Post crisis banking regulation in the european union

1 Th eoretical Aspects of Banking Regulation 1 2 Basel III: Assessment of the Guidelines for 3 Post-Crisis EU Banking Regulation: Assessment 4 Bank Governance in the EU: A Substitu

Post-Crisis Banking Regulation

in the European Union

Opportunities and Threats

Katarzyna Sum

European Union

Post-Crisis Banking Regulation in the European Union

Opportunities and Threats

ISBN 978-3-319-41377-8 ISBN 978-3-319-41378-5 (eBook)

DOI 10.1007/978-3-319-41378-5

Library of Congress Control Number: 2016953881

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1 Th eoretical Aspects of Banking Regulation 1

2 Basel III: Assessment of the Guidelines for 

3 Post-Crisis EU Banking Regulation: Assessment

4 Bank Governance in the EU: A Substitute or

5 Th e Factors Infl uencing the EU Banking Regulatory

Framework: Impediments for the New Regulations 169

6 Banking Regulation and Bank Lending in the EU 209

AIFM Alternative Investment Fund Managers

AIFMID Alternative Investment Fund Managers Directive

BCBS Basel Committee of Banking Supervision

BRRD Bank Recovery and Resolution Directive

CDS Credit Default Swap

CoCos Contingent Convertible Bonds

CRD Capital Requirements Directive

CRM Comprehensive Risk Measure

CRO Chief Risk Offi cer

CRR Capital Requirements Regulation

CVaR Conditional Value at Risk

DGS Deposit Guarantee Schemes

DGSD Deposit Guarantee Schemes Directive

EBA European Banking Authority

EC European Commission

ECB European Central Bank

ECOFIN Economic and Financial Aff airs Council

EDIS European Deposit Insurance Scheme

EFP Employee Financial Participation

EFSF European Financial Stability Facility

EFSM European Financial Stabilisation Mechanism

EIB European Investment Bank

EMIR European Market Infrastructure Regulation

ESA European Supervisory Authorities

ESM European Stability Mechanism

ESMA European Securities and Markets Authority

ESRB European Systemic Risk Board

EU European Union

FCD Financial Conglomerates Directive

FSB Financial Stability Board

GDP Gross Domestic Product

IASB International Accounting Standards Board

IMF International Monetary Fund

IRC Incremental Risk Charge

LCR Liquidity Coverage Ratio

LOLR Lender of Last Resort

MIFID Markets in Financial Instruments Directive

NPL Non-Performing Loans

NSFR Net Stable Funding Ratio

OTC Over Th e Counter

PIT Point-in-Time Ratings

ROA Return on Assets

ROE Return on Equity

SSM Single Supervisory Mechanism

SRM Single Resolution Mechanism

SVaR Stressed Value at Risk

TTC Th rough-the-Cycle Ratings

TVaR Tail Value at Risk

UCITS Undertakings for Collective Investment in Transferable Securities VaR Value at Risk

VIF Variance Infl ation Factor

Fig 3.1 Sovereign yields of peripheral countries (%) 77 Fig 3.2 Total recapitalisation and asset relief state aid used by EU

member states between 2008 and 2014 (% GDP.) 80 Fig 3.3 Th e growth rate of foreign branches’ assets from other

Table 4.1 Results of empirical studies concerning the impact

Table 5.1 Banking regulatory measures: summary statistics 184 Table 5.2 Banking sector and macroeconomic features:

Table 5.3 Correlation of the main variables 188 Table 5.4 Baseline model results (random eff ects estimation) 190 Table 5.5 Regression results with endogenous covariates

Table 5.8 Results for the regressions explaining regulation

Table 6.2 Correlation of the main variables 222 Table 6.3 Characteristics of banks in the bottom and top

Table 6.4 Estimation results for the dependent variable loan

growth during the sample period 2005–14 228

Table 6.5 Estimation results for the dependent variable NPL

growth during the sample period 2005–14 230 Table 6.6 Estimation results for the dependent variable loan

growth during the crisis period 2007–10 234 Table 6.7 Estimation results for the dependent variable NPL

growth during the crisis period 2007–10 236 Table 6.8 Estimation results for the impact of regulatory

change on loan growth during the crisis period

Table 6.9 Estimation results for the impact of regulatory

change on NPL growth during the crisis period

Table 6.10 Post-crisis regulatory changes 243

Th e recent fi nancial crisis revealed substantial drawbacks in the banking regulatory framework of the European Union (EU) Th e pre-crisis regula-tions were built mainly on the Basel II guidelines and the harmonised rules for EU banks based on the Second Banking Directive and the Financial Services Action Plan Th e regulatory solutions turned out to be insuf-

fi cient to prevent unstable credit booms and to cope with the changing banking integration patterns and deregulation in the EU banking sector

EU banks incurred large losses during the recent fi nancial crisis, even the ones which were based in countries with conservative banking reg-ulations Commonly blamed factors of the debacle were: insuffi ciently stringent and clear capital adequacy rules; the procyclicality of banking regulations; the inadequate treatment of over the counter (OTC) deriva-tive transactions; as well as the lack of regulations concerning systemic risk and supranational supervisory mechanisms Deregulation and the involvement of banks in securitisation activities have enabled the banks’ business models to change from originate to hold to originate to dis-tribute Hence, regulators were confronted with highly leveraged banks, increased opacity of their balance sheets and excessive risk taking in the banking sector Moreover, the international interconnectedness of EU banks has contributed to pronounced systemic risk One of the most seri-ous concerns of the EU banking sector turned out to be the vicious circle between the banking and sovereign debt crises Ailing banks required

large amounts of government aid; this substantially strained the public budget of EU countries and increased the riskiness of sovereign bonds and their refi nancing costs Since government bonds constituted a large part of the banks’ portfolios, their increased yields weakened further the banks’ balance sheets and rendered them even more vulnerable to the crisis

Regulators reacted to the crisis by introducing far reaching reforms

to the existing frameworks, as well on the national, and supranational, level Th e post-crisis banking regulations in the EU are based largely

on the Basel III framework Th ey are also geared towards resolving the EU-specifi c problems of the banking sector by creating new, suprana-tional, supervisory institutions and bank resolution frameworks which would help to break the vicious circle between banks’ funding costs and sovereign risk Th e new regulatory acts are aimed at establishing a bank-ing union, a project aimed at resolving the immediate problems related

to the sovereign debt crisis, as well as strengthening the single market for fi nancial services in the longer term Th e banking union entails the movement of supervisory responsibility and potential fi nancial assistance for banks to the supranational level Hence, it is expected to reduce the fragmentation of fi nancial markets, counteract deposit fl ights and restore confi dence in the EU banking sector through setting uniform standards for banking regulation

Th e post-crisis regulatory reforms in the EU have provoked an intense debate among academics, supervisors and representatives of the banking industry Contrasting views emerged with regards to the accuracy and the impact of the new solutions Hence, the aim of this book is to depict the main opportunities and threats relating to post-crisis banking regula-tion and to answer the question of whether or not the new solutions are

an appropriate response to the EU’s ailing banking sector problems To approach this question the book addresses several strands of the current discussion around EU banking regulation: the implementation of Basel III rules, the introduction of the banking union, the inclusion of bank governance elements into the regulatory frameworks, as well as the coun-try specifi c factors of regulation on national levels

