“In 42 years on the financial markets, I have seen many crises. They are rarely the same. However, the system does not have a great ability to look forward, but rather in the rearview mirror. In my experience, governments and regulators solve the problems that cause a crisis, and often the solutions found carry the seeds of the next crisis.”
Larry Fink, CEO of BlackRock, Interview with the French newspaper Le Monde, 19th September 2018
The “market failures” in the financial sector and their consequences for financial regulation have been one of my main topics of reflection. My work has been enriched by my operational responsibilities in the public and private sectors.
As a member of the French Council for Economic Analysis (CAE) and following the deep financial crisis in many emerging countries in the late 90s, I was asked in 1998 by the French Prime Minister of the time (Lionel Jospin) to write a report “on the causes of instability in financial markets and possible progress to reduce the risk of new currency and financial crises”.
This brief summary highlights two key points that today have a particular resonance in the face of the exceptional financial crisis that hit the industrialized countries ten years later:
“For Olivier Davanne, the current crisis, at various degrees, also underscores the need to have financial institutions, both in industrialized and in emerging markets, taking more responsibility for their credit decisions. In practice, the fact that a bankruptcy code perfectly adapted to the characteristics of the banking sector is lacking, makes it difficult to find the fair sanction against risky behaviors. In the absence of such codes, the international organizations concerned (Basle Committee, IMF, World Bank) could prepare a «code of good conduct» for bank-restructuring in order to reduce as much as possible incentives for excessive risk-taking.”
“Lastly, Olivier Davanne emphasizes the instability of large assets markets (shares, bonds, exchange rates) in industrialized countries. Major financial crisis of the 21st century may appear in these markets, rather than in emerging countries, according to Olivier Davanne, if nothing is done to try to improve the methods of valuation used by investors. The public sphere can help in this respect by improving markets’ transparency and by providing more accurate economic, financial and statistical studies. For Olivier Davanne, this part of the reform agenda matters a lot, but he fears that it could be neglected in favor of questions directly related to the financing of emerging countries.”
Unfortunately, none of these proposals or warnings had any impact at the time.
As Charles Goodhart, one of the best experts on financial crisis, wrote a little more than ten years later: Financial regulation has always been a-theoretical, a pragmatic response by practical officials, and concerned politicians, to immediate problems, following the dictum that « We must not let that happen again »
This “a-theoretical” approach involves many risks and the current situation illustrates them. We will return quickly to the many flaws in the far-reaching reforms introduced after the deep financial crisis of 2007-2009. Some of these flaws are already quite apparent. But the most dangerous consequences are probably still looming unspotted, hidden in the background.
After the Asian crisis, the situation was easier to analyze: the main consequence of this “pragmatic” response was that there was a lot of discussion, but few actions! In 2000, just before going back to the private sector, I wrote in English a working paper for the French CAE on what had been accomplished and not in the aftermath of the Asian crisis (see here for “Reforming the International Financial System: Where do we Stand?”). In a sort of follow-up report of my 1998 work, I re-emphasized three main concerns related to advanced countries: the bad incentives in the banking sector resulting from the lack of any credible framework to deal with failing institutions, the lack of effective regulation of liquidity risks, the “weaknesses of some of the risk control and valuation models used by investors”. As far as emerging countries are concerned, I added the lack of “guidelines on how best to manage exchange rate flexibility in emerging countries”.
Where are we on all these issues 20 years after the Asian crisis and 10 years after the so-called subprime crisis?
As far as emerging countries are concerned, rigidly managed exchange rates have (fortunately!) disappeared. However, there is still no consensus on how best to manage exchange rate flexibility. The current difficulties of Argentina and Turkey highlight the challenge of stabilizing a currency under attack. We are not going to address this issue here, but it is still as important as it was 20 years ago. Perhaps some progress will be made with the recent appointment as IMF Chief Economist of Gita Gopinath, a specialist of this subject!
