latest financial crisis. However, although Minsky pays a lot of attention to the perceived benefits of regulation, the role of side effects is mostly disregarded. It is crucial to include side effects in the equation, as they are at the epicentre of the debate about the desirability of regulation.

Side effects The dangers of excessive regulation have been acknowledged by many scholars.³¹ The goal of the debate is to find the equilibrium between the costs involved in regulation and the possible (future) benefit. There is, in the words of former London School of Economics director Howard Davies and financial regulator David Green, a balance to be struck, ‘between safety and soundness on the one hand and risk taking on the other.’³² This part will discuss three main issues related to regulation: moral hazard problems, increased inefficiency and increased fragility of the banking system.

Before turning to this topic, there are some points that need to be addressed. First of all, there is not just a single form of regulation. Regulation is a generic term describing various practices aimed at reaching a certain goal or objective. These different policies all have different results and side-effects. Second, when discussing possible negative consequences of

29 Ibidem, p. 8.

30 Ibidem, p. 3.

31 Howard Davies and David Green, Global Financial Regulation, The Essential Guide (Polity Press, Cambridge, 2008), 14.

32 Davies and Green, Global Financial Regulation, The Essential Guide, 14.

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regulation, we assume that these regulatory restrictions are supervised and enforced, and that banks that do not adhere to it will be penalized. However, regulation is done by humans. As Kindleberger points out: ‘the astute personnel needed in time of emergency are unwilling to submit to the boredom of long periods of calm – a problem encountered in the control rooms of nuclear power plants as well.’³³ Regulators themselves may overlook things, miscalculate ratios or make other mistakes. Furthermore, regulators might not have all information needed to make an accurate assessment of the situation. Thus, while a theoretical maximum of enforcement is assumed, ontological observation might tell a different story. In the words of Barth et al.: ‘neither we, nor anyone else, has data on how well supervision works on the ground.’³⁴ Third, researchers do not unanimously agree with regard to the (theoretical) effects of regulatory measures. While some authors argue for example that limiting the activities of banks may have stabilizing effects, others may argue against this. Even observed effects of regulatory policies might be explained differently. For example, private interest theory will explain the regulated oligopolistic character of Canadian banking as benefitting the small group of bankers, while the public interest theory will emphasize the stabilizing effects of it.

That being said, let’s asses the different (expected) disadvantages of regulation.

Moral hazard problems Safety net measures are one of the most prominent regulatory policies available to regulators.

These measures include deposit insurance and lender of last resort actions. Both serve to solve information asymmetries, caused by uncertainty and contagion. Deposit insurance is an insurance fund, which can be paid for both by the banks themselves or by public funds, to insure (a part) of the deposits of banks. The lender of last result is a measure to provide emergency credit for banks in distress which face liquidity problems but still are solvent, e.g.

as a result of a bank run. Moral hazard issues are expected to be related to these forms of policy measures.

Moral hazard problems occur when governments (are expected to) help banks, thereby causing distortion in the market. Kindleberger summarizes the argumentation as: ‘if markets

33 Charles P. Kindleberger, Manias, Panics and Crashes, a History of Financial Crisis (John Wiley & Sons, New York, 2000), p. 158-159.

34 Barth, Caprio, and Levine, Rethinking Bank Regulation, p. 11.

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know in advance that help is forthcoming under generous dispensations, they break down more frequently and work less effectively.’³⁵ This makes sense intuitively. If bankers receive the benefits of taking high risks – high profits - without the risk related to it, they will tend to take more and higher risks. Safety net measures result in moral hazard problems in two ways.