Th e main contribution of the book is a holistic, economic analysis of the ongoing banking regulatory reform in the EU.  Th e study adds to

the discussion about the controversial issues relating to EU regulations concerning the accuracy and the impact of the new solutions An impor-tant value added element of the book is the novel approach to banking regulations, consisting of their endogeneity and interactions with bank governance In this way the study contributes to the debate concerning insuffi cient bank governance, blamed as one of the triggers of the crisis

A substantial contribution of the book is also an analysis of the impact

of endogenous factors relating to the features of the regulatory process in the EU on the implementation of the rules Th e study investigates empir-ically the extent of regulatory capture in EU banking regulation, a topical issue, which has been barely covered in the literature until now A further contribution of the study is the empirical examination of the widely dis-cussed issue of how the new regulations will impact lending Th e book analyses banking regulation in the EU within theoretical frameworks, as well as by means of empirical exercises Based on the conducted analyses

it formulates challenges for futures reforms

Th e book is structured as follows Chapter 1 reviews the cal aspects of banking regulation, depicts the main tasks of banks and provides arguments for the need for banking regulation It discusses the special status of banks versus other fi rms, and the resulting need for pro-tection and regulation of the banking industry Moreover, it analyses the role of banking regulations within the framework of the agency theory It points out the purpose and functions of the respective elements of bank-ing regulations and their importance in maintaining the stability of the banking sector Importantly, the chapter focuses on the new post-crisis paradigm of regulation Particular attention is dedicated to the newly evolved, contradictory, strands of the treatment of banking crises in regu-lations, the issue of the regulation of fi nancial conglomerates and the Too-Big-To-Fail problem, the regulation of the shadow banking sector, the approach to systemic and endogenous risk, and the need for interna-tional coordination in regulations

Chapter 2 assesses the post-crisis Basel framework which provides the main guidelines for the reforms in the EU. It points out its main benefi ts and drawbacks in terms of its impact on banking system stability and subsequently on the liquidity provision function of banks It particu-larly addresses the issue of the risk models used for regulatory purpose,

due to their crucial role in determining the banks’ risk Th e chapter also focuses on the controversial aspects of Basel III which mainly include: the insuffi ciently addressed large exposures treatment, the portfolio invari-ance problem, the issue of sovereign risk weighting, as well the possible arbitrage resulting from the diff erent treatment of the trading and bank-ing book positions and from the possibility of shifting bank promises between fi nancial institutions

Chapter 3 describes and assesses the post-crisis banking regulations

in the EU and articulates challenges for ongoing reforms It portrays the EU-specifi c background for the post-crisis reforms It describes the vicious circle between the banking and the sovereign debt crisis and the apparent need to create supervisory and resolution mechanisms to main-tain the stability of the euro area It describes the creation of new banking supervisory authorities and the most important post-crisis regulations, directives and proposals in EU banking It depicts the utility of the new regulations for the establishment of the main pillars of the banking union: the Single Supervisory Mechanism and Single Resolution Mechanism It also refers to the planned introduction of the Single Deposit Insurance Scheme which would contribute to the completion of the banking union Subsequently, it aims to assess whether the new regulations are an appro-priate response to the specifi c EU banking sector’s problems It points out the advantages of the new solutions but also addresses their problematic aspects including: the controversial interpretation of the Basel recom-mendation on the regulatory treatment of sovereign exposures; the large exposures treatment in the EU framework; and the unresolved issues of the banking union, particularly the insuffi cient credibility of private sec-tor involvement in the bank resolution process, and the resulting poten-tial participation of taxpayers in absorbing the eff ects of banks’ failure Chapter 4 investigates the interactions between bank regulation and governance and evaluates the ongoing inclusion of governance elements

in the EU regulatory framework Th e chapter outlines the basic tions and elements of bank governance and analyses interactions between banking regulation and governance within the frameworks of the agency theory and regulatory dialectics theory Th e analysis is aimed at establish-ing whether bank governance in the EU is a substitute, or complement,

func-of banking regulation It also discusses the regulatory acts concerning

corporate governance in banks and aims at assessing the inclusion of bank governance elements in the EU regulatory framework in terms of their impact on banking sector stability

Chapter 5 aims at identifying the determinants of regulations and their implications for the implementation and conduct of EU rules on national levels It describes the regulatory process in the EU with a par-ticular focus on the stakeholders involved in the consultation process and their impact on the regulatory acts It approaches the issue of regula-tory capture in the EU banking sector, on the national, as well as on the supranational, level To determine the factors of regulation it builds on theories of regulatory choices: the private interest theory, the public inter-est theory and the regulatory dialectics theory, and conducts a series of empirical exercises aimed at testing the hypotheses concerning regulatory factors in the EU. It also analyses the individual cases of the consultation processes concerning the new, major, banking regulatory acts in the EU

by considering stakeholders’ participation in the regulatory procedure Subsequently it points to the opportunities and challenges relating to the movement of the regulatory process to a supranational level in terms of their implementation on and conduct at national levels

Chapter 6 analyses the impact of the new EU regulations on the credit provision function of banks It discusses the channels through which the respective elements of banking regulations infl uence the level and quality

of bank lending Subsequently it conducts a series of empirical exercises aimed at testing hypotheses concerning the impact of the new regulations

on credit growth On the basis of the results it draws conclusion about the eff ects of the ongoing regulatory changes on the liquidity provision function of EU banks

Th e book provides a holistic, economic analysis of the ongoing ing regulatory reform in the EU which depicts the main opportunities and threats relating to post-crisis banking regulation and aims to answer the question of whether or not the new solutions are an appropriate response to the EU’s ailing banking sector problems

© Th e Editor(s) (if applicable) and Th e Author(s) 2016

K Sum, Post-Crisis Banking Regulation in the European Union,

DOI 10.1007/978-3-319-41378-5_1

1.1.1 The Liquidity Provision Function

Banks play a prominent role in the functioning of the economy Th ey off er asset side services (e.g., originating and servicing loans), liability side services (e.g., accepting deposits and providing cash) and transfor-mation services (creation of liquidity) Banks are unique institutions since they provide liquidity by accepting a constant maturity mismatch

in their balance sheets Th ey convert deposits and short-term funding to long-term loans Since liquidity demand stems from depositors as well

as from borrowers, banks create liquidity on both sides of the balance sheet Commercial banks are responsible for liquidity creation within the boundaries set by central banks Th ey enable fi nancial transactions by processing payment transfers and servicing the payment system Banks are substantially involved in fi nancing trade by issuing letters of credit, guarantees and providing access to foreign currencies Besides that, they off er support to companies that conduct international transactions by

1

Theoretical Aspects of Banking

Regulation

providing access to local market information via their international work of representative offi ces, branches and subsidiaries

Banks also boost liquidity by acting as underwriters in bond issuance,

as well as organising and fi nancing syndicated loans for large neurial projects Banks not only provide capital and liquidity, but also supply various risk management tools, useful for companies that aim to hedge the risk of their transactions (e.g., derivative contracts) By off ering

entrepre-fi nancial instruments and guarantees for transactions banks enhance nomic activity Th e performance of the banks infl uences the liquidity and funding provision in an economy and as a consequence fi nancial stability and growth opportunities

According to the theory of banking, it is the maturity mismatch that creates incentives for banks to supply the necessary liquidity (Diamond

