C.III Applied Topics: Network Industries and Financial Stability
The Institute also continues its tradition of investigating applied topics concerning collective goods. This research is complementary to the more fundamental research summarized in Sections C.I and C.II: On the one hand, the principles that emerge from the more fundamental research provide guidance for the analysis of applied issues; this guidance is needed to avoid the danger of provincialism in studying special applications. On the other hand, the applied issues themselves serve as a proving ground for abstract ideas, also as a source of new ideas. The latter is particularly likely when different applications turn out to involve common themes.
As applied topics we have chosen in the past are:
- Sector-specific regulation and competition policy in network industries;
- Financial stability and the regulation of financial markets and financial institutions.
Our choice of these topics was to some extent motivated by considerations of comparative advantage, based on past research expertise, as well as the scope for interdisciplinary research by jurists and economists. Apart from making progress on these topics in their own right, we are also keen to explore the parallels and links between them.
The choice of these topics was and is not meant to be exclusionary. Indeed, in some of the work on which we report under the heading of network industries, we have crossed boundaries and studied questions that properly “belong” to other topics, in particular, competition law and competition policy and the law and economics of innovations and intellectual property rights.
C.III.1 Network Industries: Sector-Specific Regulation and Competition Policy
C. III.1.1 Introduction
“Network industries” such as telecommunications, electricity, gas, rail transportation and postal sectors have the common feature that the provision of services to customers presupposes the use of a fixed network infrastructure, the costs of which are by and large sunk. Traditionally, these industries have been organized as vertically integrated monopolies under state ownership and/or subject to sector-specific regulation. However, the past two or three decades have seen a paradigm shift concerning the organization and regulation of such industries.
The paradigm shift was due to the recognition that not all parts of the vertically integrated monopolies are “natural” and that, for example, long-distance telecommunication services or electricity generation exhibit no technological features which would preclude workable competition. Developments in telecommunications have also given rise to the notion that some natural monopolies may be transient as technical progress makes room for the establishment of competing networks.
The change in views of network industries has induced a change in views concerning the role of regulation. Whereas in the past, regulation was mainly seen as a constraint on the exploitation of monopoly power, under the new paradigm, it has come to be seen as a promoter of competition – competition in downstream markets, as well as competition among networks themselves, where such competition is feasible and economically sensible. A key tool for this purpose is access regulation, the government imposed requirement that the network owner open his network for use by other firms. Such access regulation provides other firms with a basis for offering their services in downstream markets, even against the wishes of the incumbent. It also provides other firms with a basis for building competing infrastructures piecemeal, using their own pieces of infrastructure where they have already built them and relying on the incumbent’s infrastructure where they do not yet have their own.
The organization and regulation of network industries under the new paradigm raise important economic and legal questions. Important economic questions are:
- What is an appropriate system for determining access prices?
- What is an appropriate system of governance for the use if the network infrastructure by the various activities in downstream markets?
- What is an appropriate system of governance for the coordination and funding of investments in network infrastructure and in downstream activities?
The first question is closely connected to the issues discussed in C.I concerning the tension between efficiency in access and the need to cover the costs of the network infrastructures. (In principle, we can think of a network infrastructure as an excludable public good, the use of which serves as an input into the provision of final outputs, which themselves are private goods.) Access prices above the marginal costs of use would entail some inefficiencies of exclusion; access prices equal to marginal costs would preclude the recovery of fixed and common costs. In this case, there would be insufficient incentives to invest in the network infrastructures at all. By contrast, if access prices contained a very generous allowance for fixed and common costs, especially one that is based on a cost-plus calculation, investment incentives could well be excessive.
The second question concerns the organization of the industry as well as the organization of statutory oversight over upstream and downstream activities. For the organization of the industry, the key question is what degree of vertical integration is desirable. In the electricity and gas industries, we have for some time had a requirement of legal unbundling of networks from production and sales. Given the lack of competition in these industries, the European Commission has proposed to go further and to require ownership unbundling of the transmission grids. This proposal raises the question how the presumed pro-competitive effects of unbundling compare to the efficiency gains (lower transactions costs, reduced holdup problems) that are usually associated with vertical integration. Because of vehement opposition from Member State Governments, as well as the industry itself, the Commission’s proposal was not enacted, but, remarkably, at least some firms in the industry decided to sell their transmission grids anyway. The reasons for these decisions are as yet unclear.
For the organization of statutory oversight, the key question is how the relation between sector-specific regulation and antitrust law should be organized. Which activities should be subject to sector-specific regulation and which activities should be subject to antitrust law? How should one deal with the tradeoff that arises between competition downstream and competition upstream because the attempt to promote competition in downstream markets by imposing access requirements upstream reduces incentives for competing companies to build their own upstream facilities? Should submission to sector-specific regulation pre-empt the application of antitrust law? If not, should antitrust law be applied by the sector regulator, or should the two systems of law be applied by separate authorities? The latter would make for some competition between authorities, but there might be a loss of coherence in the policy that is applied to the industry.
The third question, which was already raised in Chapter C.I, is particularly important in industries where network infrastructure investments require substantial funding and in industries investments in infrastructure and investments in downstream activities exhibit important complementarities. The first concern is central in railways. It is also becoming important in electricity as the replacement of nuclear energy by wind energy requires substantial new investments in grid capacity and in generation capacity for regulating energy. The second concern is important in the electricity sector where the location of power plants determines the need for transmission grid capacity.
On the legal side, the new paradigm for the organization and regulation of network industries raises the following questions:
- What are appropriate provisions for administrative and legal procedures?
- What is an appropriate system of governance for the firms in question?
- What is an appropriate system of governance for the regulatory authorities?
- What is the relation between European law and national law in the regulation of network industries?
Most substantive issues in regulation involve an important dose of judgment, rather than the straightforward application of a predetermined rule. Thus, it is well known that the allocation of fixed and common costs to the various services that are being provided and charged for is to some extent arbitrary. From the perspective of welfare economics, as well as management science, the different costs of allocation systems have their advantages and disadvantages, but there is no way of saying a priori that one system is best. Given the importance of judgment, one can ask whether the choice should be taken by the political institutions, parliament and the government, whose powers are derived from democratic elections, or whether it should be taken by the regulatory institution, which presumably has greater expertise in assessing the industry in question. If it is taken by the regulatory institution, what recourse to the courts is available to the parties concerned? If the incumbent network owner contests an access pricing decision of the regulatory institution, to what extent does the court procedure focus on the specific price that is being contested? To what extent does it consider the place of this one price in the overall system of prices, which together should permit the recovery of common costs? Which side bears the burden of proof for the appropriateness or inappropriateness of the individual access price or the pricing system? What kind of evidence is accepted as proof in court? Given the need to rely on judgment, rather than predetermined principles, in regulatory decisions, the effective scope of regulation can depend on such procedural issues. Given that hard evidence in either direction may not even exist, in a court proceeding, the side that has the burden of proof is likely to be in a hopeless position from the very beginning.
At this point, the economist is likely to recommend that the regulator be given a significant amount of discretion to exert his judgment where this is necessary and that he bear the burden of proof in legal proceedings only when he can reasonably be expected to do so, e.g., when the question is whether a given rule for allocating common costs has been correctly applied. For the lawyer, this recommendation raises fundamental questions of constitutional legitimacy. From the perspective of constitutional law, it seems problematic that important substantive choices should be taken by an administrative authority, rather than the democratically elected legislature and government. It also seems problematic that legal protection of network owners against abuses by the regulatory institutions should be undermined by the institutions’ having a great deal of discretion, without much of a burden of proof for the appropriateness of their decisions.