For the rest, unlike the Asian crisis, the political consequences of recent crises have been such in the major industrialized countries that governments have had no choice but to introduce huge changes in various regulations over the last ten years. However, this has mainly been done in the pragmatic and a-theoretical way evoked by Charles Goodhart. And as Larry Fink warned at the beginning of this post, it is likely that “the solutions found by governments and regulators carry the seeds of the next crisis”.
Many aspects of the new threats are well known and I will not discuss them in detail here, except for a well-known key risk. I am rather going to focus on a troubling systemic hidden threat. It is related to how the international community has “pragmatically” finally responded to the need for some kind of bankruptcy procedure tailored to the specificities of the banking sector.
A well spotted new threat and the new baroque liquidity ecosystem
The liquidity risk of the banking sector is much more regulated than it was before the subprime crisis (better late than never …), but as a result part of the liquidity risk in the financial sector seems to be migrating from the heavily regulated banking sector to the less regulated “shadow banking sector”. More specifically, following the new stringent banking regulations, mutual funds tend to gain market share as intermediaries over the banking sector. Mutual funds offer investors liquidity by promising easy redemptions of shares (fortunately, ETFs also offer liquidity by trading in secondary markets). Since they invest more than in the past in assets that are likely to become illiquid in times of financial crisis, there is a legitimate fear that some funds may not be able to fulfill their redemption commitments, with the risk of contagion on other funds and a general run on the “shadow banking sector”. Some people rightly point out that many funds (for example, private equity or credit funds) choose to provide investors with little liquidity, thanks to long periods of lock-in, to protect themselves against this risk of “run”. Yet, there is no free lunch: in times of crisis, these end investors (pension funds, insurance companies, etc.) can be locked in these illiquid investments extremely difficult to value with heavy consequences on their own solvency.
The provision of “liquidity services” is one of the main functions of the financial sector. Businesses and households need access to stable, long-term funding. At the same time, the ultimate holders of financial claims may sometimes have an urgent need to switch to cash for various reasons. How to reconcile this apparent fundamental contradiction? Secondary securities markets, financial institutions, collective investment vehicles and public entities, all participate in a complex way to this alchemy, sometimes competing with each other. The “pragmatic” tough treatment of the banking sector following the subprime crisis has been decided without a general analysis of this complex liquidity ecosystem and the various dangerous “market failures” that can be encountered. As a result, new regulations may have sown the seeds of the next systemic crisis.
These questions were at the heart of my 2015 PhD dissertation. This unpublished article provides an original economic analysis of the “liquidity services” ecosystem, with practical suggestions for regulating the “shadow banking sector” (Who Should Provide “Liquidity Services”? Systemic Risks, Consumer Protection and Financial Regulation).
These questions are rather complex. However, in a nutshell, the main fundamental conclusion is that in order to achieve an efficient and stable financial sector, the provision of “liquidity services” must rely more on secondary securities markets and less on other players (maturity transformation by the banking sector, lending of last resort by the public authorities or generous redemptions promises by the mutual fund industry). And that can be done. The current dangerous ecosystem is indeed the product of decades of a-theoretical and pragmatic responses to the financial crisis. In many ways, public interventions disrupt the efficient functioning of secondary securities markets. And the new “resolution powers” granted to regulators will only worsen the situation in the future.
The good, the bad and the ugly: the challenge of failing banks
It is very bad to bail out financial institutions! This creates very perverse incentives, especially for weak institutions. When banks have suffered significant losses and have little equity, shareholders are encouraged to take even more risks because they enjoy a very skewed situation: the potential gains will be for them and the losses for taxpayers. There is a term dedicated to this behavior: “gambling for resurrection”. And creditors are ready to provide fuel for these new risky bets as they hope to be bailed out by taxpayers.