& Rajan, 2001 ) Banks are fragile institutions, since on the asset side of their balance sheets they hold complex, illiquid loans with various matur-ities, while on the liability side they hold easily withdrawable demand deposits, which are an inexpensive, but risky way to fi nance loans To deal with this fragility banks are expected to have unique, specifi c skills allow-ing them to manage the above mentioned liquidity constrains Th ese skills permit banks to shield borrowers from credit limitations due to deposit withdrawals, which could occur at any moment Since market participants are aware of this bank skill, they are willing to deposit their money in banks, which constitutes a sort of liquidity guarantee for the credit institution Hence, banks have a comparative advantage in holding loans in their portfolios and off ering guarantees of liquidity (Diamond & Rajan, 2001 ) Th e guarantees prevent the banks from abusing their skills and imposing excessive charges on their customers If banks misused their liquidity management skill, for example, by demanding exorbitant fees from borrowers, they would face the risk of a bank run and potential bankruptcy Hence, the maturity mismatch and the resulting fragility of funding are crucial to avoid such a misuse Th is is especially the case for banks that already have large loan positions and use their skills to manage these loans, instead of creating new ones Th ese banks are particularly dependent on the depositors and may fear runs

Banks can develop their unique skills due to their simultaneous cialisation in deposit taking and lending (Booth & Booth, 2004 ) Th e

spe-rationale behind this argument is that both activities, deposit taking and lending, require liquidity provision on demand If banks focus on both activities simultaneously this generates synergy eff ects in liquidity holding (Kashyap, Rajan, & Stein, 2002 ) Th e specialisation of banks in lending allows them to reduce the costs of loan illiquidity, that is, high lending margins or constrained availability of funding to companies Nevertheless, bank fragility may also have negative consequences In extreme cases it may lead to bank runs, especially in times of economic downturns when banks are confronted with many non-performing loans

To counteract such a scenario it is safer to fi nance the loans by long-term liabilities, although, long-term funding, especially through equity issu-ance, is a more expensive way to fi nance bank activity than deposit fund-ing and may constrain the banks’ incentive and ability to lend (Diamond

& Rajan, 2001 ) Hence, in order to secure their liquidity provision tion, banks have to adjust their funding structure in a way that trades off the long-term funding costs and the risk of bank runs Th e latter could

func-be mitigated through the presence of deposit insurance, which would func-be

an additional unique advantage for banks as liquidity providers (Booth & Booth, 2004 ) Deposit insurance does not, though, alleviate completely the banks’ fragility, since in practice, only a part of deposits is covered by the insurance scheme Importantly, given that deposit insurance is usu-ally conditional on the banks’ performance and capitalisation, it can be viewed as a similar discipline mechanism as demand deposits, allowing banks to fulfi l their liquidity provision function

1.1.2 The Intermediary and Information Provision

Function

A further function of banks, pronounced in the theoretical literature, is their role as intermediaries Th is function is closely related to the liquidity provision task Given that single potential lenders (market participants with liquidity surpluses) cannot fully fund the projects of potential bor-rowers (market participants with liquidity defi ciencies), it is essential to gather their funds in an institution that would be willing to take depos-its and play the role of intermediary by supplying loans to borrowers

(Diamond & Rajan, 2001 ) Th e bank also acts as intermediary, since it pays the depositors the charges extracted from the borrowers Again, this

is possible due to the specifi c skill of the bank consisting of the ous management of deposits and loans

Banks also fulfi l their intermediary function by acting as delegated monitoring institutions over the borrowers on behalf of the depositors

Th is is an effi cient arrangement, since in its absence each lender would have to monitor borrowers separately Th is would lead to duplicated eff orts in the banking system or a renouncement of monitoring, con-ducive to a free-rider problem (Diamond, 1984 ) Th e delegated moni-toring also relates to another function of banks, which is information provision Banks produce information on the credit risk of borrowers, which is viewed as a credential by depositors (Boyd & Prescott, 1985 )

Th ey do not disseminate the information, but they communicate it by making payments to depositors Doing this, they reduce substantially the information asymmetry and incentive problems between depositors and borrowers (Diamond, 1984 )

Banks have incentives to carry out their delegated monitoring and information provision function since these tasks entail substantial ben-efi ts in the form of fees Banks are motivated to hold lending portfolios, instead of originating new loans and just monitoring borrowers (Beatty

& Liao, 2014 ) Th is motivation may be exacerbated by the existence of delegation costs related to carrying out the mentioned functions Th ese costs can be, though, alleviated if the bank has diversifi ed funding and sets a convenient pattern of returns to depositors and from borrowers

Th e bank can use the extracted charges from deposit and lending ties to fi nance monitoring and to minimise its cost (Diamond, 1984 )

activi-In addition, the diversifi cation of funding and lending allows banks to distinguish between the respective depositors and satisfy the need for information provision on an individual basis Th is may be requested by single depositors to avoid disclosure of the monitored information to competitor banks

Th e importance of the intermediary function of banks has been scored by Boyd and Prescott ( 1985 ) Th ey show that in an environment where the information about borrowers’ credit risk is only privately avail-able, fi nancial intermediaries arise endogenously Th e market participants

under-(agents) in this environment do not have the full information about the borrowers’ credit risk, which gives rise to adverse selection problems Also, agents are not identically endowed with market information Th e func-tion of the intermediaries, which are coalitions of agents, is to support the privately available information Th is is possible due to the lending and borrowing function of these intermediaries Since they usually borrow and lend to large groups, intermediaries are substantially diversifi ed on both sides of the balance sheet Th is diversifi cation decreases largely the cost of monitoring (Diamond, 1984 ) Th e need for intermediary coali-tions is conditional on whether there is adverse selection before contract-ing and whether information production is possible after contracting Otherwise the same functions could be fulfi lled by a simpler construct, namely the securities markets (Boyd & Prescott, 1985 )

Given the delegated monitoring task, banks enable the issue of better lending and investments contracts (Diamond, 1984 ) Th ey also facili-tate safer investments, which are less aff ected by information asymmetry (Freixas & Santomero, 2002 )

1.1.3 Non- Typical Banking Activities

Besides fulfi lling their liquidity provision and intermediary function banks have extended their scope to non-typical banking tasks over the past decades Th is tendency was triggered by various factors, mainly the competition of shadow banking institutions, deregulation in banking, technological progress and fi nancial innovation

Shadow banking institutions, for instance investment funds, money market funds or special purpose vehicles, provide services which are in direct competition with banks, although they are less regulated Weaker regulation entails lower costs of shadow banking activity and a competi-tive disadvantage for banks causing the latter to put pressure on deregula-tion and engage in regulatory arbitrage by shifting their activities to the non-regulated sector As a consequence, the banking systems worldwide have undergone substantial liberalisation and deregulation Credit institu-tions were allowed to take on more and more risk and to mix non-typical and typical banking activities (Altunbas, Manganelli, & Marques-Ibanez,

2011 ) Th e liberalisation also enabled the trading of credit risk between banks and fi nancial markets via securitisation; that is, selling loans con-verted to tradable securities at the secondary market Th e wave of con-solidation in the fi nancial sector via mergers and acquisitions led to the creation of large conglomerates with great market power which again eased exerting further infl uence on regulations As a consequence, banks undertake various non-typical activities, for instance securities trading, brokerage, real estate activities or insurance activities