Some of these issues are well known from discussions about competition law and competition policy. For close to a decade now, the European Commission has been promoting “a more economic approach”. For the implementation of abuse-of-dominance control under Article 82 EC, this reform has been more difficult and more controversial than for other areas of competition law and policy, and is by no means complete. The reason is precisely that a more economic approach to the assessment of a given practice requires the authority to have more discretion in assessing the practice; such discretion is subject to the objection that it exposes the parties to the risk of wilful intervention without sufficient protection by the legal system.
The discussion about abuse-of-dominance control in the European Union is not only paradigmatic for the more general issue of how to deal with the tradeoff between the need to provide the authority with a measure of discretion and the need to provide the private parties with legal protection. This discussion is also directly relevant to the organization of statutory oversight over network industries in Europe. The reason is that sector-specific regulation is implemented under national law, which can void the application of national antitrust law but is itself overruled by EU law, in particular, the antitrust rules of the Treaty. Thus, a few years ago, the Commission ruled – and the European Court of Justice confirmed the ruling – that a certain price that had been charged by Deutsche Telekom – and that had been approved by the national regulator – was in fact predatory and therefore in conflict with the Treaty. At this point, the technical legal question of how to assess the relation between European law and national law in the regulation of network industries is joined with the substantive economic and political question of what is the proper relation between sector-specific regulation and competition law and policy.
With the departure of Carsten Burhop, Felix Höffler, Jos Jansen, and Susanne Prantl from the institute, and with the increased focus on financial stability, research output in this area has gone down significantly. The following account serves mainly as documentation showing how past preprints have made it into academic journals, usually with significant lags due to the time taken by the refereeing process. However, we do want to take this area up again in the future.
Topics in Sector-Specific Regulation
A systematic overview over the issues arising in sector-specific regulation and competition policy for network industries is provided in Hellwig (2009). The paper provides first an abstract discussion of the comparative advantages and disadvantages of the two policy regimes, with competition policy as a system of prohibitions, with policy interventions taking place ex post, in a piecemeal, somewhat ad hoc fashion and sector-specific regulation as a regime which focuses on an industry as a whole, in systematic fashion ex ante, but with material choices taken by the regulator, rather than market participants. The basic reasoning is applied in discussions of how to determine which parts of an industry should be subject to sector-specific regulation and which ones should not, as well as questions of how to deal with issues of policy consistency when the same industry is subject to both, sector-specific regulation and competition policy, and to both, European law and national law.
Höffler and Kranz (2011 a, 2011 b) analyse the economic implications of legal as opposed to ownership unbundling of networks and other operations. Whereas, so far, the discussion on vertical integration versus unbundling has mainly focused on technical synergies and exclusionary abuses, Höffler and Kranz focus on the incentives that are driving the incumbent’s activities in downstream markets. In their analysis, legal unbundling dominates ownership unbundling because, under legal unbundling, the incumbent retains a financial interest in the network. Because of this interest, the incumbent’s subsidiary in downstream markets takes account of the fact that, from the perspective of the mother company, the marginal costs of network use to make additional sales are given by true marginal costs rather than the access price per unit: whereas the downstream subsidiary is paying the access price per unit, the margin of the access price over true marginal cost accrues to the network owner and therefore, under legal as opposed to ownership unbundling, to the mother company as well. In this analysis, legal unbundling appears as a device to overcome the well-known problem of double-marginalization in vertically separated industries.
Prantl (2012) provides empirical studies of entry regulation on entry activities and survival of entrants. The entry regulation they consider is the requirement of a “master” qualification for artisans who want to set up shop as independent entrepreneurs. They use the natural experiment provided by German unification in order to provide sufficient identification. Within a given system, say the system of the old Federal Republic before 1990, identification would be difficult because decisions to acquire the relevant human capital would already be determined by the existing set of regulations. For entry behavior after 1990, this endogeneity of human capital is at least to some extent reduced because human capital acquisition pre-1990 was hardly affected by West German regulation. The studies find strong restrictive effects of the regulation on entry, without any significant compensating advantages in terms of market outcomes, suggesting that the regulation serves mainly rent-seeking purposes.
Topics in Competition Policy
Cartels are an important object of antitrust analysis. Their study is not directly related to network industries (but see Höffler 2009). However, it provides an important application of the theory of collective goods. For the cartel members, the lack of competition which results from the cartel agreement has the features of a collective good. Compliance with the agreement is the analogue of a contribution made to the provision of this collective good. It is therefore of some interest to ask what implications can be drawn for the study of cartels from recent developments in our understanding of collective goods, in particular, from the experimental evidence showing that free-rider problems in collective-goods provision may be less prevalent than neoclassical economic theory would seem to suggest. This question had been treated by Engel (2007) with a comprehensive and systematic meta-study of oligopoly experiments, asking what factors are most responsible for the sustainability of collusion in such experiments, characteristics of products (e.g., homogeneity versus heterogeneity), markets (e.g., market size), properties of demand and supply functions, specifics of the strategic interaction (e.g., simultaneous versus sequential moves) and the information environment. Engel (2011a, 2011d) provides systematic assessments of the implications of theory and experimental evidence for the practice of competition law and competition policy. Engel (2011b) discusses implications of experimental evidence for the design of research guidelines for R&D agreements. (The experimental work on antitrust is covered in greater detail in section C.II.1.2, b).
Economics of Innovation and Intellectual Property Rights
The law and economics of intellectual property rights are considered in Engel (2011c). Following previous work (Engel 2008), the paper argues that there are limits to the need for protection of intellectual property rights as an incentive to innovation.
Engel and Kurschilgen (2011) present experimental evidence on the implications of a new legal rule in Germany, which requires books publishers to provide authors with an improvement of contractual terms ex post if the book in question turns out to be a bestseller. The law stipulates that, if ex post negotiations do not lead to agreement, there should be an adjudication by a third party. The experiment investigates to what extent third-party adjudication of fairness ex post takes account of ex ante investment risks. The idea is that the publisher does not know beforehand which book will be a bestseller and therefore he needs bestsellers in order to cover the costs of losers. The experiment finds that willingness to take account of ex ante investments in assessing fairness ex post is in fact weak. The experiment also finds that this leads to a substantial reduction in ex ante investments. (The experimental work on intellectual property is covered in greater detail in section C.II.1.2, d).
The extent of the right to a trade secret is a focus of Bechtold and Höffler (2011). This paper was motivated by a case in the electricity industry where one company sued against outsiders installing devices underneath its transmission lines in order to find out which power plants were working and which were not, with a view to using this information by taking actions in the wholesale market. From this case, Bechtold and Höffler distil the problem of how to deal with the tradeoff between the supplier’s investment and production incentives on the one hand and the efficiency implications of information asymmetry between the supplier and the demanders on the other hand. A simple result asserts that, unless the supplier is actually willing to spend resources in order to safeguard his trade secret, the efficiency implications of information asymmetry dominate concerns about the supplier’s investment and production incentives. From this result, the paper infers that the right to a trade secret should not be accepted without question, but should at the very least be subjected to the test how much the supplier himself would be willing to invest to safeguard his secret.
Burhop and Lübbers (2010, 2012) study incentive contracting at seven leading chemical, pharmaceutical and electrical engineering companies in Germany in the late 19th and early 20th century. Burhop and Lübbers (2010) find that incentive devices were used, but no significant impact of incentives on innovations can be identified. For the same period, Burhop and Lübbers (2012) study the contracts by which these same companies obtained licenses to use the innovations of outsiders. Three quarters of these contracts involved individuals, one quarter other firms as licensors. Besides fixed payment components, contracts did involve significant variable payment components, most importantly profit sharing agreements.