First, because depositors know that their credit is safe, they will take less effort to control bankers and to discourage risky behaviour. Second, because bankers know their banks will not go bankrupt, they can engage in more risky undertakings, as these are associated with higher returns. Banks, when they know that they are too big to fail, or for other reasons can count on government support, will take excessive liquidity risks, thereby increasing the likelihood that public aid indeed becomes necessary.³⁶

Increased inefficiency The implementation of regulation with the aim of restricting or limiting the activities of banks negatively affects the efficiency of banks. For example, capital requirements may unintentionally induce banks to hold too much or too little capital, therewith increasing either the costs or the risks for banks.³⁷

Furthermore, supervision may negatively affect bank performance when self-interested motivations dominate over concerns for the public welfare.³⁸ The most commonly investigated regulatory measures are: capital requirements, supervisory power, restrictions on bank activities, and private monitoring. Opinions on the presumed relation differ. George Chortareas, Professor Economics at King’s College London, found a positive relation between capital requirements and increased supervision of banks, and the efficiency of the banks.³⁹ Regulatory restrictions on bank activities and private monitoring however seem to have a negative impact on the efficiency of banks.⁴⁰

35 Kindleberger, Manias, Panics and Crashes, p. 4.

36 Luc Laeven, ‘Banking Crises: A Review’, Annual Review of Financial Economics, 2011: 3, 17-40, p. 21.

37 Georgios E. Chorareas, Claudia Girardone, and Alexia Ventouri, ‘Bank supervision, regulation, and efficiency: Evidence from the European Union’, Journal of Financial Stability, 2012: 8, 292-302, p. 292.

38 Chorareas, Girardone, and Ventouri, ‘Bank supervision, regulation, and efficiency’, p. 293.

39 Ibidem, p. 301.

40 Ibidem, p. 301.

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The same results have been wielded by Barth et al. in a research on the effects of regulation in the EU. The authors found that ‘tighter bank activity restrictions exert negative impacts on bank efficiency while the greater capital regulation stringency exerts marginally positive effects on bank efficiency.’⁴¹ It leads them to conclude that there is a ‘trade-off between bank safety/soundness and efficiency.’⁴² In addition, the authors found a positive relation between greater independence of the supervisory authority and bank efficiency.⁴³ The suggestion that a greater autonomy from politicians results in improved efficiency is more in line with private interest theories than public interest theories.

Finally, Barth et al. found that ‘market-based monitoring of banks [e.g. external auditing] in terms of more financial transparency is positively associated with bank efficiency.’⁴⁴ Related, deposit insurance is found to have a negative relation with the efficiency of banks.⁴⁵

Concluding, it is argued that some regulatory measures may have negative influences on the efficiency of banks, but this relation is not unambiguous. Only with regard to the restriction on bank activities a negative impact on the efficiency of banks has been identified by most researchers.

Increasing the fragility of the system

‘Any aid to a present bank is the surest mode of preventing the establishment of a future good bank,’ the British journalist Walter Bagehot (1826-1877) was quoted saying.⁴⁶ The idea behind the argumentation of Bagehot is that the market creates the best banks (or any other institution or firm) because of competition. Weaker banks fail, while stronger banks will survive. The market is seen as a learning organism, where only the strongest firms and institutions will survive. Seen from this ‘Darwinist’ perspective, state intervention weakens

41 James R. Barth, Chen Lin, Yue Ma, Jesús Seade and Frank M. Song, ‘Do Bank Regulation, Supervision, and Monitoring Enhance or Impede Bank Efficiency?’, SSRN Working Paper, March 21, 2010, p. 26,

42 Barth, Lin, Ma, Seade and Song, ‘Do Bank Regulation, Supervision, and Monitoring Enhance or Impede Bank Efficiency?’, p. 26.

43 Ibidem, p. 26.

44 Ibidem, p. 26-27.

45 Ibidem, p. 27.

46 Walter Bagehot, Lombard Street: A description of the Money Market (Henry S. King & Co, London, 1873), quoted in: Guillermo Rosas, ‘Bagehot or Bailout? An Analysis of Government Responses to Banking Crisis’, American Journal of Political Science, 50:1, 2006, 175-191, p. 175.

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the market as a whole, because it results in the survival of weak banks which would otherwise have collapsed.