Besides deregulation, a substantial factor of the banks’ expansion to new

fi elds of activity was technological progress, which enabled an increasing number of banks to access and use market information on a current basis and fulfi l the function of market makers (Sławiński, 2006 ) Monitoring, processing and pricing of fi nancial data improved substantially over a short period of time and reduced the cost of issuing derivatives and structured products by banks Th e large increase of derivative instrument trading worldwide and the expansion of direct funding available via the fi nancial markets further boosted fi nancial innovation Subsequently, banks’ busi-ness models changed from “originate to hold” to “originate to distribute” (Altunbas et  al., 2011 ; Blundell-Wignall, Atkinson, & Roulet, 2014 )

Th is means that banks switched to making loans with the intention to sell them on the fi nancial market to a third party, instead of keeping them

in their portfolio until maturity Th e alteration of banks’ business models was refl ected in an increased share of non-interest income in proportion

to their total revenues (Boot & Th akor, 2010 )

Th e growing complexity and availability of derivative instruments and the increasing liquidity of fi nancial markets were substantial factors con-tributing to the shift of banking activity from deposit taking and lending towards non-traditional activities An essential alteration of banks’ busi-ness models led to changes in bank size, recourse to non-interest income revenues, corporate governance and funding practices Deregulation and

fi nancial innovation have thus changed the banks’ traditional functions that relied on liquidity and credit provision, as well as maturity transfor-mation (Altunbas, Gambacorta, & Marques-Ibanez, 2009 )

A theoretical explanation for banks’ expansion into non-typical ties is given by Diamond’s model (Diamond, 1984 ) Th e delegated moni-toring function implies that the bank has to hold illiquid assets (loans)

activi-due to its task of exerting control over borrowers Th e bank cannot sell the loans If it did, it would have to transfer the monitoring to a third party Besides the cost of ownership transfer, such an action would entail

a duplicated eff ort in monitoring and an adverse selection cost relating to the choice of the loan for sale Th e bank faces a trade-off between these costs and the cost of holding illiquid assets In the presence of a market for the illiquid assets, banks might have an incentive to securitise loans Hence, deregulation and fi nancial innovation have distorted the incen-tives of banks to fulfi l also their traditional intermediary function con-sisting of managing risk on behalf of depositors and investors (Altunbas

et al., 2011 )

1.2.1 The “Special Status” of Banks

One of the main arguments for banking regulation, put forward by the economic literature, is the “special status” of banks relating to their crucial functions (Fama, 1985 ; Rosenbluth & Schaap, 2003 ) Banks are trusted

to carry out their functions better than other institutions would; that

is, they are able to manage risk to an extent to which other institutions cannot Banks, as opposed to other fi nancial intermediaries, are the only institutions that create liquidity Non-bank fi nancial institutions avoid illiquid assets and their investors are only entitled to acquire returns pro-portionally to their deposits Th is means that the liquidity of non-bank institutions stems only from the underlying holdings of these institu-tions; they do not supply any additional liquidity of their own (Diamond

& Rajan, 2001 )

On the one hand, banks are vulnerable institutions Th ey not only create liquidity, but also need access to liquidity Th ey are fragile in this respect due to a large share of ephemeral customer funding, which could

be subject to potential creditor runs Since creditors are dispersed and have limited information, even well-functioning banks are exposed to the collective action problem under a panic condition (Diamond & Dybvig,

1986 ; Mülbert, 2010 ) Moreover, the traditional bank activity profi le

relies on receiving compensation for accepting a maturity mismatch, which is an additional source of fragility Th e compensation stems from the diff erence between the charges extracted from debtors and the pre-mium paid to creditors Th is gives banks incentives to increase lending and to attract deposits in order to boost their profi ts As a consequence of creditor funding, banks are usually highly leveraged institutions, which gives rise to their additional fragility (Mülbert, 2010 ) Additionally, banks have notoriously opaque balance sheets compared to other com-panies Th is opacity is due to the fact that the quality of bank loans and various structured and securitised assets they hold in their portfolios, is not readily observable Banks are also confronted with high information cost in their lending activity and the problem of adverse selection at bor-rower screening

On the other hand, banks are viewed as special due their pronounced risk taking incentives resulting from their protection by deposit insurance, the subsequent moral hazard and debt pricing distortions, as well as their involvement in risky non-banking activities In the presence of deposit insurance, banks face moral hazard and may take distorted decisions regarding lending, funding or investment (Rosenbluth & Schaap, 2003 ) Knowing that potential losses will be covered by the insurance fund, they may have incentives to take on excessive risk to make extra profi ts and maximise shareholder value Deposit insurance also distorts debt pricing, since it protects banks from market risk (Freixas, 2010 ) Deposit rates are hence risk independent Another factor strengthening this independence

is the fact that depositors do not only place their money in banks to strive for returns, but also to obtain access to the payment system Banks may have incentives to hold too much debt due to underpricing Hence, in the presence of deposit insurance proper regulation of the banks’ funding structure is necessary Also, given the large share of non-interest income

in proportion to their revenues, banks’ profi ts and risk profi les are quite volatile Th is is due to sharp changes of the risk profi les of the complex instruments in their portfolios, which are very sensitive to market condi-tions (Mülbert, 2010 )

Th e special status of banks is also related to the inherent systemic risk resulting from bank interconnectedness Banks are interconnected due

to their common activity on the interbank market as well as on the over

the counter (OTC) derivatives and foreign exchange markets Th eir mon activity on these market segments creates an extraordinary situation where the transaction parties are at the same time competitors, which gives rise to pronounced counterparty risk (Mülbert, 2010 ) Th e inter-connectedness of banks also renders them similarly exposed to market conditions, which is conducive to the emergence of systemic risk Even

com-if banks function well as individual entities, they may fail as a system com-if they are all exposed to the same group of risky assets Banks are also prone

to contagion; the deterioration of one bank’s fi nancial condition spreads very quickly to the rest of the sector

Finally, banks are viewed as special due their systemic importance, which stems from their role in maintaining economic activity and the use of their securities in the payment system

1.2.2 Market Failure Corrections

Further arguments for regulating banks are the need to correct market failures and to mitigate the externalities of potential banks’ bankruptcy Market failure stems from the asymmetry of information and the fragility

of trust between transaction participants (Rosenbluth & Schaap, 2003 ) From a theoretical point of view banks respond to correct such market failures Nevertheless, their response also creates new market imperfec-tions, since banks exploit the information asymmetry for economic gain (Freixas & Santomero, 2002 ) Th is is possible because depositors lack full information about how banks use their money, which creates incentives for banks to take on excessive risk in their lending and investment activi-ties As shown by Chiesa (2000), when specifi c banking outcomes are not observable by the depositors, market discipline weakens and banks are demotivated to monitor borrowers Th is moral hazard situation is even strengthened by the fact that the potential gains from risky loans or investments outweigh the losses, due to the restricted liability of shares and/or the existence of deposit insurance (Rosenbluth & Schaap, 2003 )

On the other hand, in the absence of deposit insurance market pants may be reluctant to put their money in banks Th e need of regula-tion becomes apparent to ensure the intermediation function of banks

