Banking Regulation and the Financial Crisis

Jin Cao

• Publisher: Routledge
• Year: 2012
• eBook ISBN: 9781136459771
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

This book is a review on the economic theories of systemic risks in the financial market and the topics in constructing the macroprudential framework for banking regulation in the future. It explains the reasons why the traditional microprudential regulatory framework missed its target in stabilizing the market and preventing the crisis, and discusses the principles and instruments for designing macroprudential rules.

Part I

Externalities, network effects, and systemic risks

1 Unstable banking

There are many theories that justify the banks’ role as financial intermediaries. In the typical stylized banking relationship, by intermediating the “investors,” who have abundant financial resources but lack of the expertise of value producing, with the “entrepreneurs,” who have the expertise of generating higher value added goods and service, the banks allocate the scarce resources to the sectors where such resources are best used, improving the social welfare. Here “investors” and “entrepreneurs” have wider meanings than the words themselves. The “investors” are owner of the resources, which can be depositors, pension funds, and so on; the “entrepreneurs” can be the entrepreneurs in the manufacturing firms, but can also be house owners who generate a steady cash flow from their mortgage repayments. Finally, “banks” in modern finance have many faces as well. A “bank” can be a traditional saving bank which takes deposits from individuals and issues loans to the firms, but it can also be an investment bank, a broker–dealer institution trading securities for its customers. There are more “shadow banks” such as money market funds, hedge funds, etc. Although they are not subject to the traditional banking regulatory rules, their role as financial intermediaries is much the same as that of the conventional banks. In the rest of this book, we take the wider view on the parties in the banking relationship. To simplify the discussions, most of the time we use the terms “investors,” “entrepreneurs,” and “bank” as the abstracts of these parties in the banking sector.

The banking system is unstable because of the bank runs. The high yield projects from the entrepreneur side are often long term; however, the investors’ time preference of getting cash is not necessarily long term: they may want their cash back before the projects return, for example, when they want to consume early or redirect their money to some better investment opportunities. This creates a maturity mismatch: the banks’ long assets have to be financed by the short borrowing, and the liquidity problem arises once the banks have difficulties in getting cash. When some of the investors – call them “early investors” – demand their money before the projects mature, the banks need to raise cash to meet the demand. Quite often, this means that the banks need to sell part of the long, illiquid assets, or to terminate the premature long-term projects. But such early liquidation usually does not return as much as the value if the projects mature: this reduces the expected return of the other investors (or, the “late investors”) who would otherwise like to wait and encourages them to demand liquidity as well, leading to the bank run. We will start the chapter by briefly presenting the classical bank run model in Diamond and Dybvig (1983), which is the foundation of many models in this book.

However, “this time is different.” The current crisis, the worst one since the Great Depression, though, is not featured by the long queues in front of the banks – there are only a few of them, Northern Rock being one of the most infamous (Shin (2009) provides an excellent survey of Northern Rock’s failure) – but rather, is a “slap by the invisible hand” (Gorton, 2010), and the failure in the banking system this time is almost invisible to the outsiders. In modern finance, the sheer size repo market serves as the main financing resource for the banks, where the banks roll over their long-term debt by the very short-term repurchase agreements, subject to some haircuts. In the good time the repo market is fairly liquid and the haircut is next to nil. However, in the bad time, the banks cease to lend to each other and the haircuts get skyrocketed. The financing conduits are clogged and the entire financial system gets to halt. Instead of explicitly withdrawing deposits from the banks like in the traditional bank runs, the modern version of bank failure starts from the dysfunction of interbank market, or, the “run on the repos.” This will be discussed in Section 1.2.

A bank run can be triggered by the fundamentals, i.e., it happens once the late investors figure out that they will not get the return as high as the early investors if they wait till the long projects mature, so that they will join the early investors and run on the bank. However, a bank run can also be triggered by the “sunspot,” the bank run becomes a self-fulfilling equilibrium if the investors start running on an otherwise solvent bank. In Section 1.5 we further explore when and how such non-fundamental bank runs happen. Since bank run is a coordinated action of t...

Table of contents

• Cover Page
• Half Title page
• Series page
• Title Page
• Copyright Page
• Contents
• Preface
• Abbreviations
• Introduction
• Part I Externalities, network effects, and systemic risks
• Part II Topics in macroprudential regulation
• References
• Index