Jansen (2011, 2012), Ganuza and Jansen (2013), and Filipini and Jansen (2011) analyse under what conditions firms actually have an incentive to maintain secrecy and under what conditions they are willing to disclose information; disclosure is of course a precondition for patenting. The key issue is that disclosure affects competing firms’ beliefs about a firm’s technology and thereby their behaviours. Disclosure may enable competing firms to acquire the same technology cheaply, but it may also signal the innovating firm’s advantages and discourage them from even trying to compete. Depending on parameter constellations, voluntary disclosure can therefore be part of an equilibrium even if there is no patent protection. However, with sufficient asymmetry across firms, it is also possible that concealment is preferred because it has a greater discouragement effect on competitors (Jansen 2012). The choice between patenting (disclosure) and secrecy also depends on competitive pressures. Interestingly, incentives to patent go up when competitive pressure takes the form of greater substitutability of products and down when competitive pressure takes the form of a greater number of competitors (Jansen 2011).
To make progress in thinking about the general issues discussed above, we intend to work on the following specific questions:
- To what extent is there a conflict between the requirements for regulation set forward in European law and in German Constitutional Law? Tension arises not only from concerns about the democratic legitimacy of regulatory decisions and about the scope of legal protection for the addressees, but also from concerns about the role of foreign institutions, in this case the regulatory authorities of other member states, in national regulatory decisions.
- Are there modes of procedure that satisfy the economist’s concern for efficiency as well as the lawyer’s concern for due process in regulation? In 2002, the Monopolies Commission proposed a two-stage procedure whereby, at one stage, the authority determines, e.g., a system for allocating fixed and common costs, and at the second stage, the authority determines the individual price, the idea being that, at stage 1, the addressee can question the appropriateness of the chosen system, and, at stage 2, he can question the way the system is being applied, without, however, questioning the appropriateness of the individual price on substantive grounds.
- In some network industries access regulation is complicated by the fact that access can be provided at several stages of the value creation chain. This raises a question of the consistency of different access prices. If one believes that it is unrealistic to suppose that regulation can get the system of access prices right, one must ask which types of error are more important: errors that hurt entrants further upstream, who partly build their own infrastructures; or errors that hurt entrants further downstream, who don’t build much of an infrastructure at all.
- What is an appropriate procedure for calculating capital costs? The 2003 report of the Monopolies Commission shows that currently applied rules involve inappropriate measures for risk premia and an inappropriate treatment of corporate and personal income taxes. The implications of this critique need to be developed formally. To the extent that an appropriate treatment of risk premia imposes unrealistic information requirements on the regulator, suitable proxies must be proposed.
- If grids need to be vastly expanded in order to take account of the replacement of nuclear and fossile generation by generation from renewable sources, what needs to be done to ensure that the regime for access regulation will not destroy the necessary investment incentive, and how can appropriate funding be assured without generating moral hazard from subsidization?
Bechtold, S., and F. Höffler (2011), An Economic Analysis of Trade-Secret Protection in Buyer-Seller Relationships, Journal of Law, Economics, and Organization, 27 (2011), 137-158.
Burhop, C. (2011), The Underpricing of Initial Public Offerings at the Berlin Stock Exchange 1870-96, Germanic Economic Review 12 (2011), 11-32.
Burhop, C., and T. Lübbers (2010), Incentives and innovation? R&D management in Germany’s high-tech industries during the second Industrial Revolution, Explorations in Economic History 47 (2010), 100-111.
Burhop, C., and T. Lübbers (2012), The Design of Licensing Contracts: Chemicals, Pharmaceuticals, and Electrical Engineering in Imperial Germany, Business History, 54 (2012) 574-593
Engel, C. (2007), How Much Collusion? A Meta-Analysis on Oligopoly Experiments, Journal of Competition Law and Economics 3 (2007) 491-549.
Engel, C. (2011a), Competition as a Socially Desirable Dilemma: Theory vs. Experimental Evidence, in: Josef Drexl / Wolfgang Kerber / Rupprecht Podszun (eds.): Competition Policy and the Economics Approach, Cheltenham 2011, 245-269.
Engel, C. (2011b), An Experimental Contribution to the Revision of the Guidelines on Research and Development Agreements, in: FS Möschel, Baden-Baden 2011, 227-240.
Engel, C. (2011c), When is Intellectual Property Needed as a Carrot for Innovators?, in: Journal of Competition Law and Economics 7 (2011).
Engel, C. (2011d), Die Bedeutung der Verhaltensökonomie für das Kartellrecht, in: H. Fleischer / D. Zimmer (eds.): Beitrag der Verhaltensökonomie (Behavioral Economics) zum Handels- und Wirtschaftsrecht (Beiheft der Zeitschrift für das gesamte Handelsrecht und Wirtschaftsrecht 75), Frankfurt 2011, 100-121.
Engel, C., and M. Kurschilgen (2011), Fairness Ex Ante and Ex Post. Experimentally Testing Ex Post Judicial Intervention into Blockbuster Deals, Journal of Empirical Legal Studies 8 (2011), 682-708.
Filippini, L., and J. Jansen (2011), Mergers and Messages: Strategic Cost Disclosure and Mergers in Oligopoly, mimeo, 2011.
Ganuza,, J., and J. Jansen (2013), Too Much Information Sharing? Welfare Effects of Sharing Acquired Cost Information in Oligopoly, ,Journal of Industrial Economics.
Gebhardt, G., and F. Höffler (2013), How Competitive is Cross-Border Trade in Electricity Markets? The Energy Journal 34 (2013), 135-154.
Grafenhofer, D. (2012), Price Discrimination and the Hold-Up Problem: A Contribution to the Net-Neutrality Debate. Forthcoming Preprint, Max Planck Institute for Research on Collective Goods, Bonn 2012
Hellwig, M.F. (2009), Competition Policy and Sector-Specific Regulation for Network Industries, in: X. Vives (ed.), Competition Policy in the EU: Fifty Years On from the Treaty of Rome, Oxford University Press, Oxford, 203 - 235.
Höffler, F., and S. Kranz (2011 a), Legal Unbundling Can Be a Golden Mean Between Vertical Integration and Ownership Separation. International Journal of Industrial Organization 29 (2011), 576-588.
Höffler, F., and S. Kranz (2011 b), Unbundling of Monopolistic Bottlenecks, Journal of Regulatory Economics 39 (2011), 273-292.
Höffler, F., and A. Wambach (2013), Investment Coordination in Network Industries: The Case of Electricity Grids, Journal of Regulatory Economics 44 (2013), 287-307.
Jansen, J. (2011), On Competition and the Strategic Management of Intellectual Property in Oligopoly, Journal of Economics and Management Strategy 20 (2011), 1043-1071.
Jansen, J. (2012), Beyond the Need to Boast: Cost Concealment and Exit in Cournot Oligopoly, Research in Economics 66 (2012), 239-245..
Prantl, S. (2012), The Impact of Firm Entry Regulation on Long-Living Entrants, Small Business Economics, 39 (2012), 61-76.
Prantl, S., and A. Spitz-Oener (2013), Interacting Labor and Product Market Regulation and the Impact of Immigration on Native Wages, Preprint 2013/22, Max Planck Institute for Research on Collective Goods, Bonn, 2013.
Discussions of collective goods do not usually refer to the financial sector. However, collective-goods aspects play an important role in arguments about statutory regulation in this sector. In most countries, financial-sector regulation is more stringent than the regulation of other sectors. A first line of argument justifies this regulation by referring to problems of asymmetric information and moral hazard in financial relations, but that raises the question why the regulator should be able to handle these problems better than the parties themselves. A second, more solid line of argument then refers to the systemic, collective-goods aspects that arise because the handling of asymmetric-information and moral-hazard problems by the contracting parties has repercussions for the rest of the system.