Market failure also stems from an asymmetry of risk management skills, between small, uninformed depositors and large, sophisticated banks Banks take the risk of their lending and investment activity, while depositors free-ride and renounce monitoring banks Th e market thus fails to supply the public good, which is bank monitoring Th ere is the need to supply this public good by a third party, the regulator, who would act on behalf of the depositors (Tirole, 2001 ) Th is argument is referred to in the literature as the representation hypothesis It entails that

a public regulator represents the interest of the depositors better than a private regulator would Considering the alternative, self-regulation in banking, one has to point out its substantial disadvantages Given that bank regulate themselves, incumbent credit institutions will be reluctant

to allow new entities to enter the market, ensuing negative externalities

of monopolistic structures A serious issue would also be the absence of the lender of last resort (LOLR), especially in the case of a systemic cri-sis Even in the presence of private deposit insurance, if a systemic crisis occurs, the capital shortfall cannot be covered by the other banks, since all of them are exposed to the common shock (Tirole, 2001 ) A further complication is that a private deposit insurer will be reluctant to insure worse performing banks As consequence weaker banks would take on excessive risk to make potentially larger gains enabling their recovery Finally, given the information imperfection and the absence of a cen-tral monitoring institution, the depositors would not have the necessary knowledge about the fi nancial soundness of the insurer Th e drawbacks

of self-regulation give support to the representation hypothesis and tify the need for a public regulator

Further market failures, for which regulation has to account, are related

to the monetary liquidity costs due to the transformation of illiquid into liquid assets by banks Intermediaries aim to maximise their fee from this activity Since liquidity provision is the delegated role of the central banks, their responsibility is also to monitor the activity of the banks (Freixas & Santomero, 2002 ) Th e central banks’ oversight should ensure

a prudent allocation of banks’ assets enabling proper liquidity mation and provision

Market ineffi ciency may also arise in connection with the tion production function of banks Credit institutions, having incurred

informa-costs of information gathering, are reluctant to reveal it to the public Regulation in the form of disclosure requirements enhances transparency and market effi ciency due to better pricing signals It enables market par-ticipants to take better, non-distorted, investment decisions

Th e literature also stresses ineffi ciencies relating to excessive market power (Freixas & Santomero, 2002 ) Banks may exploit their unique skills in intermediation, misuse their dominant market position and pur-sue their private interest, instead of carrying out their delegated monitor-ing function Proper regulation should correct this market ineffi ciency Finally, one has to consider the ineffi ciency generated by the confl ict between the social and private costs of unregulated banking If there are

no common regulations, banks can arbitrarily choose whether to follow prudent conduct rules, or not Given, that the private returns for fi rms strictly following the conduct are lower than the social returns, banks have no incentive for careful monitoring Additionally, if only some of the banks adhere to the conduct, the less prudent banks can just free- ride on the other banks’ good reputation (Freixas & Santomero, 2002 )

Th is creates a situation of mistrust and instability in the banking market Again, a response to this market failure would be to supply the missing public good, which is banking regulation

1.2.3 Externalities of a Bank’s Failure

In an unregulated environment one has to account for the possibility

of a bank’s failure Such a scenario entails the destruction of capital and the reduction of economic welfare, due to loss of the relationship with the bank’s clients and specifi c management knowledge about custom-ers’ risk preferences (Freixas & Santomero, 2002 ) Th e externalities of a bank’s failure involve dramatic third-party eff ects Aff ected parties would

be above all dispersed, uninformed depositors that cannot take any action

to hedge the risk of credit institutions’ default Moreover such a failure would impact negatively on other stakeholders of a bank, such as share-holders, creditors, borrowers and employees Also, due to spillovers, the eff ects of a bank’s bankruptcy would aff ect parties that are not direct stakeholders Such spillovers may stem from banks’ interconnectedness

due to mutual claims on the interbank market, in OTC derivatives, or from payment system servicing Depending on the extent of the fail-ure and the spillover eff ects, bank bankruptcy may constitute a threat

to fi nancial stability Finally, given the systemic importance of banks, a failure might negatively aff ect the real economy due to constrained credit availability to enterprises

An important aspect of the bank failure’s externalities is the prevalent contagion in the banking sector Besides the above mentioned intercon-nectedness of banks via mutual claims, one has to stress the role of behav-ioural factors that trigger spillovers A bank failure aff ects not only the actual stability of the system but also the perceived one Information asymmetry causes markets to be ineff ective, that is, security prices do not refl ect the full available information Moreover, investors do not act fully rationally; their decisions are based on superfi cial information and heuristic methods Th ey are prone to disaster myopia which occurs if the objective and subjective probabilities of crisis events diff er Banks tend

to base their assessment on past events which may not be accurate in the current situation As a consequence, market participants are prone

to herding eff ects and panic runs Given this behavioural aspects, even sound credit institutions can be the subject of bank runs Domino eff ects exacerbate the situation and lead to fi re sales and deleveraging

Counteracting and mitigating such costly scenarios are further ments for introducing banking regulation Th ese rationales become even more pronounced if one underscores the large social cost of bank bank-ruptcy versus the relatively mitigated private costs Banks receive state aid and may be bailed out at taxpayers’ cost Importantly, the mentioned welfare reduction constitutes a substantial social cost

argu-1.2.4 Agency Theory Arguments

Th e need for regulation is also well demonstrated within the framework

of agency theory Basic agency theory states that in corporations there is a confl ict of interest between owners and managers stemming from infor-mation asymmetry Th e theory assumes normal or competitive markets and refers generally to industrial corporations, that is, “ordinary fi rms”

(Jensen & Meckling, 1976 ) Due to the special status of banks, their activity involves multiple stakeholders embedded in a confl ict of inter-ests Th e bank’s stakeholders include:

(1) Large shareholders (blockowners)

(2) Small, dispersed shareholders

(3) Managers or executive directors

(4) Supervisory board members

(5) Creditors (e.g., depositors, bondholders, deposit insurers)

(6) Borrowers

Th e agency confl icts that may arise between stakeholders can take at least fi ve forms For one, there can be a confl ict between shareholders and managers which results from the separation of ownership and control Managers are more risk averse than shareholders since the company’s fi nan-cial condition is majorly their responsibility Also, shareholders, unlike managers, are dispersed, hence they can take a higher risk as a group Th e risk limitations are usually only put on managers, not on owners, which strengthens the agency confl ict between these two parties A second type of confl ict arises between blockowners and small shareholders Blockowners are more risk averse, since they have invested a large share of their funds

in the bank Also, they prefer payouts in the form of exclusive benefi ts rather than dividends (Mülbert, 2010 ) Th e third type of confl ict arises between owners (shareholders) and creditors Creditors are adherents of less risky investment strategies since their major interest is to regain their claims, whereas shareholders put pressure on higher returns and more risk taking Fourth, a confl ict also arises between depositors and bank manag-ers Due to delegated monitoring, bank managers strive for diff erent risk profi les than depositors Fifth, delegated monitoring also produces a con-

fl ict between borrowers and managers due to diff erences in preferred risk profi les, conducive to diff erent preferred rates charged to loans

Agency confl icts encourage risk shifting from owners to ers, creditors and borrowers Also, owners and managers may follow short- term objectives to increase profi ts at the creditors’ expense Th e consequences of such behaviour are even more pronounced given that banks’ risk profi les can change very rapidly, in contrast to regular fi rms

manag-Th is situation is exacerbated even further due the mentioned opacity of banks’ balance sheets, which makes it harder to control banks and to align the interests of the stakeholders (Mülbert, 2010 )

To control these agency problems, outside monitoring mechanisms are essential As discussed in Sect 1.1.1 banking theory puts forward demand-able deposits as a control device; nevertheless if deposits are insured they cannot fulfi l the monitoring function (Olszak, Pipień, Kowalska,

