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Regulation

Bailing Out the Banks: Reconciling Stability and Competition in Europe

Thorsten Beck's picture

The relationship between market structure, competition and stability in banking has been a policy-relevant but controversial one (see Beck, 2008 for a pre-crisis survey).  The current crisis has put the topic back on the front-burner, and particularly so in Europe, where competition concerns about the effect of national bail-out packages on competition across Europe rank high.  Together with four other European economists, I have tackled this question in a recent CEPR report: Bailing out the Banks: Reconciling Stability and Competition.

The crisis has provoked two common but quite different reactions concerning the role of competition policy in the banking sector.  One reaction has been to jump to the conclusion that financial stability should take priority over all other concerns and that therefore the "business as usual" preoccupations of competition regulators should be put on hold.  Another reaction has been to fear that intervention to restore financial stability will lead to massive distortions of competition in the banking sector, and therefore to conclude that competition rules should be applied even more vigorously than usual, with the receipt of State aid being considered presumptive grounds for suspecting the bank in question of anti-competitive behavior.  We endorse neither of these points of view. 

Thoughts on the Financial Crisis and Improving Financial Regulation

Editor’s Note: The following post was contributed by Ross Levine, the James and Merryl Tisch Professor of Economics at Brown University.  This post summarizes a presentation Professor Levine gave at the World Bank on April 28 entitled An Autopsy of the Financial System: Suicide, Accident, or Negligent Homicide?  The presentation from the event is available here and video of the event will be made available soon on the All About Finance blog.  

In this blog entry, I address three issues: (1) The causes of the cause of the financial crisis, (2) Core approaches to financial regulation, and (3) Systemic improvements.  I also direct readers to longer treatments of each of these issues.

Causes

In a recent paper, An Autopsy of the U.S. Financial System: Accident, Suicide, or Negligent Homicide, I show that the design, implementation, and maintenance of financial policies by U.S. policymakers and regulators during the period from 1996 through 2006 were the primary causes of the financial system’s collapse.  I study five important policies (1) Securities and Exchange Commission (SEC) policies toward credit rating agencies, (2) Federal Reserve policies that allowed banks to reduce their capital cushions through the use of credit default swaps, (3) SEC and Federal Reserve policies concerning over-the-counter derivatives, (4) SEC policies toward the consolidated supervision of major investment banks, and (5) government policies toward the housing-finance giants, Fannie Mae and Freddie Mac.

Let me be blunt—time and again, U.S. regulatory authorities and policymakers (1) were acutely aware of the growing fragility of the financial system caused by their policies during the decade before the crisis, (2) had ample power to fix the problems, and (3) chose not to.  This crisis did not just fall from the sky on the heads of policymakers; policymakers helped cause this crisis.  While Alan Greenspan (former Chairman of the U.S. Federal Reserve) depicts the financial crisis as a once in a “hundred years flood” and a “classic euphoric bubble,” the evidence is inconsistent with these overly simple characterizations.  More importantly, this focus on “irrational exuberance” self-servingly deflects attention from the policy determinants of the crisis.

Regulators were not simply victims of limited information or a lack of regulatory power. Rather, the role of regulators in the five policies I mention above demonstrates that the crisis represents the selection—and most importantly the maintenance—of policies that increased financial fragility.  The financial regulatory system failed systemically.  To fix it, we need more than tinkering, we need systemic change. 

What Does the Financial Crisis Teach Us about the Feasibility of Different Banking Models?

Asli Demirgüç-Kunt's picture

The recent financial crisis has seen the demise of large investment banks in the U.S.  This major change in the financial landscape has also rekindled interest in discussion of optimal banking models.  All over the world, perceived costs and benefits of combining bank activities of various kinds have given rise to a wide variation in allowed bank activities.  Should banks operate as universal banks, a model which allows banks to combine a wide range of financial activities, including commercial banking, investment banking and insurance; or should their activities be restricted?

