Über die Autorin bzw. den Autor

Mathias Dewatripont is professor of economics at the Université Libre de Bruxelles (ECARES and Solvay Brussels School of Economics and Management), annual visiting professor of economics at the Massachusetts Institute of Technology, and research director of the Center for Economic Policy and Research. Jean-Charles Rochet is professor of mathematics and economics at the University of Toulouse I. Jean Tirole, the winner of the 2014 Nobel Prize in Economics, is chairman of the Foundation Jean-Jacques Laffont at the Toulouse School of Economics, scientific director of Toulouse's Industrial Economics Institute, and annual visiting professor of economics at the Massachusetts Institute of Technology.

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"Three giants in the field have teamed up to offer their insightful perspectives on prudential regulation at a crucial time. The book is both academic and pragmatic, a real bridge between these two worlds. Mandatory reading for all policymakers and academics involved in the difficult subjects of banking regulation and crisis prevention."--Ricardo Caballero, Massachusetts Institute of Technology

"This is a very good book on the financial crisis by three of the best economists in the world. Unusually among top economists, all three are knowledgeable about banking and the financial system. It will have an important impact on the debate about the reform of regulation."--Franklin Allen, Wharton School, University of Pennsylvania

"This timely book provides valuable insights and suggestions from three of the foremost experts in the field of regulation."--Markus K. Brunnermeier, Princeton University

"This book offers a clear analysis of the financial crisis: causes, mechanisms, and policy. Written by top experts in economics and prudential regulation, it will be read by many economists and graduate students, as well as journalists, policymakers, the general public, and advanced undergraduate students. The scholarship is top-notch."--Xavier Gabaix, New York University

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"Three giants in the field have teamed up to offer their insightful perspectives on prudential regulation at a crucial time. The book is both academic and pragmatic, a real bridge between these two worlds. Mandatory reading for all policymakers and academics involved in the difficult subjects of banking regulation and crisis prevention."--Ricardo Caballero, Massachusetts Institute of Technology

"This is a very good book on the financial crisis by three of the best economists in the world. Unusually among top economists, all three are knowledgeable about banking and the financial system. It will have an important impact on the debate about the reform of regulation."--Franklin Allen, Wharton School, University of Pennsylvania

"This timely book provides valuable insights and suggestions from three of the foremost experts in the field of regulation."--Markus K. Brunnermeier, Princeton University

"This book offers a clear analysis of the financial crisis: causes, mechanisms, and policy. Written by top experts in economics and prudential regulation, it will be read by many economists and graduate students, as well as journalists, policymakers, the general public, and advanced undergraduate students. The scholarship is top-notch."--Xavier Gabaix, New York University

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BALANCING THE BANKS

Princeton University Press

Contents

Acknowledgments....................................................................................................viiCHAPTER 1 Introduction—Mathias Dewatripont, Jean-Charles Rochet, and Jean Tirole............................1CHAPTER 2 Lessons from the Crisis—Jean Tirole...............................................................10CHAPTER 3 The Future of Banking Regulation—Jean-Charles Rochet..............................................78CHAPTER 4 The Treatment of Distressed Banks—Mathias Dewatripont and Jean-Charles Rochet.....................107References.........................................................................................................131Index..............................................................................................................137

Chapter One

Mathias Dewatripont, Jean-Charles Rochet, and Jean Tirole

The recent financial crisis was a mix of "unique" and much more conventional events. This short book offers our perspective on what happened and especially on the lessons to be learned in order to avoid a repetition of this large-scale meltdown of financial markets, industrial recession, and public deficits. Chapter 2 provides a diagnosis of what went wrong and discusses some key financial regulation reforms. Chapter 3 takes a more detailed look at the flaws in the prudential framework that was in place when the crisis erupted and at the required remedies, and chapter 4 focuses on the treatment of distressed banks, a key element of this prudential framework. This introduction takes a more general look at the rationale for and challenges of banking regulation.