However, as has been mentioned above, this of course depends upon which regulatory measures are being taken. Barth et al. argue that specifically policies that ‘reduce the incentives of the private sector to assess and discipline banks tend to increase the probability that the country will suffer a systemic financial crisis.’⁴⁷ Such measures may for example include deposit insurance which, as has been explained above, decreases the incentive of depositors to supervise banks and discourage risky behaviour of bankers. In addition, the authors found that restricting banks from engaging in certain activities (e.g. derivatives trading), and prohibiting banks from lending abroad increases the fragility of the system.⁴⁸ Thus, some regulatory measures might (unintentionally) increase the fragility of the banking system, resulting in banking crises or failures. This might suggest in favour of the public interest point of view, as Barth et al. suggest, as the limited entrance of banks into the sector might not decrease the risk of crisis, but does fill the pockets of those who regulate. However, such unintentional effects might also derive from ignorance or incompetence, instead of pure malice.

Public choice- & private interest theory Public choice- and private interest theory are the two main camps in the broad debate over the effects of regulation. It should be recognized that both public interest and private interest theory are ideal types, which will not be found in ‘the real world’. People are likely to recognize their self-interest and act accordingly, but are on the other hand unlikely to do this at any cost. It is more likely that we will find a combination of both theories, where regulators aim to regulate on behalf of the ‘society’, but are influenced by their self-interests as well as by lobbying groups pressing for their needs.

It is necessary to understand both public choice- and private interest theories, as they provide the basics for the discussion over the desirability of regulation. Both theories implement parts

48 Barth, Caprio, and Levine, Rethinking Bank Regulation, p. 310-311.

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of the above described pros and cons of regulation, but have opposing views. Let us now take a look at the fundamentals of both theories.

Public choice theory According to public choice theory, the banking system is unstable and opaque as a result of its intrinsic risk and uncertainty. Because the costs for society of banking crisis are high, supervision and regulation of the sector is necessary. This should result in decreasing risk (via limitations on the banks activities) and uncertainty (via deposit insurance and the central bank as a lender of last resort).

In 1920, the English economist Arthur Pigou wrote his famous book ‘The Economics of Welfare’, in which he formulated his ideas about negative externalities, which could be corrected through a Pigovian tax. ‘The essence of the matter’, Pigou wrote, ‘is that person A, in the course of rendering some service, for which payment is made, to a second person B, incidentally also renders services or disservices to other persons (not producers of like services), of such a sort that payment cannot be exacted from the benefited parties or compensation enforced on behalf of the injured parties.’⁴⁹ Pigou thus argued that for some products, the invisible hand theory did not work, as the negative externalities were not internalized in the price of the product. For such products (or services), a helping hand is required. Although today much of Pigou’s work is related to environmental economics, it could as well be applied to banking crises which also produce negative externalities (reductions in credit, economic recession, fiscal pressures) for other persons that are not directly involved.

Although banking as such does not necessarily produce negative externalities (as for example the coal industry does), the fragility of banks and the related banking crises does produce such

‘disservices to other persons’. One obvious negative result of banking crises is the effect it has on the wider economy, mainly via a contraction of credit. In general, a bubble, such as the 2007 real-estate bubble, is able to develop because of the abundance of ‘easy money’ and low

49 Arthur C. Pigou, The Economics of Welfare (Macmillan and Co, London, 1920), 4^th edition, 1932, p. 183.

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interest rates.⁵⁰ Then, when this bubble starts to burst and investors, banks and other financial institutions start to withdraw from the risky asset, the value of it further collapses. In a desperate attempt to limit the exposure to risk, banks start to overcompensate by curtailing lending and therewith ‘triggering an economy wide liquidity and credit crunch.’⁵¹ As a result, recessions as a result of financial crises are ‘much worse’ and last longer than recessions where banking crises were not involved, the International Monetary Fund (IMF) found.⁵² There are a number of other factors that contribute to the perceived necessity of governmental regulation of the banking sector. The first is the fragility that is inherent in our modern financial system (see above), as a result of information asymmetries and the risks that are intrinsic in banking – especially liquidity creation via fractional reserve banking, and maturity and currency transformation, as shown by the two case studies. The regulation of the banking sector is legitimized because of these risks and uncertainties. Donald Morgan, assistant Vice President at the Federal Reserve Bank of New York states: ‘Were banks as transparent as other firms, the problems of “sick” banks would not infect the “healthy” ones, and […]

deposit insurance would be unnecessary.’⁵³ However, banks are not transparent. Morgan compared disagreement between two rating agencies (Moody’s and S&P), and used it as a proxy for uncertainty. He observed that only insurance firms generated more disagreement between the two firms than banks.⁵⁴ This opacity of banks provides justification for government intervention.⁵⁵

Another important justification for government supervision and regulation of the banking sector is the emergence of systemic, globally operating, banks. These banks are thought to play such an important role in the domestic or global economy that failure should be averted

50 Nouriel Roubini and Stephen Mihm, Crisis Economics, A crash course in the future of finance (The Penguin Press, New York, 2010), p. 121.

