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financial stability

CEO Pay at Banks is Not to Blame for the Credit Crisis

René M. Stulz's picture

Conventional wisdom has it that compensation in the financial industry is responsible for much of the credit crisis. For instance, Paul Krugman states that “reforming bankers’ compensation is the single best thing we can do to prevent another financial crisis a few years down the road.” Unfortunately, the facts are stubborn and they do not fit this conventional wisdom.

Rüdiger Fahlenbrach and I study the incentives of bank CEOs before the start of the crisis and how the performance of banks is related to these incentives in a paper published in the Journal of Financial Economics. Our sample includes 95 large banks for which we have detailed information on CEO compensation, option holdings, and equity holdings. The paper shows that the value of the shares held by CEOs in the companies they managed in 2006 was roughly ten times the value of their total annual compensation. Such large holdings dwarfed annual bonuses (see Table 1). Experts in governance would have argued before the crisis that the interests of these CEOs were well aligned with the interests of the shareholders because they had so much skin in the game. The CEOs of Lehman Brothers and Bear Stearns had equity holdings in their firms worth approximately one billion dollars in 2006. With such holdings, it would have made little sense for CEOs to take actions that knowingly decreased shareholder wealth.

The Future of Banking

Thorsten Beck's picture

For better or worse, banking is back in the headlines. From the desperate efforts of crisis-struck Eurozone governments to the Occupy Wall Street movement currently spreading across the globe, the future of banking is hotly debated. A new compilation of short essays by leading financial economists from the U.S. and Europe analyzes the short-term challenges in addressing the Euro-crisis as well as the medium- to long-term regulatory issues. The essays cover a wide variety of topics, ranging from Eurobonds to ring-fencing and taxation, but there are several themes that come through across the chapters. First, many reforms have been initiated or are under preparation, but they are often only the first step towards a safer financial system. Second, there is a need to change banks’ incentive structure in order to reduce aggressive risk-taking. Third, there is an urgent – also political – need to move away from privatizing gains and nationalizing losses, thus from bailing out to bailing in bank equity and junior debt holders.

I will not be able to touch on all the topics discussed in the book, so let me discuss some of the main messages in more detail. Ring fencing – the separation of banks’ commercial and trading activities, known as the Volcker Rule but also recommended by the Vickers Commission in the UK – continues to be heavily discussed among economists. While Arnoud Boot thinks that “heavy-handed intervention in the structure of the banking industry … is an inevitable part of the restructuring of the industry”, Viral Acharya insists that it is not a panacea as long as incentive problems are not addressed. Banks might still undertake risky activities within the ring or might even have incentives to take more aggressive risk. Capital regulations have to be an important part of the equation.

Addressing the Too-Big-to-Fail Problem before the Banks Become Too-Big-to-Save

Inci Otker-Robe's picture

The unprecedented scope and intensity of the ongoing global financial crisis has underscored the too-important-to-fail (TITF) problem associated with systemically important financial institutions (SIFIs). Ahead of the crisis, implicit government backing permitted these institutions to take on greater risks without being adequately subjected to market discipline, and to enjoy a competitive funding advantage over systemically less important institutions. When the crisis broke, their scale, complexity, and interconnectedness, which had made them difficult to manage and supervise, also proved too significant to permit them to fail. The large-scale public support provided during the crisis has reinforced the moral hazard problem and allowed SIFIs to grow even more complex and larger.

In a recent IMF Staff Position Note with my coauthors, Aditya Narain, Anna Ilyina, Jay Surti, and other IMF colleagues, we found that a regionally diverse group of 84 banks, which are sufficiently large or interconnected to be considered systemic at national, regional, or global levels, doubled their share of total global financial assets over the period 2000-09, to about a quarter (Figure 1). The assets of some of these banks exceed multiples of the size of their home economies (Figure 2). This importance, in turn, gives such banks greater influence over the regulatory and legislative process and a competitive advantage over systemically less important institutions, while making the rescue of such institutions, when they get into trouble, a very costly affair. In countries affected by the recent financial crisis, governments protected many of these institutions from failure by providing direct and indirect support to contain the damage to the broader economy (the direct support, excluding guarantees, is estimated at 6.4 percent of GDP on average in the most crisis-affected countries in end-2010).