Such collective-goods aspects can be due to domino effects or to confidence effects, acting alone or in combination.1 Domino effects arise when outcomes in one set of financial relations or financial transactions have implications for the participants’ relations with third parties. In a simple case, the insolvency of a firm or a set of firms brings the firms’ banks into difficulties, and this has repercussions for the banks’ depositors and other financiers. A recent example was provided by the 1997 crisis in Thailand, when the devaluation of the Baht induced defaults by many Thai firms that had borrowed in dollars. These defaults in turn compromised the solvency of the Thai banks that had lent to these firms and caused problems for the international banks that had lent to the Thai banks. Another important example occurred n September 2008, when the Lehman Brothers bankruptcy caused the Reserve Primary money market fund to “break the buck”, so that the value of a share went below $1, inducing a run of depositors on Reserve Primary and other money market funds.
Domino effects can also arise through markets. A financial institution that gets into difficulties may be forced to sell its assets. By putting the assets on the market, it may depress asset prices. The decrease in asset prices in turn may put pressure on other financial institutions that have also invested in them. A domino effect arises even though there may be no contractual relation at all between the first institution and the others. Thus, in 1998, the Federal Reserve Bank’s organization of an operation to rescue Long Term Capital Management (LTCM), at least for the time being, was motivated by fear that an immediate closure and liquidation of LTCM’s assets would have a drastic effect on the prices of long-term bonds to the detriment of all financial institutions that were holding these bonds. As discussed in Hellwig (2008/2009, 2010a, 2010b) and again in Chapter 5 of Admati and Hellwig (2013 a), such “fire sale effects” also played a central role in 2007 and 2008, with a slow downward spiral of asset values and bank balance sheets from July 2007 to September 2008 and a dramatic downturn after the Lehman Brothers bankruptcy.
A final domino effect concerns the macroeconomy. A financial institution that gets into difficulties is usually unable to continue its financing operations on the same level as before. Its clients may find it expensive or difficult to get funds elsewhere because nobody else knows them as well as their previous partner. If many financial institutions get into difficulties at the same time, there may then be a “credit crunch”, leading to an overall decline in external investment finance and in aggregate investment activity, with further repercussions on aggregate demand and employment in the economy. These kinds of “multiplier effects” of financial crises on macroeconomic investment played a major role in the Great Depression, as well as the banking crises and macroeconomic recessions of the early nineties in the Scandinavian countries. Remarkably, such effects have been much weaker for stock market downturns (1987, 2001) than for real-estate and banking crises (early 1990s and since 2007).
Confidence effects are important because the willingness to participate in financial relations depends on confidence, which in turn depends on what one sees happening in the financial system. If one bank goes under, another bank’s depositors may become apprehensive and start to withdraw their funds, putting pressure on that bank’s liquidity. With deposit insurance, nowadays, depositors may be less fidgety. However, several episodes of the financial crisis show that the effect is still very relevant for non-bank institutions such as money market funds and hedge funds. When, as mentioned above, the Lehman Brothers bankruptcy caused the Reserve Primary Fund to “break the buck”, there was a run not just on Reserve Primary but on all money market funds, forcing these funds in turn to reduce their lending, to European banks such as Dexia, as well as US investment banks, which themselves were also affected by a drop of confidence from the Lehman bankruptcy. If the different banks’ or funds’ asset positions are correlated, such behaviour is fully rational, reflecting the information provided by the first institution’s difficulties.
Similarly, somebody’s wanting to sell an asset may contain information about the asset. If people are thereby induced to be apprehensive, market liquidity is greatly reduced. In the LTCM crisis, the price effects of immediate closure and liquidation were deemed to be incalculable because market participants were apprehensive about the prospect of a crisis, and the closure itself might have provided a bad signal, making people unwilling to buy the assets that LTCM would have had to liquidate, except at greatly depressed prices. In the financial crisis of 2007 – 2009, similar effects caused the markets for mortgage-backed securities and collateralized debt obligations to freeze and contributed to the downward spiral and eventual implosion of the system.
In the LTCM crisis, concerns about the impact of an insolvency was a major reason for at least temporary forbearance. The Federal Reserve Bank induced a consortium of major creditors to bail LTCM out, making room for an orderly liquidation over time, rather than a Chapter 11 bankruptcy. At the time, there was no desire to do experimental research on the systemic effects of such a bankruptcy in a situation of market nervousness as well as legal uncertainty about the treatment of complex contractual structures with many large counterparties in multiple jurisdictions. Ten years later, the experiment was carried out anyway with Lehman Brothers and the domino effects were such that governments all over the world found themselves forced to put taxpayer money at risk for bank guarantees and recapitalizations. The collective bads of domino effects and confidence effects were eventually reined in, but by that time, much damage had been done.
The experience of the crisis demonstrates the importance of having collective-goods concerns bear on the decision making of bankers and supervisors. In contrast to the network industries, the collective-goods concerns here are not associated with any one good that is bought or sold, but concern the functioning of the overall system of institutions, contracts, and markets. The actions that individuals take and the contracts that groups of individuals write have repercussions for the functioning of the system, but people do not consider these repercussions. Actions are taken from the perspective of the individual person or institution in question, contracts are written from the perspective of the participants – how they affect the system is of little interest to them.
This is where statutory regulation and supervision of financial institutions and financial markets come in. In principle, this regulation is intended to induce participants to adjust their behaviours so that collective-good aspects are duly taken into account. Thus, traditional asset allocation rules and capital adequacy requirements are meant to protect the solvency of financial institutions and to eliminate the possibility of domino effects even before they have a chance to get started. Publicity rules for listed securities, as well as rules against insider trading regulations of market microstructure, are meant to protect the orderly functioning and the liquidity of markets by eliminating the worst instances of asymmetric information leading to market breakdown. In the context of banking, rules for the resolution of banks in difficulties must also be considered.
However, the incidence of statutory regulation is not always clear. Poorly designed rules may well be counterproductive. Thus, statutory deposit insurance seems to have played a role in exacerbating the crisis of the savings and loans industry in the United States in the nineteen-eighties. The enhancement of depositor confidence by deposit insurance may avert destabilizing bank runs, but it also worsens the incentives of depositors to monitor the institutions in which they deposit their money and, by implication, the incentives of these institutions’ managers to avoid exposing their institutions to excessive risk. In the eighties, this latter effect prevailed when institutions close to insolvency were “gambling for resurrection”, using advertisements of high interest rates on “federally insured deposits” to expand their deposit base and thereby the funds they had available for such gambling.
Capital adequacy requirements, which, over the past two decades, have become a mainstay of banking regulation, have also been questioned. Initially, in the early nineties, discussion focussed on incentive distortions due to inappropriately chosen “risk weights” in capital requirements. In the late nineties, discussion has turned to the procyclical macroeconomic implications of more finely tuned capital requirements, as well as the implications of such requirements on the actual risk exposure of the financial system. The financial crisis has confirmed these concerns and triggered a quest for suitable “macroprudential” rules. As yet, however, there is little understanding of the difference between macroprudential rules that focus on macroeconomic flow variables such as new lending, aggregate investment and aggregate demand and macroprudential rules that focus on the problems of system adjustment to a misalignment of stock variables when writedowns on assets reduce bank capital and the ensuing deleveraging induces further price declines.