To some policymakers the universal banking model may appear to be a more desirable structure for a financial institution due to its resilience to adverse shocks, particularly after the crisis.  However, others have called for the separation of commercial and investment activities (along the lines of the Glass-Steagall Act of 1933 in U.S. which was repealed by Gramm-Leach-Bliley Act in 1999) to minimize the crisis-related costs imposed on taxpayers through the financial safety net.  So which model is more desirable?

Theory, as usual, provides conflicting predictions about the optimal asset and liability mix of an institution.  On the one hand, banks gain information on their customers in the provision of one financial service that may prove useful in the provision of other financial services to these same customers.  Hence, combining different types of activities – non-interesting earning, as well as interest-earning assets – may increase return as well as diversify risks, therefore boosting performance.  This argues for the merits of universal banks.

On the other hand, if a bank becomes too complex, bank managers may actually start taking advantage of this complexity for their own private benefit (what are sometimes known as “agency costs”) at the expense of the bank.  So, too much diversification may actually not be optimal, increasing bank fragility and reducing overall performance.  This tends to support the separation of commercial and investment activities. 

The Disastrous Consequences of Weak Financial Sector Policies

Asli Demirgüç-Kunt's picture

What is the role of the financial sector in development?  Does it really contribute, or does it merely respond to the demands of the real sector?  Are markets simply casinos for betting, or do they perform some productive role?  Shouldn’t the development community just focus its attention on more important issues, such as health, education, and the real sector?

I hear these questions all the time.  It is not surprising because prominent economists also hold conflicting views.  Many development economists do not even bother to discuss the role of the financial sector in development.  Joan Robinson famously stated “Where enterprise leads, finance follows,” and Robert Lucas has argued that the role of finance in the literature on growth has been “over-stressed.”

But at the other extreme, Joseph Schumpeter observed “The banker…authorizes people in the name of society…to innovate” and Merton Miller stated: “That financial markets contribute to economic growth is a proposition almost too obvious for serious discussion.”  This debate is crucial since it affects the decisions of policymakers to prioritize financial sector reforms, and the attention they pay to identifying and adopting appropriate financial sector policies.  Where do we come out?

New publication on ICT convergence-strategies and regulation

Siddhartha Raja's picture

With my co-author, Rajendra Singh, I had written two reports in 2008 on the topic of ICT convergence. These reports have been compiled with an updated introduction and are now available as a book published by the World Bank. I will be happy to answer any questions through this blog. 

You may also browse through this book in its entirety by clicking on the preview at the bottom of the page.

Building broadband: Strategies and policies for the developing world

Siddhartha Raja's picture

With broadband becoming an important topic in ICT policy discussions, it seems like the right time to publish a new report on what strategies and policies might help countries boost broadband access and use.

With the generous funding of the Korean Trust Fund for Information and Communications for Development (IC4D), I along with co-authors Yongsoo Kim and Tim Kelly, have prepared a report that does just that. 

Doing Business Report 2010: South Asia

Joe Qian's picture

The World Bank released its annual Doing Business report (pdf) last week which tracks regulatory reforms for conducting business and ranks countries based on their ease of doing business.

Countries are evaluated and ranked by indicators such as starting a business, employing workers, getting credit, paying taxes, etc.

In South Asia, seven out of eight (75%) of the countries instituted reforms that were conducive to business, higher than any previous year of the study.

Pakistan was the highest ranked country in the region at number 85 while Afghanistan and Bangladesh were the most dynamic reformers with three reforms each. Afghanistan’s rank in the study also increased the most in the region, climbing eight spots.

A Little Goes a Long Way: Creating an Enabling Environment for Media Development

Anne-Katrin Arnold's picture

CommGAP's work on a toolkit for media development has passed its second stage! After a learning needs assessment among governance advisors Shanthi Kalathil conducted three expert round table discussions on training and skills, sustainability, and an enabling environment for media development projects.


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