Cross-Border Banking Linkages: Good or Bad for Banking Stability?

Martin Cihak's picture

When a country’s banking sector becomes more linked to banks abroad, does it get more or less prone to a banking crisis? In other words, should cross-border banking linkages be welcomed? Or should they be approached with caution or perhaps even suppressed in some way?

The recent global financial crisis has illustrated quite dramatically that increased financial linkages across borders can have a ‘dark side’: they can make it easier for disruptions in one country to be transmitted to other countries and to mutate into systemic problems with global implications. 

But financial cross-border linkages may also benefit economies in various ways. They can provide new funding and investment opportunities, contributing to rapid economic growth, as witnessed in many countries in the early part of the 2000s. The more ‘dense’ linkages also provide a greater diversity of funding options, so when there are funding problems in one jurisdiction, there are potentially many ‘safety valves’ in terms of alternative funding.

Triplet Crises: Lessons European Leaders Can Learn From Emerging Markets

Maria Soledad Martinez Peria's picture

Much of the discussion surrounding the current European crisis focused initially on whether a default by Greece was inevitable and how that would impact bond holders. Over time, the attention has shifted to banks and the potential for a generalized run and failure of the financial system, not only in Greece but also in other countries. Unfortunately, the developments in Europe are awfully similar to those in emerging economies in the past. The lessons learned in emerging markets might have helped European policymakers lessen the spillovers from macroeconomic risk to the financial sector, and even at this stage may still be useful for understanding how to manage the on-going crisis.

Many emerging economies used to follow exchange rate pegs, had large degree of liability dollarization, and ran fiscal deficits financed by the banking sector, which led to “triplet crises” involving debt, currency, and banking collapses. The  crises in Argentina and Uruguay in 2000–02 are illustrative. In a recent paper co-authored with Levy Yeyati, we show that macroeconomic risks like exchange rate devaluations or sovereign debt defaults can quickly cause the collapse of banking systems. These macroeconomic events are not random or driven by contagion across banks. Macroeconomic factors that are largely irrelevant in explaining depositor behavior during tranquil times can rapidly become the main driver of market response during crisis episodes, even after controlling for standard bank-specific traits. Furthermore, a crisis in one country (Argentina) can contaminate the banking system of a neighboring country (Uruguay) in a matter of days.

Crisis Recovery and the Role of Credit: Do Phoenix Miracles Exist?

Asli Demirgüç-Kunt's picture

One of the most hotly debated policy questions with respect to the 2008 global crisis is how to stimulate business recovery. Because the crisis started in and severely affected the financial sector, the conventional assumption is that the recovery of the financial sector is a precondition to recovery in the corporate sector. While this conjecture appears reasonable, some have challenged it, pointing to numerous crises across the world in recent years in which real sector recovery preceded that of the financial sector. Of particular interest are episodes characterized by Calvo et al. (2006) as Systemic Sudden Stops (3S episodes) where output declines are associated with sharp declines in the liquidity of a country’s financial sector. Subsequent credit-less recoveries—in which external credit collapses with output but fails to recover as output bounces back to full recovery—have been termed “Phoenix Miracles.”

Empirically, 3S episodes offer an unusual natural experiment since they provide an opportunity to observe how firms are affected in economies which have been subjected to a financial shock that precedes or is contemporaneous with a recession. To date there has been little evidence at the firm-level on how corporations respond to crises in general. In a recent paper, my co-authors Meghana Ayyagari, Vojislav Maksimovic and I use a database of listed firms in emerging markets to analyze the recovery process after a financing crisis. We try to see if recovery of the financial sector precedes or occurs at the same time as the recovery in output of the corporate sector. In other words, we ask: Do firms experience Phoenix Miracles where their sales recover without a recovery in external credit? We then compare and contrast the experience of emerging market firms to that of US firms during the 2008 US financial crisis and investigate if the recent US recovery process qualifies as a Phoenix Miracle.

Bank Competition and Stability: Cross-Country Heterogeneity

Thorsten Beck's picture

In a recent Economist debate, Franklin Allen and I discussed the relationship between competition and stability. In the debate I argued that it is not so much the degree of competition in the banking market but rather bank regulation and supervision that drives bank fragility. In a recent paper with Olivier de Jonghe and Glenn Schepens, we now combine these two areas and test whether the regulatory and supervisory framework influences the competition-stability relationship. And we indeed find several dimensions of the market, regulatory and institutional framework that influences the degree to which competition harms or helps bank fragility.