& Roszkowska, 2015 ) Another solution is proper equity levels (Tirole,

2006 ), which could be subject to capital regulations Also, other forms

of oversight, for instance disclosure requirements, asset quality review

or liquidity requirements, could help to trade off the mentioned agency confl icts Assuming that the banking sector is regulated, there is an addi-tional party involved in the agency confl ict: the regulator Regulators are one of the main stakeholders of banks, nevertheless their objectives are not in line with the ones of shareholders or managers Hence, regulations trade off the market power of bank stakeholder behaviour (Ciancanelli & Reyes Gonzales, 2001 )

Th e presence of the regulator creates additional information tries and subsequent agency problems Th e regulator is expected to act

asymme-as an agent of public interest Th e regulating institution is not in sion of the information a bank has, and it also follows a diff erent objec-tive then the owners and managers It aims at ensuring fi nancial stability and also shares the risk of the bank Th e risk sharing with the regulator gives rise to pronounced moral hazard on the bank’s part Regulation thus aff ects the balance of the intermediaries’ costs and benefi ts and may boost the creation of banks that would not exist in the absence of regula-tion (Ciancanelli & Reyes Gonzales, 2001 )

Th e mentioned distortions created by banking regulation can be viated by a proper design of the regulatory framework Th e risk shifting incentives are only pronounced in the case of minimalist regulation, for example, unconditional deposit insurance or LOLR function If these bank support measures were accompanied by sophisticated regulations, for example, liquidity requirements or disclosure standards, the men-tioned asymmetric information and agency problems could be mitigated

alle-Th e next section focuses on the various elements of banking regulations, which can be incorporated individually or jointly in the frameworks

1.3 The Elements of Banking Regulation

Given the importance of the banking sector for the economy and the mentioned confl icts of interest between the involved stakeholders, bank-ing regulation has to fulfi l a prominent role Th e literature enumerates the following main functions of banking regulation:

(1) Depositors’ protection

(2) Monitoring of banks’ individual and systemic risk

(3) Monitoring of legal aspects of banks’ activity

Given the “special status” of banks, the instruments of banking ulation have to be adjusted to the sector’s specifi c features (Freixas & Rochet, 1997 ) As mentioned in the previous section, banking regulation can potentially create market distortions As a consequence, it is essential

reg-to design instruments that would allow us reg-to supervise the banks and counteract their excessive risk taking (Dionne, 2003 ) As a matter of fact, contemporary banking regulation subjects banks to a broad, diverse set

of restrictions and rules

Regulators are confronted with the problem of how to choose the mal combination of regulatory tools Th e approaches vary from mini-malist, to far-reaching interventionist patterns Th e two extreme ends are “prudential regulation”, which pushes the cost of the maintenance

opti-of banking system stability on the banks themselves, and “propti-ofi t ding” regulation, which imposes these costs on taxpayers and bank cus-tomers by constraining competition in the banking sector (Rosenbluth

pad-& Schaap, 2003 ) In the latter case, the monopolistic structure helps to keep loan rates at a high level, and deposit rates at a low level Potential bank bail-outs are fi nanced by taxpayers In practice, regulators choose between numerous instruments that can be classifi ed into broad areas of banking regulation Th e main ones are discussed below

1.3.1 Entry and Ownership Regulations

One of the main types of banking regulations is entry requirements Usually the establishment of a bank is subject to numerous restrictions

Th e regulatory barriers to entry determine substantially the degree of competition in the banking market (Barth, Caprio, & Levine, 2013 )

On one hand, such regulation can help to increase the quality of credit institutions and contribute to fi nancial stability Th e market power of the incumbent banks may lead to increased franchise value and prevent credit institutions from excessive risk taking (Keeley, 1990 ) On the other hand, entry restrictions can serve as a pretext for protectionism in bank-ing, ensuing competition constraints Strict entry regulation may lead to excessive power of incumbent banks, entailing negative externalities for depositors and borrowers (Barth, Caprio, & Levine, 2004 )

Entry regulations usually refer to the complexity of the application procedure for a banking licence and the scope of information that has to

be provided by the candidate Th is may comprise the draft of the statute, the planned organisational form, fi nancial information about the owners and the sources of funds, as well as information about the qualifi cations

of the directors and managers (Barth et al., 2013 )

Also, regulators put restrictions on bank ownership (the ratio of shares that can be held by a single entity or related parties), barriers to foreign ownership, non-bank fi nancial fi rm ownership or non-fi nancial fi rm own-ership in banks Th e rationale behind this type of regulation is to avoid the emergence of large fi nancial conglomerates that would be hard to supervise and to counteract excessive market power concentration in single entities

1.3.2 Capital Requirements

Capital requirements refer to the amount, type and quality of capital that banks should hold Th e requirements are usually expressed as a ratio of capital to assets Of crucial importance is the defi nition of capital and the valuation of banks’ assets (Barth et al., 2013 ) Capital, in the strictest sense (Tier I), refers to equity and disclosed reserves, or retained earnings, although in a broader sense it may also comprise undisclosed and revalu-ation reserves, hybrid debt-equity instruments, as well as general provi-sions and subordinated debt (Tier II) Tier I capital is often referred to as

“going concern capital”, that is, used by a solvent, operating bank, while Tier II capital is called “gone concern capital” and constitutes a guarantee

for stakeholders in the case of the bank’s bankruptcy Th e capital ratios can be conditional on various types of bank risk (credit, market or opera-tional risk) Besides capital adequacy, regulations state whether capital sources are to be verifi ed by the supervisor

Capital regulations are supposed to trade off imperfect information problems, risk shifting incentives, as well as the ineffi ciencies created by deposit insurance, that is, moral hazard Capital requirements impact bank’s portfolio choices since they aff ect the returns of the respective assets held by banks Th ey aff ect the competition and intermediation strategies

of banks and incentives to monitor borrowers (Mehran & Th akor, 2011 )

Th ey also constitute a guarantee of bank soundness and are viewed as a buff er against potential losses

Nevertheless, excessive capital accumulation is undesirable, since it may decrease the value of the bank and elevate its fi nancing costs, due

to replacement of deposit funding by equity (Berger, Herring, & Szegö,

1995 ; Diamond & Rajan, 2000 , 2001 ; Gorton & Winton, 2014 ) Given that equity fi nancing is more expensive than deposit fi nancing, capital regulations may induce loan contraction and hence decrease the value of

a bank’s portfolio (Th akor, 1996 ) In the presence of deposit insurance, capital regulation may stimulate banks to choose ineffi cient portfolios due to biased returns of the respective assets (Rochet, 1992 ) High capital requirements can also lead to excessive risk taking since they boost banks’ risk absorption capability; also banks’ higher fi nancing costs push them

to take on more risk just to increase the future value of equity (Berger & Bouwman, 2013 ; Blum, 1999 ) In this case capital regulations would not trade off the mentioned agency problems

Economic theory has developed a particular interest in determining optimal capital regulation Arguments in favour of optimal capital levels are also found by Mehran and Th akor ( 2011 ) and Calem and Rob ( 1999 )