51 Roubini and Mihm, Crisis Economics, p. 25.

52 Prakash Kannan, Alasdair Scott, and Marco E. Terrones, ‘From Recession to Recover: How Soon and How Strong, p. 11, in: Stijn Claessens, M. Ayhan Kose, Luc Laeven and Fabián Valencia, Financial Crisis: Causes, Consequences and Policy Responses, International Moneteray Fund, 2013.

53 Donald P. Morgan, ‘Rating Banks: Risk and Uncertainty in an Opaque industry’, The American Economic Review, 2002: 92, 874-888, p. 874.

54 Donald P. Morgan, ‘Rating Banks: Risk and Uncertainty in an Opaque industry’, The American Economic Review, 2002: 92, 874-888, p. 874-875.

55 Morgan, ‘Rating Banks: Risk and Uncertainty in an Opaque industry’, p. 887-888.

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at all costs; they are too big to fail. The immense public expenditures are justified because government expenses would have been even higher if the financial crisis would have resulted in a global depression. These large costs involved in the bailouts or (partial) nationalizations of banks is another justification for government regulation of the sector. Supervision then is designed to reduce the expected costs of this function.⁵⁶

The idea that financial markets, when left at themselves, generally create systemic instabilities, is not unfounded. In 2001, The World Bank wrote in a report on Global Finance that: ‘there had been 112 episodes of systemic banking crises in 93 countries since the late 1970s – and 51 borderline crises were reported in 46 countries.’⁵⁷ Such figures seem to emphasize the fragility of the international financial system. In addition, it has been observed that the number of crises increases as financial markets become more liberalized and international.⁵⁸

Private interest Theory The private theory of regulation, which argues that regulation primarily benefits the regulator, provides a more ambiguous image than public choice theory. One of the more fundamental problems of the public choice theory is that it suggests a certain form of altruism from the regulator. In this sense, public interest theory seems to be describing an ideal world, but is less suitable for describing the ‘real world’, where regulators have interests themselves as well.

Scholars critical of the public interest theory describe it as ‘a normative analysis’ or ‘positive theory’; i.e. it describes how regulation should be, but is less capable of explaining regulation as it is.⁵⁹

Private interest theory makes sense intuitively. After all, there is a lot to gain by influencing policy makers, as the vast amount of lobbyists at the capitals of the world demonstrate. The banking sector is no exception to the huge interests that are at play at the making of legislation and regulation, and thus will aim to bend the regulation in its favour. The idea of the public

56 Davies and Green, Global Financial Regulation, 17-18.

57 World Bank, ‘Finance for growth, policy choices in a volatile world’, A World Bank Policy Research Report (2001), 75.

58 Davies and Green, Global Financial Regulation, 15.

59 W.K. Viscusi, J.E. Harrington and J.M. Vernon, Economics of regulation and antitrust, (Cambridge and London, MIT press, 1995), p. 326.

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interest theory where regulation is drawn in a vacuum, isolated from lobbyists and other interest groups, seems to be somewhat incomplete.

The private interest theory is generally attributed to George Stigler. Stigler wrote an influential article in 1971 that ‘as a rule, regulation is acquired by the industry and is designed and operated primarily for its benefit.’⁶⁰ The private interest view in a way is more pessimistic than the public interest theory as it assumes that not all of society benefits from a form of regulation, but only a specific group. Yes, the government is rationally devised and rationally employed and aims to fulfil the desires of all members of society, but this is not to say that the

‘state will serve any person’s conception of public interest.’⁶¹ Regulatory capture is the successful influencing by regulatees (those who are being regulated) or another interest group who have an interest in altering the regulation of the regulator. Although private interest theory recognizes that there are market failures, it differs from the public interest view in that it does not assume that the government necessarily has the incentives and capabilities to ameliorate market failures.⁶² For this thesis, this would mean that some forms of (de- )regulation might not be designed to prevent the market from failing, but might instead be the result of regulatory capture by an interest- or lobby group which has no specific interest in financial stability. This contrasts starkly with public choice theory rationale, which as a principle holds that government regulation, if implemented and enforced correctly, should increase stability.