Thus, there is a consensus to end decades of bailouts and for shareholders and creditors (with the exception of insured depositors) to pay the losses. This is a rather difficult exercise and the previous governments did not follow this bad way simply because they were friends of the bankers … The main difficulty with the banks is that they are essential suppliers of “liquidity services”: they issue short-term debts that they use to make long-term loans. As a result, a large number of economic agents depend on the ability of banks to keep their promises and repay all their creditors quickly in the short term. If this promise is broken, many agents will find themselves in a very difficult situation, including the financial counterparts of the failing institution. Indeed, if there is the sheer suspicion that the promise may be broken, a run will result on the failing and similar institutions with devastating consequences. With maturity transformation at the heart of the banking model, it is almost impossible to trigger the “creditor stay” at the center of all effective bankruptcy procedures. This suspension provides the time needed to liquidate or properly restructure the failing company so as not to destroy too much value. It also allows a careful allocation of losses among different categories of creditors according to the hierarchy of claims (see Chapter 11 bankruptcy procedure in the United States).
Yet, the international community believes that it has found the solution in the aftermath of the 2007-2009 crisis. Let’s leave the impossible court process aside and let’s regulators spread the losses between shareholders and various creditors over the weekend. In all countries, the legal system has been modified to allow this rapid process. Now, two LLRs cohabit: the traditional Lender of Last Resort, which is nice, and the Liquidator of Last Resort, which can turn its ugly face on weekends … They need each other: the Lender of Last Resort helps troubled banks pay their bills in the short term, but needs the threat of the Liquidator of Last Resort to avoid overly perverse incentives. And the latter knows too well that Monday morning can be pretty chaotic for all the institutions still alive and in private hands every time he’s hit over the weekend. It will probably need the resolute help of the Lender of Last Resort to stabilize the situation.
As far as shareholders are concerned, the two LLRs act in dramatically different directions: the Lender of Last Resort subsidizes the bank by providing credit on better terms than market conditions. The Liquidator of Last Resort punishes the shareholders. There is no doubt about that. The Financial Stability Board has stated that “the resolution regime should provide for timely and early entry into resolution before a firm is balance-sheet insolvent and before all equity has been fully wiped out” (key attribute 3.1). The priority is to protect the taxpayer and the shareholders will lose their remaining equity over the weekend.
This new process involving subsidies and sanctions has never been put to the test in the context of a general economic crisis in which many institutions are seriously injured at the same time. In Europe, it has been used in recent years in a globally favorable environment to solve the specific problems of a few isolated institutions.
The main problem with this new approach is that it assumes that it is possible to form a reasonable opinion on the real value of a bank by examining its audited balance sheet. If this were the case, regulators could decide in a transparent and predictable way to switch to Lender mode of Last Resort or to switch to Liquidator mode of Last resort. Yet, in times of severe economic crisis, no one is able to determine the value of most assets while many debtors are struggling to repay their loans. In addition, these periods are generally characterized by high and volatile risk premia. Thus, the regulator would have a lot of latitude to classify banks between creditworthy and insolvent.
There is no doubt that in the next sharp economic slowdown, uncertainty as to how regulators will use their discretionary powers to subsidize or expropriate will create tremendous volatility in the market for securities issued by banks. This will significantly increase their cost of capital and make banks tired of lending just when the economy needs their help. There is also no doubt that banks’ stock prices would suffer from the risk of resolution threatening weak banks. One should note that the fall in stocks prices makes it difficult to recapitalize troubled banks. Indeed, during the crisis of 2007-2008, a lot of new capital was provided during the first phase of the crisis, but with a low stock price, Lehman Brother was unwilling and unable to attract new capital in the spring and summer of 2008. We can only imagine what would have been the situation in the winter of 2007-2008 on the stock market, with the risk of resolution hovering around several banks …
It would be interesting to have an idea of the type of discount that investors would require to buy bank shares threatened with resolution. It’s hard to say because it obviously depends a lot on how the regulators would analyze the balance sheet of a bank weakened by potential losses difficult to estimate. One possible case is that regulators give significant weight to the stock prices to assess the banks’ situation. This can make sense for four main reasons:
- Market value reflects how the investment community assesses the true value of the company. In an uncertain economic environment, regulators may think that it provides more information than the audited balance sheet.