For the lawyer, financial regulation raises even more questions than the regulation of network industries. The concerns about democratic legitimacy and the rule of law that were discussed above for the regulation of network industries must also be raised here. Democratic legitimacy is in doubt because the “Basel process” for developing rules for capital regulation has not really been controlled by any institutions whose legitimacy was based on democratic elections. While the individual members of the Basel Committee on Banking have been appointed by their respective national governments, the Basel Committee as such has worked as a committee of experts with little outside interference, except for pressure from the industry lobby, and has presented its accords for individual countries, or the European Union, to adopt. Parliamentary involvement in legislation was practically non-existent. This was as true for “Basel III” as previously for “Basel II”; the process of legislation for the Capital Requirements Directive IV/Capital Requirements Regulation (CRDIV/CRR), which is supposed to implement “Basel III”, suggest that, with the European Commission’s monopoly on initiating legislation, a similar deficit exists in that context.
At the level of rule implementation, i.e. of banking supervision, concerns about the rule of law arise with respect to the handling of the model-based approach to determining required capital and with respect to the valuation of a bank’s assets and the assessment that the bank is in difficulties. Within the model-based approach, the assessment of the model used by a bank involves an important element of arbitrariness. Backtesting of such models could be helpful if the underlying data exhibited sufficient stationarity. In practice, however, they do not; this is a problem for the banks themselves and even more so for the bank supervisors. Important elements of arbitrariness are also involved in the valuation of loans that the bank has made and in the supervisory assessment that a bank is in such trouble that it ought to be closed. If loans are not traded in open markets, there is no extraneous measure of borrower solvency and, hence, no “objective” valuation standard.
All of these assessments require judgment and can hardly be codified so as to lend themselves to sensible court proceedings. Even if a court review of such administrative decisions was feasible, it would hardly be effective. By the time the courts rescind an unjustified regulatory intervention, the damage may be beyond repair. The major damage is likely to involve reputation and depositor confidence. These are difficult and sometimes even impossible to restore once they have been impaired. Given the role of discretionary judgment and given the substantive importance of supervisory intervention for a bank, the question how such decisions can fit into the framework of German constitutional and administrative law is even more puzzling than for the regulation of network industries.
Some of these issues are bound to come up with the single supervisory mechanism (SSM) for the euro area. Under this mechanism, ultimate responsibility for banking supervision will rest with the European Central Bank (ECB), which is given the task to apply and enforce all relevant EU law. However, in the case of directives, which are not directly applicable, the ECB will have to apply the national laws that implement the directives, subject to national judiciary review. Most of the issues involving discretionary judgment (“Pillar 2” of the Basel Accords) are dealt with in directives rather than the regulation. Moreover, on these issues different member states have different legal traditions. There is thus a lot of room for frictions and conflict.
“The Bankers’ New Clothes” and “Fallacies,…”
The main product of the past two years has been the book “The Bankers’ New Clothes: What’s Wrong with Banking and What to Do about It”, by Admati and Hellwig (2013 a), which appeared in the spring of 2013. The book has three purposes. First, it debunks flawed arguments that are used by bankers and others to fight against banking regulation. Second, it provides an overview over the history of banking and banking regulation during the past century, including the recent crisis. Third, it makes a contribution to the policy debate, arguing that much higher equity requirements for banks would be appropriate and, moreover, the use of risk weights should be abandoned.
The book originated from discussions on what to do with Admati et al. (2010/2013), which is too long for a journal article and too short for a monograph. Our experience in policy discussions about banking regulation had suggested that it would be more useful to pursue a more ambitious comprehensive treatment of banking problems, which moreover ought to be addressed at a general audience rather than professionals such as academics, regulators, and bankers. The final product combines material from previous work, such as Admati et al. (2010/2013) or Hellwig (2008/2009, 2010 a) and Admati and Hellwig (2011), with more basic material about the concept of equity, the role of banks in the economy, and the development of banking in the 20th century. The material comes in two different modes, the main text, which tries to communicate the issues to the general reader, and a set of extensive notes, which gives references and which takes up the details of the various academic and political disputes.
The first part of the book develops basic notions of equity as a residual on the right-hand side of the balance sheet and as a mode of funding, leverage, illiquidity and insolvency, deposit banking, and maturity transformation. It also explains the history of banking crises, regulation and deregulation, and the demise of the Glass-Steagall system in the United States, the different kinds of risks in banking and the different kinds of contagion mechanisms, in particular, as they played out in the crisis.
The second part of the book considers banking regulation and regulatory reform, expressing scepticism about the scope for eliminating the too-big-to-fail status of banks and about the scope for containing systemic risk (and eliminating the need for taxpayer support of failing institutions). This part also explains the focus on equity regulation as a way of improving the banks’ ability to absorb losses, of improving liability of bank owners and managers, and of reducing contagion from fire sales after losses. (If equity accounts for 2 percent of total assets, a loss on the order of 1 percent of assets wipes out half the equity, so 50 percent of the assets must be sold to re-establish the 2 percent equity ratio; if equity accounts for 20 percent of assets, only 5 percent of assets must be sold for this purpose.)
This second part of the book provides a systematic explanation of the different objections to equity requirements that Admati et al. (2010/2013) characterized as “fallacies, irrelevant facts, and myths” – statements that are conceptually flawed, such as a confusion between equity and cash, statements that are correct but irrelevant for welfare assessments, such as the finding that more equity funding and less borrowing would increase the bank’s corporate tax bill (and raise the government’s tax revenue), and, finally, theoretical models that claim to explain the use of deposits for bank funding and are inappropriately used to justify keeping equity requirements low.
Whereas the discussion of theoretical models of bank finance in the original version of Admati et al. (2010/2013) had mainly focused on models of debt as a means of imposing discipline on bankers, the discussion in Admati and Hellwig (2013 a) focuses mainly on models of bank deposits and other short-term debt as a means of providing customers with “liquidity”.
We criticize this literature, most importantly Gorton (2010, 2012) on two grounds. First, the explanation of the crisis of 2007 – 2009 as a result of a pure liquidity breakdown overlooks the severe solvency problems that arose because banks were poorly capitalized; it also overlooks the contagion effects that were due to poorly capitalized banks scrambling to deleverage through asset sales. These omissions are facilitated by a sometimes selective, sometimes inaccurate use of empirical material. For example, the breakdown of funding for shadow banking institutions holding mortgage-backed securities and collateralized debt obligations in the summer of 2007 is interpreted as a liquidity problem. However, all that happened was that the regulated banks which had sponsored these institutions were forced to make good on the guarantees they had given and to take the toxic assets onto their own balance sheet. These banks then were squeezed for equity, and some would have been insolvent without government support, but they did not have liquidity problems. Second, the liquidity literature fails to consider the possibility that having more equity reduces the vulnerability of banks to losses and thereby actually enhances the liquidity of bank debt.
By contrast, the “debt-as-a-disciplining-device” literature, which was at the center of the discussion in Admati et al. (2010/2013) receives only a cursory treatment in the book because people from the political, regulatory, and banking communities had told us that “this was an academic thing”, of little interest to the actual political discussion. A critique of this literature is, however, presented in Admati and Hellwig (2013 b), posted on the web as an “omitted chapter” from the book. Ironically, the two literatures that consider short-term funding of banks to be highly desirable, even if there is a risk of liquidity crises, are based on contradictory assumptions about the role of information. The literature on bank debt as a disciplining device assumes that depositors and other short-term creditors are constantly on their toes, monitoring everything the bank’s managers do, and ready to run whenever they see something untoward. In contrast, the literature on liquidity provision by banks is based on the idea that debt is “information insensitive” in the sense that, under normal circumstances, debt holders do not care about the bank’s assets because, in contrast to shareholders, the returns they will get do not depend on the bank’s returns on its assets.