Regulation is not constant. The respective powers of interest groups may alter, and therefore the regulatory pressure can change.⁶³ Furthermore, the interests of interest- and lobby groups may vary, which can be reflected by a change in regulation. Thus, the ‘limits placed on banking earlier in the twentieth century did not just result from competitive forces and

60 George Stigler, ‘The Theory of Economic Regulation’, The Bell Journal of Economics and Management Science, 1971: 2, 1, 3-21, p 3.

61 Stigler, ‘The Theory of Economic Regulation’, p 4.

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technological change but also were the result of the benefits to the industry, and to government officials as well, who imposed the limits.’⁶⁴

Economics professor Randall Kroszner and Finance professor Philip Strahan have argued that the private interest theory is more capable of explaining deregulation of the banking sector in the US between 1970 and 1994 than the public interest theory.⁶⁵ During this period, small banks fought against deregulation, because this would increase competition from other ‘larger and more efficient banking organizations.’⁶⁶ Although deregulation would thus result in more efficient banking organizations (i.e. it would be beneficial for the sector as a whole and for

‘the public’), the authors found that states would only deregulate later when small banks are relatively strong financially.⁶⁷ This is in line with the rationale of private interest view, while the public interest theory has troubles to explain this phenomenon. Such findings suggest that regulatory capture might result in less efficient and stable markets. The latest financial crisis, regarded in this way, could as well thus be a result of regulatory capture and its related decreasing stability.

Some authors, notably James Barth, Gerard Caprio and Ross Levine, have argued that regulation can be counterproductive. As they argue in Rethinking Bank Regulation: ‘The evidence suggests that fortifying official supervisory oversight and disciplinary powers actually impedes the efficient operation of banks, increases corruption in lending and therefore hurts the effectiveness of capital allocation without any corresponding improvement in bank stability.’⁶⁸ Such results should urge for caution. Where public choice theory would have it alteration in regulation would result in increased stability of the sector, private interest theory would argue that this is not necessarily the case. This means that some forms of regulation might damage financial stability as a result of regulatory capture by interest and lobby groups which have no interest in financial stability.

64 Ibidem, p. 46.

65 Randall S. Kroszner and Philip E. Strahan, ‘What Drives Deregulation? Economics and Politics of the Relaxation of Banking Branching Restrictions’, The Quarterly Journal of Economics, 1999:114, 4, 1437-1467, p. 1438-1439.

66 Kroszner and Strahan, ‘What Drives Deregulation?’, p. 1443.

67 Kroszner and Strahan, ‘What Drives Deregulation?’, p. 1453.

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Chapter 2: Theory and methodology

“Nothing is so firmly believed as that which is least known.”⁶⁹ - Michel de Montaigne, philosopher

This thesis argues that, if regulation of the banking sector increases, ceteris paribus, the costs for saving banks decreases. In the previous chapter, a relation between regulation and banking crises was shown although this relation seemed ambiguous. Some authors have argued that regulation decreases the chances of a banking crisis, while others argued that it increases fragility and thus the chances of a crisis. In this part, a theoretical model is provided for the rationale that tighter forms of regulation result in lower cost for authorities to intervene in the banking sector during crisis. This rationale is founded upon public choice theory, i.e. that regulation should result in a more stable banking system. If such results are not found in the empirical research, this might prove a hint that public choice theory has no strong explanatory power for the facts found.

Regulation & costs of public intervention In this hypothesis, regulation (R) is the independent variable, while the cost of public intervention (C) is the dependent variable. Regulation in this thesis is understood as the sum of the regulation of capital, restrictions on non-bank activities, regulation of non-performing loans, regulatory power and incentives for private sector to monitor of banks. The cost of public intervention here is synonymous to financial crisis aid provided by authorities and is understood as the sum of recapitalisation measures, guarantees, asset relief interventions and liquidity measures other than guarantees, in line with the criteria used by the EC.

