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The Capital Markets Union-project of the European Commission aims for an increase of marketbased debt financing of small and medium-sized enterprises (SMEs), complementing bank lending. In this essay we argue that rather than focussing on pure non-bank lending, a reasonable mix of bankand market-based financing should be considered. Banks are said to have a comparative advantage in critical lending functions such as credit screening, debtor monitoring and debt renegotiation. All forms of lending require a persistent skin-in-the-game of critical players in order to be effective. The regulator should insist on full disclosure of skin-in-the-game, thereby improving capital allocation and reducing systemic risks.
This note discusses the basic economics of central clearing for derivatives and the need for a proper regulation, supervision and resolution of central counterparty clearing houses (CCPs). New regulation in the U.S. and in Europe renders the involvement of a central counterparty mandatory for standardized OTC derivatives’ trading and sets higher capital and collateral requirements for non-centrally cleared derivatives.
From a macrofinance perspective, CCPs provide a trade-off between reduced contagion risk in the financial industry and the creation of a significant systemic risk. However, so far, regulation and supervision of CCPs is very fragmented, limited and ignores two important aspects: the risk of consolidation of CCPs on the one side and the competition among CCPs on the other side. i) As the economies of scale of CCP operations in risk and cost reduction can be large, they provide an argument in favor of consolidation, leading at the extreme to a monopoly CCP that poses the ultimate default risk – a systemic risk for the entire financial sector. As a systemic risk event requires a government bailout, there is a public policy issue here. ii) As long as no monopoly CCP exists, there is competition for market share among existing CCPs. Such competition may undermine the stability of the entire financial system because it induces “predatory margining”: a reduction of margin requirements to increase market share.
The policy lesson from our consideration emphasizes the importance of a single authority supervising all competing CCPs as well as of a specific regulation and resolution framework for CCPs. Our general recommendations can be applied to the current situation in Europe, and the proposed merger between Deutsche Börse and London Stock Exchange.
The eurozone remains in a deep, largely macro-economic crisis. A robust global economy and falling oil prices have supported Europe’s economy for some time, but by now it is clear that the eurozone will only be able to pull itself out of this crisis by means of more decisive action. One response, the recent easing of monetary policy by the European Central Bank (ECB), has, for the most part, been sharply and one-sidedly criticised in Germany. Monetary policy inaction seems to be the preferred option of many in Germany.
The authors discuss the following question: What would happen if the ECB failed to respond to the excessively low inflation and the weak economy? And what economic policy would be suitable under the current circumstances, if not monetary policy?
In the wake of the recent financial crisis, significant regulatory actions have been taken aimed at limiting risks emanating from trading in bank business models. Prominent reform proposals are the Volcker Rule in the U.S., the Vickers Report in the UK, and, based on the Liikanen proposal, the Barnier proposal in the EU. A major element of these reforms is to separate “classical” commercial banking activities from securities trading activities, notably from proprietary trading. While the reforms are at different stages of implementation, there is a strong ongoing discussion on what possible economic consequences are to be expected. The goal of this paper is to look at the alternative approaches of these reform proposals and to assess their likely consequences for bank business models, risk-taking and financial stability. Our conclusions can be summarized as follows: First, the focus on a prohibition of only proprietary trading, as envisaged in the current EU proposal, is inadequate. It does not necessarily reduce risk-taking and it likely crowds out desired trading activities, thereby negatively affecting financial stability. Second, there is potentially a better solution to limit excessive trading risk at banks in terms of potential welfare consequences: Trading separation into legally distinct or ring-fenced entities within the existing banking organizations. This kind of separation limits cross-subsidies between banking and proprietary trading and diminishes contagion risk, while still allowing for synergies across banking, non-proprietary trading and proprietary trading.
The European Central Bank (ECB) increased the emergency liquidity assistance (ELA) for Greek banks from €50 billion in February 2015 to approximately €90 billion in June 2015. Its actions were accompanied by a discussion among academics, politicians and practitioners regarding the legitimacy of the ELA. Some have even accused the ECB of deliberately delaying the bankruptcy filing of already insolvent Greek banks.
We take the claim regarding insolvency delay as an opportunity to highlight the underlying economics of the ELA program and discuss its legitimacy in the current situation. We start by characterizing the complex interrelationship of the European Union, the ECB and the Greek banks through the lens of financial economics, with a particular focus on the political economy of a monetary union with incomplete fiscal union (or fiscal consolidation). Combining these two issues, we examine the decision of the ECB to continue the provision of ELA to Greek banks. Our conclusions, drawn from the analysis, do not support the claim that the ECB’s actions are consistent with a delayed filing for insolvency.