The third part of the book proceeds to a discussion of policy issues, beginning with the debate about “BaseL III”, developing our own recommendations, and commenting on the political debate so far, political economy and convenient narratives that can be used to deflect calls for regulatory reform. This part calls for substantially higher capital requirements than are stipulated in “Basel III”. It also calls for abandoning the reliance on risk weights, in particular, under the model-based approach, which is highly manipulable. Problems with risk weights had previously been raised in Hellwig (1008/2009, 2010). In his doctoral research, Markus Behn provides empirical evidence of the problem; see Behn et al. (2014).
The books was widely reviewed and discussed. Many reviews were favourable, some unfavourable. Many of the unfavourable reviews repeated arguments about banks that actually had been discussed and dismissed in the book, without however engaging on substance. This observation motivated the writing of Admati and Hellwig (2013 c), “The Parade of Bankers’ New Clothes Continues: 23 Flawed Claims Debunked”, a series of short pieces taking up one claim after the other and giving the essential arguments about them.
By now, a Spanish and a German translation of the book have also come out. Japanese, Chinese and Italian translations are in preparation.
In the meantime, Admati et al. (2010/2013) has also been thoroughly revised. Relative to the original version, which was extensively discussed in the report two years ago, major changes involve (i) a more precise discussion of issues concerning debt overhang and asymmetric information (see below), (ii) a more extensive discussion of the liquidity argument for the importance of debt finance of banks, and (iii) an extensive discussion of the proposition, often heard in policy debate, that higher equity requirements would harm bank lending and growth. An important point here concerns timing: If a bank is indeed unable to raise more equity today, a stricter equity requirement reduces the amount of loans and other investments it can make today, but at the same time, this requirement is likely to increase the amount of loans and other investments the banks can make a year from now if, in the meantime, it has incurred losses; after all, the biggest downturn in lending and growth since the Great Depression of the 1930s occurred in the fourth quarter of 2008, after the Lehman Brothers bankruptcy. For the reasons given above, final publication of this paper continues to be in limbo but meanwhile the number of downloads on SSRN has risen over 4000.
Analytical Contributions: Debt Overhang
Whereas Admati et al. (2010/2013) as well as Admati and Hellwig (2013 a, 2013 b, 2013 c) can be regarded as pieces of synthesis, we have also moved forward with new analytical contributions.
Admati et al. (2012) and Admati et al. (2013) consider the dynamics of bank funding in the absence of binding commitments about future recapitalizations. These papers argue that shareholder resistance to increases in equity mainly due to the effects of debt overhang along the lines of Myers (1977). This is in contrast to the literature, which mostly attributes such resistance to the effects of asymmetric information that were treated in Myers and Majluf (1984). However, the Myers-Majluf argument cannot explain shareholder resistance ot increases in equity that take place through retained earnings or through rights offerings. In fact, Myers and Majluf claim that retaining earning is a cheaper form of funding than debt. Moreover, if new equity is raised through rights offerings,, incumbent shareholders of highly profitable companies can avoid the asymmetric-information costs of dilution because they can exercise their acquisition rights and hold the additional shares until the profitability of the firm is recognized by the market.
By contrast, the debt overhang argument applies to all forms of increases in equity. IN its simplest form, the argument starts from the original propositions of Modigliani and Miller that, in the absence of distortions and frictions, the value of a firm and the cost of capital of a firm are independent of its financing mix. As discussed in the fallacies part of Admati et al. (2010/2013), this proposition implies that, ex ante, before any securities have been issued, a corporation’s owners are indifferent about the choice of funding mix. Subsequently, however, after some debt, and possibly some outside equity, has been issued, they are no longer indifferent. At this time, a recapitalization that lowers the probability that the firm might go bankrupt provides a benefit to debt holders. The Modigliani-Miller Theorem implies that the total value of the firm is unchanged. Unless debt holders can be made to pay for the benefits they obtain, it follows that shareholders must lose. Debt holders can perhaps be made to pay if the recapitalization involves some kind of collective bargaining. If instead there is simply a debt buyback in the open market, the price at which the buyback occurs will already reflect the increase on the value of the debt that is due to the reduction in the bankruptcy probability, a phenomenon that is well known from experiences with buybacks of sovereign-debt, such as Bolivia 1988 or Greece 2012. The reason is that, if debt holders can choose whether to hold on to the debt or to sell it, they will only sell if the price is high enough to compensate them for the benefits from holding the debt, taking account of the improvement in these benefits from the buyback itself.
In this setting, debt holders fully appropriate the benefits from a debt buyback, and shareholders resist such a buyback. Indeed they will resist an increase in equity no matter what form it might take. Like the effects of taxes and bailout subsidies, This is a private cost of additional equity funding that does not reflect a social cost. Indeed, the debt overhang effect generates resistance to a recapitalization even when such a recapitalization would be beneficial to the firm and to society as a whole. It might actually do so even if the benefits from avoiding bankruptcy were very large. By contrast, in Myers (1977), the debt overhang effect works only if benefits from new investment are sufficiently small.
Admati et al. (2012, 2013) show that the effect of debt overhang on shareholder preferences with respect to additional debt and equity issues is very robust to changes in the structure of the model. They argue that this effect can make for a “leverage ratchet” where debt goes up if negative shocks require additional funding but fails to go down if positive shocks generate additional earnings.
Admati et al. (2012, 2013) also consider shareholder preferences over different modes of dealing with a regulatory requirement to raise the ratio of equity to assets. In the simplest formulation, they obtain a striking neutrality result: If there is a single class of debt, a single homogeneous asset, and the price of the asset is equal to the expected present value of returns taking account of tax and bankruptcy cost effects, then shareholders are indifferent between (i) asset sales used to reduce debt, (ii) an equity issue used to retire debt, and (iii) an equity issue used to buy more of the asset. The neutrality result breaks down if the price of the asset Is not equal to the expected present value of returns taking account of tax and bankruptcy cost effects, or if there are multiple classes of debt and/or multiple classes of assets, and the operation can be used in discriminatory fashion to make some incumbent debt holders worse off. For example, with multiple debt classes and multiple assets, a sale of relatively safe assets and reduction of junior debt makes senior debt holders worse off and will be preferred by shareholders. Predictions from this analysis are much in accord with experiences in Europe over the past few years.
Analytical Contributions: Liquidity Provision and Equity Funding
In a forthcoming new paper, Hellwig (2014) considers the question whether liquidity provision and equity funding of banks are substitutes or complements. This research was triggered by DeAngelo and Stulz (2013) following Gorton’s line of argument and claiming to show that banks should fund with deposits only because any equity funding would detract from liquidity provision through deposits. The DeAngelo-Stulz paper has two major shortcomings. First, it considers bank optimization for a given assumed constellation of interest rates for deposits and loans, but fails to do the requisite equilibrium and welfare analysis. Second, it assumes that bank returns and deposits are riskless, so there is no reason to worry about default.
Hellwig (2014) develops a general equilibrium model with many consumers and many banks in which deposits provide liquidity benefits by a “warm-glow” effect on their holders, the details of which are not analysed. However, the warm-glow effect occurs only if the bank is not in default. Three sets of models are analysed, first a model without uncertainty, then a model with uncertainty and full commitment of banks to their funding policies, finally a model with uncertainty and a lack of commitment of banks to their funding policies. For the model with uncertainty, the analysis shows that there are two types of equilibria: If consumers’ savings are small enough, any savings will go into bank deposits. There may be a threshold however, above which it would be inefficient to have additional savings go into deposits because the additional costs exceed the additional benefits. In this case, equilibrium deposits are equal to the amount where marginal costs and marginal benefits are the same and any additional savings go into shares or bonds, with a Modigliani-Miller indeterminacy result for the mix of the two.