There are three different ways of measuring the cost of public intervention: as a percentage of GDP, as a percentage of the size of the banking sector and in euros (or any other currency).

Measuring in euros would provide distorted results, as countries with a larger financial sector,

69 Michel de Montaigne, ed. Mary Carolyn Waldrep, Selected Essays, (Dover, 2011), p. 35.

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usually provide more extensive financial aid to this sector.⁷⁰ Measuring as a percentage of GDP, as the EC has done, provides a similar distorted view. Countries with a relatively small financial sector compared to its GDP, such as Russia in 1998, might provide extensive support to its small financial sector, while measured in its GDP, this support is limited.

Measuring provided financial aid as a percentage of the total assets of the banking sector in a country thus seems to provide the best way to compare public aid in different countries.

Methodology This thesis takes a small n qualitative analysis approach to test its hypothesis. It has benefited hugely by a policy research paper published in December 2012 by the World Bank and its accompanying World Bank’s 2011-2012 Bank Regulation and Supervision Survey (BRSS).⁷¹ This version substantially updates earlier surveys conducted in 2001, 2003, and 2007. As this survey covers the period between 2008 and 2013, it provides the opportunity to examine the relative strictness of regulation in different countries during the crisis. Using this database, two groups of countries are selected. In the first group, the most likely case studies, countries are selected with a strict regulatory system. The other group consists of the least likely case studies, where countries with a weak regulatory system are selected. If the hypothesis is to prove correct, countries in the first group should, on average, have spent less on saving banks than countries in the second group.

The report ‘Bank Regulation and Supervision around the World’ uses several criteria to classify weak or strong regulatory and supervisory systems in different states, based on the 2007 and 2011-2012 World Bank survey. The criteria can roughly be separated into four categories: capital regulation, regulation of non-bank activities, regulation of non-performing loans and the power or influence of the regulator.⁷²

70 Luc Laeven and Fabian Valencia, ‘Resolution in banking crises: the good, the bad and the ugly’, IMF Working Paper 10/44, 2010.

71 Martin Čihák, Aslı Demirgüç-Kunt, María Soledad Martínez Pería, and Amin Mohseni-Cheraghlou, ‘Bank Regulation and Supervision around the world, a crisis update’, The World Bank, Policy Research Working Paper 6282, December 2012.

72 Čihák, Demirgüç-Kunt, Pería, and Mohseni-Cheraghlou, ‘Bank Regulation and Supervision around the world’, p. 7 – 10.

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The other variable, and presumed effect of regulation, is the financial aid provided by a given country to banks in the country between 2008 and 2013. Public financial aid consists out of capital injections, guarantees on bank liabilities, relief on impaired assets and liquidity and bank funding support.⁷³

This thesis takes October 1^st, 2008 as a starting point for measuring regulatory strictness and state aid for the banking sector, and October 1, 2013 as an end date. This timeframe of five years has been chosen for two reasons. The first is that almost all serious distress of banks and all decisions on state aid for banks have occurred in this period. The second is of a more practical nature: the EC has drafted statistics providing a comprehensive overview of the state aid for banks offered by EU-member states during this period.

The model Regulation in this thesis is, in line with public choice theory, regarded as the government- controlled damping effect on the causes of banking crises. Such causes, or external disturbances, include: large imbalances on the balance sheet of the private sector (such as the maturity mismatch and currency mismatches during the East Asian- and Russian crisis at the end of the previous century), asset booms or bubbles (such as the real estate bubble prior to the 2008 financial crisis, or the internet bubble prior the dot com burst in 2000) and private sector indebtedness (such as the household sector during the 2008 financial crisis or the corporate sector during the East Asian crisis).