In light of the failed negotiations with Greece, Jan Krahnen argues that an effective reform agenda for Greece can only be designed by the elected government. Fundamental reforms will take time to take full effect and euro area member states will, in the meantime, have to offer Greece a basic level of economic security.
Krahnen demands that policy makers and the professional public involved view the Greek crisis as an opportunity to take the next necessary steps to formulate a reform agenda for the European Monetary Union. A community of supranational and non-party researchers and intellectuals could take the initiative and in a structured process develop a trustworthy and realistic concept that drafts the next big step towards a political union of Europe, including elements of a fiscal union.
The European Commission has published a Green Paper outlining possible measures to create a single market for capital in Europe. Our comments on the Commission’s capital markets union project use the functional finance approach as a starting point. Policy decisions, according to the functional finance perspective, should be essentially neutral (agnostic) in terms of institutions (level playing field). Our main angle, from which we assess proposals for the capital markets union agenda, are information asymmetries and the agency problems (screening, monitoring) which arise as a result. Within this perspective, we make a number of more specific proposals.
A recent proposal by the Financial Stability Board (FSB) suggests a new risk capital buffer for globally operating systemically important financial institutions. The suggested metric, “Total Loss Absorbing Capacity“ (TLAC), is composed of Tier-1 capital and loss absorbing debt. In a crisis situation, “bail-in-able” debt is to be written down or converted into equity. Jan Krahnen argues that the credibility of bail-in, in the case of systemically important financial institutions, hinges crucially on the design of TLAC and the requirements that will be placed on loss absorbing “bail-in-able” debt.The fear of direct systemic consequences through bail-in could be overcome, if a holding ban were placed on the “bail-in-bonds” of financial institutions. The holding ban would stipulate that these bonds cannot be held by other institutions within the banking sector.
Collateral, default risk, and relationship lending : an empirical study on financial contracting
(1999)
This paper provides further insights into the nature of relationship lending by analyzing the link between relationship lending, borrower quality and collateral as a key variable in loan contract design. We used a unique data set based on the examination of credit files of five leading German banks, thus relying on information actually used in the process of bank credit decision-making and contract design. In particular, bank internal borrower ratings serve to evaluate borrower quality, and the bank's own assessment of its housebank status serves to identify information-intensive relationships. Additionally, we used data on workout activities for borrowers facing financial distress. We found no significant correlation between ex ante borrower quality and the incidence or degree of collateralization. Our results indicate that the use of collateral in loan contract design is mainly driven by aspects of relationship lending and renegotiations. We found that relationship lenders or housebanks do require more collateral from their debtors, thereby increasing the borrower's lock-in and strengthening the banks' bargaining power in future renegotiation situations. This result is strongly supported by our analysis of the correlation between ex post risk, collateral and relationship lending since housebanks do more frequently engage in workout activities for distressed borrowers, and collateralization increases workout probability.
This essay reviews a cornerstone of the European Banking Union project, the resolution of systemically important banks. The focus is on the inherent conflict between a possible intervention by resolution authorities, conditional on a crisis situation, and effective prevention prior to a crisis. Moreover, the paper discusses the rules for bail-in debt and conversion rules for different layers of debt. Finally, some organizational requirements to achieve effective resolution results will be analyzed.
We develop a dynamic network model with heterogenous banks which undertake optimizing portfolio decisions subject to liquidity and capital constraints and trade in the interbank market whose equilibrium is governed by a tatonnement process. Due to the micro-funded structure of the decisional process as well as the iterative dynamic adjustment taking place in the market, the links in the network structures are endogenous and evolve dynamically. We use the model to assess the diffusion of systemic risk, the contribution of each bank to it as well as the evolution of the network in response to financial shocks and across different prudential policy regimes.
We develop a dynamic network model with heterogenous banks which undertake optimizing portfolio decisions subject to liquidity and capital constraints and trade in the interbank market whose equilibrium is governed by a tatonnement process. Due to the micro-funded structure of the decisional process as well as the iterative dynamic adjustment taking place in the market, the links in the network structures are endogenous and evolve dynamically. We use the model to assess the diffusion of systemic risk (measured as default probability), the contribution of each bank to it as well as the evolution of the network in response to financial shocks and across different prudential policy regimes.