For the model with uncertainty and full commitment, the distinction between equilibria involving deposit satiation and equilibria without deposit satiation remains relevant. However, even the equilibria without deposit satiation typically involve share finance; indeed they must do so if the marginal cost of deposit provision is constant (e.g., zero). By reducing the default probability, equity funding enhances the liquidity of deposits. Whereas bond finance is undesirable, the choice of an equity-deposit mix involves a trade-off between having more liquidity providing deposits providing liquidity and having better liquidity providing deposits. The case of constant returns to scale is one where, in equilibrium, the banks’ charter value is zero and, in the absence of equity funding, default would occur with probability one, i.e. there wold be no liquidity benefits from deposits at all.
If the liquidity benefit function is linear, i.e., the product of deposit size times the marginal liquidity benefit is equal to the total liquidity benefit, equilibrium allocations in the model with commitment are efficient. If instead the marginal liquidity benefit function is decreasing, equilibrium allocations involve too little equity finance. The reason is that, in the trade-off between having more liquidity providing deposits providing liquidity and having better liquidity providing deposits, the banks neglect part of the gain in consumers’ surplus from deposit liquidity that results from increasing equity and lowering the default probability.
In the model with uncertainty and no commitment, the lack of commitment creates what is probably a more important source of inefficiency. In this model, a combination of the debt overhang effect discussed in Admati et al. (2012, 2013) and the Coase conjecture for durable-goods monopolists leads to the conclusion that equity funding is always inefficiently low. Indeed, with constant returns to scale in deposit provision, banks will end up with 100 percent funding by deposits, a 100 percent probability of default, and no liquidity benefits from deposits at all. A version of the Coase conjecture implies that, in this model, banks behave as price takers and do not consider the effects of changing their funding mix on the interest rates they have to pay. Without even considering the need for consumer protection or the systemic fallout from bank bankruptcies, in this model, statutory requirements for bank equity are called for as a mechanism to compensate for the effects of banks’ not being able to commit their future borrowing.
The contributions by Admati et al. (2012, 2013) and Hellwig (2014) point to an important methodological issue. Ever since Jensen and Meckling (1976), economic theory has pursued the research program of “explaining” observed contracts and observed institutions as efficient way to deal with some information and incentive problems. This research program has been very fruitful but it has also introduced a bias into our welfare assessments. If we “explain” what we observe with reference to some optimization problem under information and incentive constraints, we are bound to find that equilibrium outcomes are efficient and any government intervention would be harmful.
However, any such efficiency assessment depends on the commitment technology that is assumed. If commitment possibilities are weak, observed leverage of banks may reflect the desire of bank managers and new creditors to conclude new debt contracts at the expense of incumbent creditors rather than any efficiency-enhancing effects of debt finance. In practice, commitment problems are evident in the creation of contracts such as repo borrowing and lending that are specifically designed to jump maturity and priority queues – and that, presumably, have such collateral that creditors do not invest in information as would be required for debt as a disciplining device.
Analytical Contributions: Liquidity Provision and Government Debt
Two forthcoming papers by Luck and Schempp (2014 a, 2ß014 b) consider the liquidity provision by banks in a standard Diamond-Dybvig model with the modification that the short-term storage technology of Diamond and Dybvig (1983) is replaced by third parties providing banks with the resources needed to satisfy liquidity needs, receiving claims on future earnings instead. In the absence of government intervention, the model now gives rise to the possibility of twin runs, from withdrawals of deposits and a third-party refusal to provide new loans. In this setting, each kind of run can be triggered independently, but if one is triggered, the other will follow automatically.
Government intervention can sometimes improve upon the situation. One possibility is for the government to provide insurance of all creditors. Another would be for the government to step in itself, along the lines of Holmström and Tirole (1998), issuing long-term debt to acquire resources, investing these resources with banks, allowing the banks to make long-term investments only and having the holders sell the government debt to third parties when they need to. These forms of intervention work if the government is known to be always solvent. If, however, a bank breakdown affects the government’s ability to raise funds in order to repay its debts, the twin runs problem can apply with government support as well as without.
In a multi-country setting, with cross-border investments of financial-market actors, the twin crisis problem can be a reason why the government of one country might intervene to support the other country when this is necessary to avoid twin runs in the other countries affecting the seemingly stronger country through contagion.
Analytical Contributions: Equity Markets and Information
As mentioned above, models showing that callable debt induces discipline because managers fear a run by debt holders usually have no room for outside equity at all. Within the models, zero equity issue is optimal (as in the certainty version of Hellwig (2014)), and, if we are honest, we must admit that our profession has no really good model of outside equity at all. In the real world, however, corporations do issue outside equity to strangers who trade these securities on exchanges. Moreover, corporate managers have to some extent submitted to “market discipline” from shareholders, and “shareholder value” has become an accepted measure for management performance. In the real world therefore, there is a question as to how incentives from debt finance interact with incentives from equity finance.
This is in part a question about information collection and transmission. Given that equity is more information sensitive than debt, one would expect shareholders to invest more in information acquisition than debt holders, and one would expect debt holders to free-ride on the information contained in stock prices. Such behaviour would imply an absence of debt holder discipline in the upswing and a run of debt holders in the crisis, precisely the pattern that we have seen in 2004 – 2007 and 2007 – 2008, without much discipline when the risks were taken.
A full-fledged analysis of the issue has so far eluded us. However, a first step is taken by Gorelkina and Kuhle (2013) in a model of information acquisition by shareholders and information aggregation and transmission through stock prices. Creditors are assumed to condition their actions on stock prices. Firms are shown to internalize some of the externalities inherent in shareholders’ investing in information and having the infomration communicated through share prices; this is possible because firms with a strong fundamental will issue more equity and less debt than they would without the informational spillover. In the larger market, more equity is traded, and incentives ro invest in information are stronger.
Analytical and Policy Contributions: Bank Resolution
Resolution of difficulties in financial institutions is a major problem for legislation. Existing institutions and rules for resolution have been largely inspired by analogies to insolvency law. As such they are not well suited to handling systemic risk, i.e., the risk that statutory intervention in the bank may trigger an avalanche of problems at other banks. Fear of such risk was a major reason why, in the fall of 2008, many governments intervened without using existing laws. Since then, there has been an ongoing debate about a reform of the legal arrangements.
Some countries, such as the US and the UK, have been very thorough and pragmatic, formulating the new rules so as to minimize systemic risk (Dodd-Frank Act in the US, Banking Act of 2009 in the UK). Others have been inactive or, like Germany, provided for legal reform that is so much wedded to old ways of thinking that it does not really address the problem. For a critique of the German Bank Restructuring Act of 2010 and a systematic discussion of the issues, see Hellwig (2010 b, 2012).
The subject is taken up again in three reports of the Advisory Scientific Committee of the European Systemic Risk Board (2012 a, 2012 b, 2013). The first of these reports begins by considering the role of forbearance in times of difficulties, forbearance of banks towards their debtors and of supervisors towards their banks. Concerning the former, the report notes that there is no way to distinguish “good forbearance” and “bad forbearance”, since any decision to be patient with a debtor in the hope that the money will be paid later after all is a decision under uncertainty which can turn out badly or well without any way to tell beforehand which it is going to be. The proper distinction is therefore not between “good” and “bad” forbearance but between forbearance decisions that rest on standard entrepreneurial considerations and forbearance decisions that serve to arbitrage around creditors and supervisors. For example a bank might exert forbearance towards it6s debtors because it wants to avoid having a credit event and having to take a write-down on its claims. At that point, the question is why supervisors would tolerate such behavior. The answer of course might be that they do have confidence in the resolution regime and the ability of responsible authorities to deal with problems once they are brought into the open. The report then goes on to discuss difficulties in resolution that a viable resolution regime should handle. It also moves forward with a suggestion for a European banking union that would encompass resolution as well as supervision. The second report of the Advisory Scientific Committee (2012 b) reaffirms the need to deal with resolution as well as supervision.