Regulation in a Historical Perspective

What degree of regulation of the banking sector is appropriate has been a controversial question for almost a century. The Great Depression, with its wave of bank failures triggered by bank runs, led in the 1930s to heavy-handed regulation, combining deposit insurance, interest-rate regulations, barriers to entry, restrictions on activities (compulsory specialization), and constraints on bank size. Although the succeeding decades witnessed a return to stability, the banking system gradually became perceived as inefficient and poorly innovative. In order to encourage cost-cutting and innovation, and to induce banks to pass efficiency gains on to consumers, governments deregulated the banking industry and fostered competition from the 1970s on. This trend was also the result of pressure from commercial banks, which were facing competition from other less regulated financial institutions (e.g., money-market mutual funds and investment banks).

Although details vary from country to country, the removal of interest-rate controls promoted competition at first. In the turbulent macroeconomic environment of the 1970s and 1980s, though, this form of deregulation, together with an interest-rate maturity mismatch in a period of rising interest rates, resulted in the 1980s in a large-scale banking crisis in the United States (the savings and loan—S&L—crisis). This crisis led to a mix of further deregulation and reregulation. On the one hand, diversification of activities was allowed in order to reduce the specialization-induced fragility of the S&Ls. S&Ls had used short-term savings deposits to fund long-term, fixed-rate mortgages, and were thereby exposed to yield-curve risk. On the other hand, in order to limit the exposure of deposit insurance funds, the regulation of solvency ratios became more stringent and intervention rules in case of violation of these ratios were strengthened.

This emphasis on prudential regulation and the desire to harmonize country-specific capital adequacy requirements led to the international standard embodied in the Basel system of regulation. New international regulations, including the 1988 accords, were intended to ensure a level playing field in a world of increasing globalization of banking. Subsequent events made this attempt to establish a level playing field, however imperfect in practice, seem prescient since large international banks have now become common in the United States, Europe, and Asia.

This internationalization and the intensification of competition among various marketplaces (e.g., between Wall Street and the City of London) led to a weakening of regulatory standards, fed by pressure from large banks, themselves facing competition from more lightly regulated financial institutions. One can interpret the recent modification of the Basel capital adequacy rules (Basel II), which allow large banks to reduce effective capital ratios if they can show that their risks are "limited," as an outcome of lobbying by these banks. The assessment of risk under the new regulations comes from the banks themselves, through "internal models"—which represents a step toward self-regulation. The complexity of these internal models can make it very hard for supervisors to verify what is being computed and raises concern, despite the requirement that those models be authorized by regulatory authorities.

The trend toward weaker regulation also came from the inability of the system to cope with the pace of financial innovation, itself fed by a desire to lower the amount of capital required by the regulatory agencies. Indeed, the growth of the shadow banking system, of securitization, and of structured products (backed by credit ratings that had been inflated by the rating agencies) can be partly traced to this desire.

The gradual lowering of regulatory standards predated the recent crisis. To be sure, other developments such as "irrational exuberance," loose monetary policy, and global macroeconomic imbalances also contributed to the crisis. But underregulation or ineffective regulation is rightly blamed for playing a central role in the crisis. Not surprisingly, this has led to calls for a strengthening of regulations in a number of countries. It is worth pausing, however, to ask what the purpose and extent of regulation should be.

To Regulate or Not to Regulate?

Banking is one of a handful of industries (others include insurance, financial market making, and pension-fund investing) subject to prudential regulation on top of consumer protection. The focus of this book will be on the former, and more substantial and decisive, form of regulation. This is not to imply that insufficient consumer protection played no role in the recent crisis. Indeed, the crisis started with problems in subprime loans. Although these problems were small compared to the overall crisis that ensued, subprime lending was the release mechanism. Subprime loans are associated with weak consumer protection regulation of banking products in the United States. Therefore the creation of an agency specifically dedicated to strengthening borrower protection in the United States is a welcome development.

What is so unique about banks as to warrant industry-specific regulation? Banks fulfill a specific role in the economy through their involvement in the payment/deposit system as well as in lending to households and firms (for a survey of models of banking, see Freixas and Rochet 2008). Although these activities are essential to the economy, they are no more essential than, say, cars or pharmaceuticals, sectors in which...