A model helps to clarify the relation between regulation and financial aid in relation to external disturbances, the banking sector and the real economy. Such a model is provided below:

73 See appendix 2 for a comparison between the size of the banking sectors & financial aid provided by states.

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In this model, there are two forms of regulation: regulation which dampens the effect of the external disturbance on the banking sector (R1), and regulation which dampens the effect of distortions in the banking sector on the real economy (R2). While activity restrictions might be regarded as an example of the first form of regulation, deposit insurance forms might be regarded as a form of the second form of regulation. It is especially R1 which decreases the negative effect of the external disturbance on the banking sector and thus decreases the financial aid necessary to help this sector. Thus, when R1 increases, logically the financial aid provided will decrease. This thesis only measures R1 regulatory policies and its effect on the banking sector. The effectiveness of R2-related policies should be measured against the effect of the financial crisis on the ‘real economy’, and thus is not taken into account.

Criteria to measure regulatory strictness Regulators are able to choose from a wide variety of R1-measures to counter risk, uncertainty and contagion. This thesis uses five broad criteria to identify whether a country is identified as having a weak or a rather strong regulatory framework: the regulation of capital, restrictions on non-bank activities, regulation of non-performing loans, regulatory power, and incentives for the private sector to monitor banks.

Regulation of capital Capital regulation is regarded necessary for two reasons: first, banks can make more profit if their leverage is higher, i.e. the lower the capital to asset ratio, the more profitable it is for a bank. However, as a result of risk and uncertainty, it also results in greater instability. The regulation of capital is assumed to increase the capital reserves held by the bank, thereby reducing the risk of liquidity problems and chances of default by the bank and increasing stability.

Bank capital acts as a ‘buffer to cushion potential future bank losses’ and to ‘minimize negative spill overs to other stakeholders apart from bank owners.’⁷⁴ Note that the ‘buffer’

here is intended to mitigate risk, while minimizing the negative spill-over is related to the

74 Allen N. Berger and Christa H.S. Bouwman, ‘How does capital affect bank performance during financial crises?’, Journal of Financial Economics, 109, 2013, 146-176, p. 149.

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before mentioned contagious nature of banking. It ‘acts as an incentive device, stimulating bank owners of well capitalized banks to avoid excessive risk taking and properly account for risk.’⁷⁵

Three aspects of capital here are of importance: the quantity of the capital, the quality of it, and risk-based capital regulation. For the latter, it is problematic that the nature of risk is dynamic and constantly shifting in which neither banks nor regulators have perfect insights.⁷⁶ The risk and quality of capital is divided in Tier 1 (core capital), Tier 2 (supplementary capital), and Tier 3 (tertiary capital), where Tier 1 capital is regarded to be of the highest quality and thus contains the lowest risk and Tier 3 of lower quality with higher risk. The amount of capital that a bank has to hold as required by the regulator is called regulatory capital. Depending on the regulatory framework, this regulatory capital may contain only Tier 1, or also Tier 2 and Tier 3 capital. When Tier 3 is allowed in regulatory capital, the quality of this capital will be lower, and the risks involved will be higher.

Differences in regulatory systems, or in the regulatory framework, create an unfair competitive environment. With the implementation of Basel I (1992), II (2008), and III (expected in 2019) progression is made in creating a level playing field where banks are bound by the same rules. Indeed, Basel III’s main function will be to strengthen the stability of banks by increasing bank liquidity and decreasing bank leverage. However, although an international framework exists, national differences in capital requirements remain.

Restrictions on non-bank activities National regulators may restrict banks to a narrow range of activities. Such restrictions not only define what is understood to be a bank, it also describes the allowed combinations of banks and nonbanks to form financial conglomerates. There is a great diversity in the degree to which countries restrict banks from engaging in certain activities. Čihák et al. found that crisis countries faced fewer restrictions on non-bank activities such as insurance, investment

75 Matej Marinč, Mojmir Mrak and Vasja Rant, ‘Dimensions of Bank Capital Regulation: a Cross-Country Analysis’, Panoeconiomicus, 4, 2014, 415-439, p. 417.

76 Marinč, Mrak and Rant, ‘Dimensions of Bank Capital Regulation’, p. 417.

Chapter 1: Literature review

BLACK SWAN OR BROKEN SYSTEM?

Acknowledgements

Table of contents

Introduction

Chapter 1: Literature review

Chapter 2: Theory and methodology