- As noted above, the ability of a company to call on its shareholders and rebuild its depleted capital depends on its market value. Regulators may be concerned about supervising a bank with a low market value that we will not be able to recapitalize in the event of a problem.
- Shareholders are encouraged to “gamble for resurrection” when a company has little value: they have little to lose if new investments go wrong, while benefiting from the rise. A zombie bank with low market value is a pretty dangerous institution!
- Last, but not least, the lower the share price, the easier it will be to expropriate the shareholders without triggering a political and legal reaction.
But if regulators place too much weight on stock prices, they would be sure to trigger a “death spiral”. When stock prices fall, this increases the chances of resolution and justifies further falls. It can be shown that there is no limit to this “death spiral”: if the decision to expropriate shareholders is solely based on stock prices, they will fall to 0 regardless of the real value of the assets owned by the bank!
For political and economic reasons, it is absolutely necessary to stop bailing out financial institutions. However, I do not believe that the international community has found the solution. With the fear of widespread resolution, the financial system risks to be brought to a standstill when the economy goes into deep recession. But, is there a possible solution?
Sometimes governments try very long to do impossible things … The best example is the famous “incompatibility triangle” highlighted by Nobel laureate Robert Mundell. It is not possible to benefit simultaneously from a fixed exchange rate, a perfect mobility of capital and the independence of monetary policy. We must give up one of the three objectives (or a bit of both …). The reason is the rationality of investors who anticipate the next movement of the authorities and who quickly attack a currency when monetary policy may diverge in a country.
The same type of incompatibility triangle exists in financial regulation and for the same reason: the ability of financial markets to anticipate. Thus, you probably cannot simultaneously have a banking sector that plays a key role in maturity transformation (short-term borrowing and long-term lending), a financial sector that is robust enough to finance the economy in times of crisis and no taxpayers’ money at risk. The policy “Too big to fail” favored the first two objectives with a potential cost for public finances (bad!). The new “resolution powers” probably give up the second, namely the ability of the financial sector to finance the economy in times of crisis (possibly ugly …).
Is it possible to do better? Probably. The solution appears to further reduce the role of the banking sector’s “maturity transformation” (already limited by the introduction of tighter liquidity rules after the 2007-2009 financial crisis). This is probably the least important of the three “goals” and, in fact, the evolution of modern financial sectors means that the provision of “liquidity services” can be more effectively delivered by other mechanisms (a very similar view if defended by John Cochrane who argues for a “run-free Financial System”). Less “maturity transformation” means more time is available to solve the problem of bankrupt banks in a way that fully respects the rights of shareholders and other creditors. Thus, it may be possible to avoid disrupting the financial sector at the worst possible time while protecting taxpayers. This is a complex issue that requires a thorough analysis of how liquidity may be efficiently provided to investors, and this is the main subject of my PhD dissertation.
November 9, 2018
 Davanne, Olivier. 1998. Instabilité du système financier international. Rapport au Premier Ministre, Collection des rapports du Conseil d’Analyse Economique, La Documentation Française.
 In Goodhart, Charles. 2010. How should we regulate the financial sector? The Future of Finance. London School of Economics and Political Science.
 FSB. 2011. Key Attributes of Effective Resolution Regimes for Financial Institutions.
 See FDIC. 2011. The Orderly Liquidation of Lehman Brothers Holdings Inc. under the Dodd-Frank Act. FDIC Quarterly Volume 5, No. 2.
 This is formerly demonstrated in my PhD dissertation, see On the impossibility of using stock prices as a resolution indicator.
 Cochrane, John H. 2014. Toward a Run-free Financial System. In Martin Neil Baily, John B. Taylor, eds., Across the Great Divide: New Perspectives on the Financial Crisis, Hoover Press..