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The paper analyses the relationship between deposit insurance, debt-holder monitoring, bank charter values, and risk taking for European banks. Utilising cross-sectional and time series variation in the existence of deposit insurance schemes in the EU, we find that the establishment of explicit deposit insurance significantly reduces the risk taking of banks. This finding stands in contrast to most of the previous empirical literature. It supports the hypothesis that in the absence of deposit insurance, European banking systems have been characterised by strong implicit insurance operating through the expectation of public intervention at times of distress. Hence the introduction of an explicit system may imply a de facto reduction in the scope of the safety net. This finding provides a new perspective on the effects of deposit insurance on risk taking. Unless the absence of any safety net is credible, the introduction of deposit insurance serves to explicitly limit the safety net and, hence, moral hazard. We also test further hypotheses regarding the interaction between deposit insurance and monitoring, charter values and "too-big-to-fail." We find that banks with lower charter values and more subordinated debt reduce risk taking more after the introduction of explicit deposit insurance, in support of the notion that charter values and subordinated debt may mitigate moral hazard. Finally, large banks (as measured in relation to the banking system as a whole) do not change their risk taking in response to the introduction of deposit insurance, which suggests that the introduction of explicit deposit insurance does not mitigate "too-big-to-fail" problems.
This paper uses the co-incidence of extreme shocks to banks’ risk to examine within country and across country contagion among large EU banks. Banks’ risk is measured by the first difference of weekly distances to default and abnormal returns. Using Monte Carlo simulations, the paper examines whether the observed frequency of large shocks experienced by two or more banks simultaneously is consistent with the assumption of a multivariate normal or a student t distribution. Further, the paper proposes a simple metric, which is used to identify contagion from one bank to another and identify “systemically important” banks in the EU.
Depending on the point of time and location, insurance companies are subject to different forms of solvency regulation. In modern regulation regimes, such as the future standard Solvency II in the EU, insurance pricing is liberalized and risk-based capital requirements will be introduced. In many economies in Asia and Latin America, on the other hand, supervisors require the prior approval of policy conditions and insurance premiums, but do not conduct risk-based capital regulation. This paper compares the outcome of insurance rate regulation and risk-based capital requirements by deriving stock insurers’ best responses. It turns out that binding price floors affect insurers’ optimal capital structures and induce them to choose higher safety levels. Risk-based capital requirements are a more efficient instrument of solvency regulation and allow for lower insurance premiums, but may come at the cost of investment efforts into adequate risk monitoring systems. The paper derives threshold values for regulator’s investments into risk-based capital regulation and provides starting points for designing a welfare-enhancing insurance regulation scheme.
We show that market discipline, defined as the extent to which firm specific risk characteristics are reflected in market prices, eroded during the recent financial crisis in 2008. We design a novel test of changes in market discipline based on the relation between firm specific risk characteristics and debt-to-equity hedge ratios. We find that market discipline already weakened after the rescue of Bear Stearns before disappearing almost entirely after the failure of Lehman Brothers. The effect is stronger for investment banks and large financial institutions, while there is no comparable effect for non-financial firms.
We introduce a new measure of systemic risk, the change in the conditional joint probability of default, which assesses the effects of the interdependence in the financial system on the general default risk of sovereign debtors. We apply our measure to examine the fragility of the European financial system during the ongoing sovereign debt crisis. Our analysis documents an increase in systemic risk contributions in the euro area during the post-Lehman global recession and especially after the beginning of the euro area sovereign debt crisis. We also find a considerable potential for cascade effects from small to large euro area sovereigns. When we investigate the effect of sovereign default on the European Union banking system, we find that bigger banks, banks with riskier activities, with poor asset quality, and funding and liquidity constraints tend to be more vulnerable to a sovereign default. Surprisingly, an increase in leverage does not seem to influence systemic vulnerability.
We present a thought-provoking study of two monetary models: the cash-in-advance and the Lagos and Wright (2005) models. We report that the different approach to modeling money — reduced-form vs. explicit role — neither induces theoretical nor quantitative differences in results. Given conformity of preferences, technologies and shocks, both models reduce to one difference equation. The equations do not coincide only if price distortions are differentially imposed across models. To illustrate, when cash prices are equally distorted in both models equally large welfare costs of inflation are obtained in each model. Our insight is that if results differ, then this is due to differential assumptions about the pricing mechanism that governs cash transactions, not the explicit microfoundation of money.
This paper summarizes the key proposals of the report by the Liikanen Commission. It starts with an explanation of a crisis narrative underlying the Report and its proposals. The proposals aim for a revitalization of market discipline in financial markets. The two main structural proposals of the Liikanen Report are: first, for large banks, the separation of the trading business from other parts of the banking business (the "Separation Proposal"), and the mandatory issuing of subordinated bank debt thought to be liable (the strict "Bail-in Proposal"). The credibility of this commitment to private liability is achieved by strict holding restrictions. The anticipated consequences of the introduction of these structural regulations for the financial industry and markets are addressed in a concluding part.
This note proposes a new set-up for the fund backing the Single Resolution Mechanism (SRM). The proposed fund is a Multi-Tier Resolution Fund (MTRF), restricting the joint and several supranational liability to a limited range of losses, bounded by national liability at the upper and the lower end. The layers are, in ascending order: a national fund (first losses), a European fund (second losses), the national budget (third losses), the ESM (fourth losses, as a backup for sovereigns). The system works like a reinsurance scheme, providing clear limits to European-level joint liability, and therefore confining moral hazard. At the same time, it allows for some degree of risk sharing, which is important for financial stability if shocks to the financial system are exogenous (e.g., of a supranational macroeconomic nature). The text has four parts. Section A describes the operation of the Multi-Tier Resolution Fund, assuming the fund capital to be fully paid-in (“Steady State“). Section B deals with the build-up phase of the fund capital (“Build up“). Section C discusses how the proposal deals with the apparent incentive conflicts. The final Section D summarizes open questions which need further thought (“Open Questions“).
Ausgehend von einer Erläuterung der Kriseninterpretation (crisis narrative), wie sie in dem Bericht der Liikanen-Kommission zugrunde liegt, werden die nach Ansicht des Verfassers zentralen Vorschläge des Kommissionsberichts ausgewählt, vorgestellt und in den größeren Rahmen einer erneuerten Ordnungspolitik für die Finanzmärkte Europas eingeordnet. Die mit den Vorschlägen eng zusammenhängenden Reformelemente der Bankenunion werden in diesem Text bewusst ausgeklammert. Die beiden zentralen Strukturvorschläge des Liikanen-Berichts betreffen die Abspaltung der Handelsgeschäfte von dem Universalbankengeschäft für große, internationale Banken (der Trennbankenvorschlag), sowie die verpflichtende Emission nachrangigen, glaubwürdig haftenden Fremdkapitals (der strenge Bail-in Vorschlag). Glaubwürdigkeit der Haftungszusage wird durch strenge Halterestriktionen erreicht. Vorhersehbare Folgerungen einer Einführung dieser Strukturregeln für die Finanzindustrie und -märkte werden in einem abschließenden Teil angesprochen.
In the aftermath of the financial crisis, the ECB has experienced an unprecedented deterioration in the level of trust. This raises the question as to what factors determine trust in central banking. We use a unique cross-country dataset which includes a rich set of socio-economic characteristics and supplement it with variables meant to reflect a country’s macroeconomic condition. We find that besides individual socio-economic characteristics, macroeconomic conditions play a crucial role in the trust-building process. Our results suggest that agents are boundedly rational in the trust-building process and that current ECB market operations may even be beneficial for trust in the ECB in the long-run.