Th ey show that both very low and very high levels of capital are cive to excessive risk taking by banks, although other studies postulate that given the large volatility of banks’ credit and market risk profi les optimal capital requirements are infeasible (Freixas & Santomero, 2002 ) Various approaches to capital regulations have emerged One of them stipulates that banks, knowing their activity profi le, should declare an ex- ante capital threshold, which would be verifi ed ex-post by the regula-

condu-tor Such a solution was, though, hard to introduce in practice (Freixas

& Santomero, 2002 )

Another solution to strengthen monitoring over banks was the sition that banks should hold a substantial part of capital as subordinated debt Th e pronounced incentives of subordinated creditors to monitor the bank are expected to increase market discipline Any price changes

propo-of subordinated debt would trigger immediate market reactions Another rationale behind this approach is that higher leverage ratios motivate bor-rowers to exert pressure on bank managers and mitigate the problem

of risk shifting from managers and shareholders to debtholders, which occurs in the case of high equity ratios (Diamond & Rajan, 2001 ) A drawback of this solution is that the long-term maturity of subordinated debt prevents the bank from incurring the immediate cost of increased risk, therefore the disciplining eff ect of this type of capital is only limited Also, subordinated creditors are subjected to the imperfect information problem, hence their ability to monitor the bank would be restricted

A further proposition for setting capital requirements is based on banks’ internal models One of the rationales behind this approach

is that common capital regulations are ineffi cient and increase the

fi nancing cost of banks, since the levels of capital are chosen for the whole banking sector without accounting for individual bank char-acteristics (Allen, Carletti, & Marquez, 2011 ; Repullo & Suarez,

2008 ) Such an arbitrary approach to capital regulation does not off er, though, a solution to the imperfect information problem, it even exacerbates it Th is internal model-based approach also requires more intense ex-ante oversight on the part of the regulator (Freixas & Santomero, 2002 )

1.3.3 Activity Regulations

A widely discussed regulation type is restrictions on banks’ activities Restrictions usually refer to the scope and extent of non-typical banking activities banks can engage in As mentioned in Sect 1.1.3 such activities may encompass, primarily, securities trading, underwriting and broker-age, involvement in mutual funds activities, providing insurance con-

tracts and insurance underwriting, as well as investing in, developing and managing real estate Activity restrictions may also apply to the contro-versial mixing of the ownership of banks and non-fi nancial fi rms (Barth

et al., 2013 )

Th e purpose of imposing restrictions on banks’ activities is to trade off the agency confl icts and to mitigate the information asymmetry with par-ticular consideration of the pronounced risk shifting incentives brought about by the involvement in non-typical banking activities Strict regula-tions prevent banks from subordinating less profi table activities to more profi table ones, a practice which may increase their propensity to take on excessive risk (Boyd, Chang, & Smith, 1998 ; Barth et al., 2004 ) Ring fencing of non-banking and banking activity can prevent confl icts of interest between the respective activities Non-typical activities are usu-ally more profi table, hence bank owners will strive to increase their share

in a bank’s profi le Given, that the income derived from non-interest activities is much more volatile than interest income, banks involved in non-typical activities are exposed to much higher losses, in the case of downturns, than ring-fenced institutions Restrictions are, hence, aimed

at limiting this risk and preventing its shift to creditors

A further argument for imposing activity regulations is that broadened banking activity may motivate banks to consolidate As a consequence, bank size may increase, rendering regulatory oversight more diffi cult Also, a multiplicator eff ect may be at work here, since larger banks tend

to take on excessive risk, mainly due to their moral hazard incentives (Too-Big-To-Fail), and the possibility of engaging in diversifi ed high- risk activities Increased bank size might hence be conducive to more excessive risk taking Th is tendency is especially pronounced during cri-ses (Altunbas et al., 2011 ; Demirgüç-Kunt & Huizinga, 2012 ; Vallascas

& Keasey, 2012 ) Bank consolidation would also lead to oligopolistic structures, impeding competition and exacerbating the above mentioned asymmetry and agency problems

A counterargument for activity restrictions is that liberalisation allows banks to achieve economies of scale and scope, and diversifi cation ben-efi ts; hence it may be conducive to greater bank stability (Altunbas et al.,

2011 ; Barth et al., 2004 ) Empirical evidence, in general, supports the view that non-interest income increases bank risk (De Jonghe, 2010 ;

Lepetit, Nys, Rous, & Tarazi, 2008 ), although benefi ts of banking ity diversifi cation are also found (Altunbas et al., 2011 )

activ-1.3.4 Auditing Requirements and Private Monitoring

Auditing requirements and private monitoring are established to reduce the information asymmetry and agency confl icts through a strengthened framework enabling private investors to monitor banks Th e main ele-ments of such regulations are the requirement to supervise banks by certi-

fi ed auditors, the requirement to rate banks by rating agencies, the extent

of information subjected to disclosure requirements (unconsolidated and consolidated reports), and the explicit standards for the audit and the legal liability of directors for the accuracy of information provided Auditing requirements and private monitoring thus allow bank stake-holders to be informed appropriately about the bank’s fi nancial situation and enable them to take better, non-distorted decisions

Private monitoring can be also used for the benefi t of the supervisory authority since banks may be required to disclose the auditor’s report Th e regulator can also reserve the right to communicate with the auditor with

or without the banks’ approval, depending on the regulation stringency Regulators can also require auditors to communicate to them directly any fraudulent activity of the bank discovered during the audit and potentially take legal action against it in the case of negligence (Barth et al., 2013 )

1.3.5 Liquidity and Asset Quality Requirements

Liquidity requirements are a substantial element of regulation, since they maintain one of the basic functions of banks: asset transformation for liquidity provision As mentioned, banks not only produce liquidity, but also need access to it Th is need becomes very apparent during times of

fi nancial turmoil One of the important tasks of the regulators is thus to formulate strict prudential regulatory norms for banks’ liquidity risk and its management

Liquidity regulations mainly concern explicit liquidity or funding ratios, or maturity mismatch restrictions More preventive, forward look-ing regulatory measures comprise limits on concentrated exposures: that

is, standards that dictate to what extent banks are limited in their lending

to single or interrelated borrowers or requirements concerning asset and funding diversifi cation Such measures counteract the excessive impact

of a potential illiquidity of a counterparty on the bank’s liquidity tion Substantial measures are also contingency funding provisions, for example stress tests, which help to maintain the credit institution’s liquid-ity during times of fi nancial turmoil or economic downturn (Barth et al.,

While liquidity regulations primarily impose quantitative limits on banks’ portfolios, asset quality requirements help to determine the qual-ity of these portfolios Th ey may impact directly the liquidity provision function by determining the ability of the bank to perform the transfor-mation function with the assets held Th is regulation type entails such elements as the existence and coverage of a regulatory asset classifi cation system, standard of loan classifi cation, criteria for the determination of non-performing loans and the consequences in terms of fi nancial report-ing, and standards for loan provisioning