We analyse the coordination problem in multi-creditor relationships empirically, relying on a unique panel data set that contains detailed credit-file information on distressed lending relationships in Germany, including information on creditor pools, a legal institution aiming at coordinating lender interests in borrower distress. We report three major findings. First, the existence of creditor pools increases the probability of workout success. Second, the results are consistent with coordination costs being positively related to pool size. Third, major determinants of pool formation are found to be the number of banks, the distribution of lending shares, and the severity of the distress shock.
Multiple lenders and corporate distress: evidence on debt restructuring : [Version Juli 2002]
(2002)
In the recent theoretical literature on lending risk, the common pool problem in multi-bank relationships has been analyzed extensively. In this paper we address this topic empirically, relying on a unique panel data set that includes detailed credit-fie information on distressed lending relationships in Germany. In particular, it includes information on bank pools, a legal institution aimed at coordinating lender interests in borrower distress. We find that the existence of small bank pools increases the probability of workout success and that coordination costs are positively related to pool size. We identify major determinants of pool formation, in particular the distribution of lending shares among banks, the number of banks, and the severity of the distress shock to the borrower.
On January 29, 2014, EU Commissioner Barnier published a draft law proposing a ban for proprietary trading by big banks in Europe. In this opinion piece, published in a German newspaper on 30 January, 2014, Jan Pieter Krahnen, who was a member of the Liikanen Commission, argues that the proposal could prove to be effective in preventing systemic risk.
This paper provides a systematic analysis of individual attitudes towards ambiguity, based on laboratory experiments. The design of the analysis allows to capture individual behavior across various levels of ambiguity, ranging from low to high. Attitudes towards risk and attitudes towards ambiguity are disentangled, providing pure measures of ambiguity aversion. Ambiguity aversion is captured in several ways, i.e. as a discount factor net of a risk premium, and as an estimated parameter in a generalized utility function. We find that ambiguity aversion varies across individuals, and with the level of ambiguity, being most prominent for intermediate levels. Around one third of subjects show no aversion, one third show maximum aversion, and one third show intermediate levels of ambiguity aversion, while there is almost no ambiguity seeking. While most theoretical work on ambiguity builds on maxmin expected utility, our results provide evidence that MEU does not adequately capture individual attitudes towards ambiguity for the majority of individuals. Instead, our results support models that allow for intermediate levels of ambiguity aversion. Moreover, we find risk aversion to be statistically unrelated to ambiguity aversion on average. Taken together, the results support the view that ambiguity is an important and distinct argument in decision making under uncertainty.
The bail-in puzzle
(2011)
Under the current conditions of a global financial crisis, notably in Europe’s banking industry, the governance role of bond markets is defunct. In fact, investors have understood that bank debt will almost always be rescued with taxpayers’ money. The widespread practice of government-led bank bailouts has thus severely corrupted the bond market, leading to the underestimation of risk and, as a consequence, the destruction of market discipline. Any feasible solution to the bank-debt-is-too-cheap problem will have to re-install true default risk for bank bond holders.
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“).
This policy letter provides an overview of the strengths, weaknesses, risks and opportunities of the upcoming comprehensive risk assessment, a euro area-wide evaluation of bank balance sheets and business models. If carried out properly, the 2014 comprehensive assessment will lead the euro area into a new era of banking supervision. Policy makers in euro area countries are now under severe pressure to define a credible backstop framework for banks. This framework, as the author argues, needs to be a broad, quasi-European system of mutually reinforcing backstops.
On November 8, 2013, several members of the British House of Lords’ Subcommittee A conducted a hearing at the ECB in Frankfurt, Germany, on “Genuine Economic and Monetary Union and its Implications for the UK”. Professors Otmar Issing and Jan Pieter Krahnen were called as expert witnesses.
The testimony began with a general discussion on the elements considered necessary for a functioning internal market. Do economic union and monetary union require a fiscal union or even a political union, beyond the elements of the banking union currently being prepared? In this context, also the critique of the German current account surplus and the international expectations that Germany stimulate internal demand to support growth in crisis countries, were discussed.
With regard to the monetary union, the members of the subcommittee asked for an assessment of how European nations and the banking industry would have fared in the banking crisis that followed the Lehman collapse, had there not been a common currency. Given the important role that the ECB has played in the course of the crisis management, the members further asked for an evaluation of the OMT-program of the ECB and also if the monetary union is in need of common debt instruments, in order to provide the ECB with the possibility of buying EU liabilities, comparable to the Fed buying US Treasury bonds. Finally, the dual role of the ECB for monetary policy and banking supervision was an issue touched on by several questions.