But let us first review what theory tells us about the competition-stability link, and then examine how this relationship might vary with certain country features.

Cross-border Banking in Europe: Implications for Financial Stability and Macroeconomic Policies

Thorsten Beck's picture

Understanding the role of banks in cross-border finance has become an urgent priority. The recent Global Financial Crisis and ongoing European crisis have shown the importance of creating the necessary regulatory and macroeconomic conditions for a Single European Banking Market to function properly in good and in tough times. Together with five other economists (Franklin Allen, Elena Carletti, Philip Lane, Dirk Schoenmaker and Wolf Wagner) I have  published a CEPR policy report that analyzes key aspects of cross-border banking and derives policy recommendations from a European perspective. We argue that for Europe to reap the important diversification and efficiency benefits from cross-border banking, while reducing the risks stemming from large cross-border banks, reforms in micro- and macro-prudential regulation and macroeconomic policies are needed.

The benefits and risks of cross-border banking have been extensively analyzed and discussed by researchers and policy makers alike. The main stability benefits stem from diversification gains; in spite of the Spanish housing crisis, Spain’s  large banks remain relatively solid, given the profitability of their Latin American subsidiaries. Similarly, foreign banks can help reduce funding risks for domestic firms if domestic banks run into problems. However, the costs might outweigh the diversification benefits if outward or inward bank investment is too concentrated. Based on several new metrics, we find that the structure of the large banking centers in the EU tends to be well balanced. However, problems are identified for the Central and Eastern European countries which are highly dependent on a few West European banks, and the Nordic and Baltic region which are relatively interwoven without much diversification. At the system-level, we find that the EU,  in contrast to other regions, is poorly diversified and is overexposed to the United States.

Do We Need Big Banks?

Asli Demirgüç-Kunt's picture

In the past several decades banks have grown relentlessly. Many have become very large—both in absolute terms and relative to their economies. During the recent financial crisis it became apparent that large bank size can imply large risks to a country’s public finances. In Iceland failures of large banks in 2008 triggered a national bankruptcy. In Ireland the distress of large banks forced the country to seek financial assistance from the European Union and International Monetary Fund in 2010.

An obvious solution to the public finance risks posed by large banks is to force them to downsize or split up. In the aftermath of the EU bailout Ireland will probably be required to considerably downsize its banks, reflecting its relatively small national economy. In the United Kingdom the Bank of England has been active in a debate on whether major U.K. banks need to be split up to reduce risks to the British treasury. In the United States the Wall Street Reform and Consumer Protection Act (or Dodd-Frank Act) passed in July 2010 prohibits bank mergers that result in a bank with total liabilities exceeding 10 percent of the aggregate consolidated liabilities of all financial companies, to prevent the emergence of an oversized bank.

So public finance risks of systemically large banks are obvious. But what are some of the other costs (and benefits) associated with bank size? This is the question Harry Huizinga and I try to address in a recent paper. Specifically, we look at how large banks are different in three key areas:

How Corporate Stress Testing Can Enhance Bank Stress Testing

Inessa Love's picture

The Financial Sector Assessment Program (FSAP) performs bank stress testing to evaluate the resilience of the banking sector to different unexpected shocks, including sharp changes in the interest rate or exchange rate. In addition to macroeconomic shocks like these, the soundness of the banking sector also depends on the soundness of bank borrowers: systemic shocks to borrowers’ ability to repay loans is transmitted to banks through corporate defaults.

For example, an interest rate shock may affect banks directly, through its impact on the income and expenses from their lending practices. In addition, if the interest rate shock affects borrowers’ ability to repay, the shock will also be transmitted to the banking sector through an increase in corporate defaults. Similarly, a negative shock to corporate earnings will manifest as higher default rates and also adversely affect bank stability.

Assessment of corporate vulnerability thus would strengthen the analysis of bank vulnerability to shocks and should play an important role in bank stress testing. Unfortunately, assessment of corporate vulnerability is rarely included in the FSAP’s standard bank stress testing.

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