The latest report considers the issue of bail-ins and systemic risk in resolution. Two major points are (i) the need to make creditors liable, as they would be under insolvency law, and (ii) the need to think about closing banks down as well as protecting them. The first point concerns the need to give the banks’ creditors appropriate incentives to take care as to who they lend to. The second point concerns the need to allow for a downsizing of the industry if the underlying problem is one of excess capacity combined with artificial exit barriers, which may be enhanced by bailouts. The problem of excess capacity had previously been raised in Zimmer et al. (2011), which suggested that among the possible exit strategies for the German federal government’s crisis-induced participations in banks, closing the banks down was to be taken very seriously since otherwise the necessary adjustment of market structure might not take place.
Like the organization and regulation of network industries, the financial sector provides research questions for both lawyers and economists:
- How will the governance of financial supervision be affected by the new European legislation. For financial supervision, the question concerns the relation between the European Central Bank as the supranational supervisor in the euro area (and other countries that join) and the different national supervisors in a setting in which much of the law consists of national law implementing European directives. The question also concerns the relation between the euro area and the non-euro members of the European Union and the relation between euro area institutions and European Union institutions such as the European Banking Authority and the European Systemic Risk Board.
- In substantive terms, key questions concern the different approaches taken in different countries, and in the European Union as a whole, to the trade-off between the practical need for discretion and the legal concern about democratic legitimacy. To what extent is this trade-off affected by the observation that democratic legitimacy itself is compromised if impracticalities in existing legislation force the government to introduce shotgun legislation to provide remedies in emergencies? To what extent does the European umbrella make a difference? This question is also arising in the context of legal disputes about the European Central Bank in its own domain.
- How are we to assess the relation between supranational supervision, national or supranational resolution, and national or supranational fiscal authorities? Given that bank resolution requires funding, from bank restructuring funds or from taxpayers, activities of supervisory authorities and resolution authorities have fairly direct implications for fiscal authorities. In the European context, the question is to what extent resolution should be handled at the national or the supranational level and how the financial burden should be divided. This is both a question about the sharing of losses from past activities and a question about governance and funding for the future. Can resolution work without a backstop at the European level? And can such a backstop work without the power to tax? How are the constitutional problems to be handled?
- Financial regulation is motivated by a desire to protect the financial system. However, the addressees of financial regulation are the individual institutions. How do these things go together? Banking regulation and supervision is intended to eliminate systemic risks. For the economist, this raises the question by what mechanisms the regulation of individuals safeguards the functioning of the system. For the lawyer, this raises the question as to what precisely is being protected and how the desire for protection supports the rules that are imposed on individual institutions.
- Ongoing discussion about the role of macroprudential concerns highlights the issues. In the new institutional framework of the European Union, macroprudential concerns are in principle a charge of the European Systemic Risk Board (ESRB). The ESRB itself does not have responsibility for microprudential supervision. However, microprudential supervision has macroprudential implications, as can be seen by the sequence of events following the September stress test by EBA and the October Summit’s call for a recapitalization by June 2012. The deleveraging that was induced here, purely as a matter of microprudential concerns, affects markets and prices and risks feeding right back into bank balance sheets, thereby destroying the very purpose of the exercise, following the pattern of 2007/2008. Similarly, countercyclical capital buffers as stipulated by Basel III, are microprudential measures that serve a macroprudential purpose.
- The notion of macroprudential concern itself needs clarification. Much of the literature fails to distinguish between concerns related to macroeconomic flows of new lending, investment and aggregate activity and concerns related to outstanding stocks, asset values, asset prices, and funding structures. The distinction needs to be made and supplemented with a distinction of regulatory and supervisory measures that are appropriate for dealing with them.
- What tradeoffs have to be considered in financial regulation? Relevant tradeoffs concern risk sharing and moral hazard through securitization, effectiveness of “market discipline” and vulnerability of institutions to market vagaries, efficiency gains and contagion risks from having more extensive markets.
- What are appropriate governance mechanisms for financial institutions? What scope is there for counteracting the yield bias of prevailing incentive systems, in particular those that are based on “market discipline” and “return on equity” (ROE)? Taking the notion of debt as a disciplining device seriously, what can be said about the respective roles of debt and equity in view of the incentives that come from stock markets, “shareholder value”, and ROE?
- Is the kind of formula-driven system of capital regulation and supervision that we have the best way to counteract excessive risk-taking incentives? Are there mechanisms by which one can give effective “voice” to the concerns of creditors and tax payers in banking governance, e.g., by having compulsory deposit insurance and having the insurance institution represented on the board of the bank?
- If we do depart from formula-driven supervision, allowing e.g. for forbearance in times of stress, what governance measures should accompany such forbearance to avoid excessive risk taking as a means of “gambling for resurrection”? Whereas there are good reasons for forbearance, the experience with savings and loans institutions in the United States in the eighties indicates that forbearance must be accompanied by some form of interference with bank management.
Admati, A.R., P.M. DeMarzo, M.F. Hellwig, and P. Pfleiderer (2010/2013), Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Socially Expensive, Preprint 2013/23, Max Planck Institute for Research on Collective Goods, Bonn 2013 (Revision of Preprint 2010/42).
Admati, A.R., P.M. DeMarzo, M.F. Hellwig, and P. Pfleiderer (2012), Debt Overhang and Capital Regulation, Preprint 2012/05, Max Planck Institute for Research on Collective Goods, Bonn 2012.
Admati, A.R., P.M. DeMarzo, M.F. Hellwig, and P. Pfleiderer (2013), The Leverage Ratchet Effect, Preprint 2013/13, Max Planck Institute for Research on Collective Goods, Bonn 2013 (Revision of Preprint 2012/05).
Admati, A.R., and M.F. Hellwig (2011), Comments to the UK Independent Commission on Banking, mimeo, Stanford and Bonn, http://bankingcommission.s3.amazonaws.com/wp-content/uploads/ 2011/07/Admati-Anat-R-Hellwig-Martin-F.pdf.
Admati, A.R., and M.F. Hellwig (2013 a), The Bankers’ New Clothes: What’s Wrong with Banking and What to Do about It, Princeton University Press 2013,
Admati, A.R., and M.F. Hellwig (2013 b), Does Debt Discipline Bankers? An Academic Myth about Bank Indebtedness, Rock Center for Corporate Governance at Stanford University, Working Paper No. 132, Stanford 2013.
Admati, A.R., and M.F. Hellwig (2013 c), The Parade of the Bankers’ New Clothes Continues: 23 Flawed Claims Debunked, Rock Center for Corporate Governance at Stanford University, Working Paper No. 143, Stanford 2013.
Advisory Scientific Committee of the European Systemic Risk Board (2012 a), Forbearance, Resolution, and Deposit Insurance, Report 01/2013.
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1 For a systematic discussion, see Staub (1998), Hellwig (1998 b) and, more recently, Hellwig (2008/2009, 2010a, 2010b), Wissenschaftlicher Beirat (2010), Admati and Hellwig (2011, 2013 a).