1.3.6 Lender of Last Resort and Deposit Insurance

Schemes

Deposit insurance schemes are established to prevent bank runs, potential contagion eff ects and as a consequence systemic crises In their absence, banks would have to pay their depositors a rate corresponding to the riskiness of their portfolios Given the asymmetry of information, this might be a costly solution for the depositors Deposit insurance schemes create a substantial “safety net” for the banking system to protect bank customers; that is, from the theoretical point of view, dispersed, unin-formed agents Nevertheless, other stakeholders can also benefi t from the existence of deposit insurance (Freixas & Santomero, 2002 ) Th e extent

of this safety net is thus the subject of an intense debate

Th e downside of deposit insurance for the regulator is the arising moral hazard for the bank to take on excessive risk and to shift it to the insurer Banks, knowing the level of insurance premiums, can take on excessive risk to achieve a predetermined return (Dewatripont & Tirole, 1994 ) If

the insurance premium is fi xed, risk taking allows us to increase the value

of insurance Banks do not really have to worry about the downside of their risky activities, since potential losses will be covered by the insurer Moreover, depositors are prone to free-riding, since they have less incen-tive to monitor the bank Hence, the presence of deposit insurance can exacerbate the above mentioned agency confl icts between bank owners, managers, and creditors

To mitigate moral hazard and free-riding, a proper structuring of the deposit insurance scheme is necessary Th e regulator has to set the limit, scope and conditions of the insurance cover to be able to control the behaviour of owners and depositors Important incentive devices are coinsurance, that is, the involvement of banks in fi nancing the scheme, the overall structure of funding for the scheme, as well as the structure

of the insurance premium A substantial control instrument is also the extent of the rights of the insurer to intervene in banks, for instance, to revoke insurance or take legal action against banks that violate the statute and regulations of the scheme (Barth et  al., 2013 ) Deposit insurance does not usually depend on a bank’s risk It has been argued in the litera-ture, that uniform insurance entails subsidising riskier banks at the cost

of more prudent ones, although, fair pricing of deposit insurance would

be a hard task, due to the above mentioned information asymmetries

Th is diffi culty causes that regulators to strive for risk-based capital tion rather than for risk-based deposit insurance (Freixas & Santomero,

Another element of the safety net, the LOLR, is a liquidity facility granted to banks As opposed to deposit insurance, LOLR is implicit and unregulated Th eoretically it is a facility open to illiquid, but solvent, credit institutions against good collateral In practice it is used as rescue package for failing banks Bank bail-outs entail large costs for taxpay-ers, who have to bear the burden of banks’ distorted, excessively risky decisions It exacerbates the risk shifting incentives relating to agency problems, although, the presence of systemically important institutions renders bail-out programmes unavoidable Th e large costs of the LOLR function can be mitigated by non-conventional liquidity provision meth-ods by central banks via multiple channels Another helpful measure is proper bank resolution mechanisms and bank closure requirements

1.3.7 Supervision Over Sound and Problematic

Institutions

Supervision over sound institutions is aimed at trading off information asymmetry, while problematic institutions’ discipline strives at prevent-ing bank failures and their negative externalities A substantial aspect of this regulation type is the supervisory power granted to the regulator Supervisory power determines the rights of the regulator to obtain the necessary information from the banks in order to assess their fi nancial situation, as well as the entitlement to undertake corrective or discretion-ary action

Besides the supervisor’s rights to obtain information from the banks’ auditors, substantial instruments of supervisory power are intervention rights in banks Depending on the regulatory stringency, regulators may enforce changes to the bank’s organisational structure and give manda-tory directions for managers regarding provisioning Th ey may also be entitled to suspend the directors’ decisions concerning dividends or extra compensation, or even replace management or directors An important supervisory instrument in terms of bank resolution is the right of the regulator to declare the insolvency of a bank Th e most far-reaching inter-vention tool is the entitlement to ownership rights suspension

Th e problematic institutions’ oversight entails similar tools as the monitoring of sound banks with the addition of discipline devices in the case of imprudent bank practices Such instruments may take the form of cease and desist type orders, setting extra regulatory limits for capital levels, or imposing additional restrictions on activity Th e supervi-sor may also be entitled to order a bank to make specifi c provisions or to enforce measures of internal bank governance Th e problematic institu-tions’ oversight also triggers the rights to banking licence withdrawal Important tools, in terms of crisis prevention, are early intervention mea-sures, for instance, automatic prompt corrective action rights in the case where banks do not fulfi l specifi c regulatory requirements

Many studies, though, stress the importance of carefully balanced supervisory power for proper banking system functioning If the authori-ties are granted too much supervisory power thist may lead to politically

induced decisions and disable the banks’ intermediary function (Djankov,

La Porta, Lopez-de-Silanes, & Shleifer, 2002 ; Quintyn & Taylor, 2002 )

Substantial changes to the theory of banking regulation were introduced after the emergence of the recent fi nancial crisis Two contradictory strands of treatment of banking crises in regulations evolved Th e fi rst view regards them as unavoidable and puts forward the necessity of pro-viding mitigating regulatory tools According to the other view, crises can

be avoided if appropriate regulatory instruments are available Regulators have to strike a balance between these two extreme approaches, since settling for one may not fully address the potential ineffi ciencies of the banking sector (Freixas, 2010 )

Th e crisis exacerbated the problem of information asymmetry and consequently deteriorated market discipline Th e pre-crisis view that dis-closure is suffi cient to counteract information asymmetry proved inad-equate, since the existing rules did not provide the desired transparency

In the economic literature a discussion emerged as to how to improve the transparency of information To solve the problem of information asymmetry one has to account for the diff erent information dissemina-tion patterns during times of stabilisation and during crises While dis-closure requirements mainly concern the standards of the provided data, transparency is only achieved if the disclosed information reaches the market and is processed in an appropriate way Th is is conditional on the ability of market participants to access and manage the abundant, available information One should also stress the endogenous mechanism between information provision and processing While investors base their reactions on the disclosed information, the banks’ incentives to disclose information are conditional on the expected outcome of the investors’ reactions Given behavioural biases, for instance, decisions based on heu-ristic methods and herding, investors might be prone to overreaction Banks, knowing that, fi lter the disclosed information in an appropriate way to avoid price crashes or liquidity shortages Another complication is caused by expectations resulting from regulation; that is, if investors con-

sider regulatory standards, or the existence of the lender of last resort as legitimate, they may be demotivated to collect the disclosed information (Dewatripont & Freixas, 2012 )

Th e lack of transparency led to a similar treatment of solvent and vent banks in the wake of and during the fi nancial crisis, which indicated the failure of market discipline Th e immediate reaction of regulators was the introduction of stress tests, which alleviated a part of the informa-tion asymmetry To enhance their credibility and counteract behavioural biases the tests were based on clear, identical scenarios for all banks and were certifi ed by regulatory agencies Stress tests allowed market partici-pants to discriminate between well, and badly, performing banks and hence to reinforce market discipline

A further solution put forward to counter the problem of pronounced information asymmetry during crises is to require disclosure standards based on information that cannot be manipulated, instead of arbitrary bank risk models Th is would help to avoid practices like asset reclassifi -cation and window-dressing of fi nancial statements Given that investors base their decisions on multiple information sources, clear-cut reports should be also required from rating agencies Information provision and market discipline could also be improved by explicit bank resolution mechanisms

Th e pre-crisis information asymmetry and the lack of market pline were due to important fallacies of regulations Th ese include, above all, regulatory arbitrage resulting from an unregulated shadow banking system, insuffi cient regulation of systemically important institutions, the materialisation of endogenous systemic risk, as well defi cient inter-national coordination of regulation despite the increased international interconnectedness of banks Th ese four issues are analysed in the subsec-tions below

disci-1.4.1 Shadow Banking and Regulatory Arbitrage

Major challenges for regulators arose due to pronounced regulatory trage, resulting from the activity of shadow banking institutions Shadow banks, for instance money markets funds or special purpose vehicles, play