Risk Management

The Unexpected Consequences Of Banking Regulation (Article 3 of 3)

Suppress moral hazard to make Basel III obsolete?

Le 19/06/2015
Jean-Bernard Caen

The fundamental objective of the Basel Committee "to develop a framework that enhances the strength and the stability of the international banking system" is ambiguous and can be understood two-ways: the first, narrow, assumes that the banking system can reach this objective by its own means, inside a closed system; the second, wide, puts the objective in the context of an organic vision of the economy, with the banking system acting as an essential and non-detachable component.

It is easy to demonstrate that the narrow view does not hold, because changing banks necessarily affects the rest of the economy. When banks receive more capital, a scarce resource, the share available to other actors is necessarily reduced. As for the banks' balance sheets, they mirror households and businesses own balance sheets. The banking system is organically open, by its very nature. Its regulation and supervision must therefore take place in a broad economic context; and the objective of the Basel Committee must be understood under the constraint of a thriving economy at the service of the Nation’s strategic ambitions.

In this logic, the banking system must be able to fulfill its economic role: to finance the economy with the Nation’s savings, safely, effectively and fast, at reasonable cost. Otherwise, other actors will take over this essential function, actors without a banking status naturally. Already markets fund businesses, internet actors orchestrate payments, insurance companies buy credit portfolios, asset management companies invest savings, peer-to-peer provides retail credit, etc.

This opens a new perspective to the Basel Committee's objectives: strengthening the soundness and the stability of the banking system has to be done under the double constraint of its sustained economic utility and competitiveness in regards to generic competition.

Is the banking system fulfilling its role properly?

The main question is: Under regulatory constraint, do banks retain their ability to fulfill their economic role?

To succeed in this role, banks face two critical success factors, functional and organic.

- Functionally, they must keep on assessing financial risks better than other economic actors; it is crucial for them to retain their role of allocating savings to capital consumers. Also, the return on their capital must be sufficient to finance the new technological infrastructures required by online banking, video branches, touch-free payments, etc.

But today’s regulatory pressure endangers both their expertise in measuring risks 1 and their ability to finance the investments required for their survival 2.

- Organically, the banking system should be an essential contributor to the economic development and receive a fair reward for this. Like a part of a living organism, it must be flexible and able to adapt to the economic world it belongs; the banking system should then include entities of various sizes and skills that can either develop or disappear depending upon their economic and social utility.

Today the banking system clearly does not have these qualities. It is ruled by regulators whose vision for the future looks like a static and risk free world. The institutions are becoming uniform, and their products too. The banking system mummifies. Banks are no longer born nor die: Can you name one single new bank in Europe (besides bad banks)? In the US, on average, only 2 banks were created yearly since 2008, against more than a hundred previously [1]. Maybe is it the fault of the low rates? What is certain is that the heavy investments required for compliance with regulations reinforce the status quo. And banks do not die either: Even those that were faced with the most deadly issues do not disappear, they are put into "resolution" over several years while retaining a banking license (it must monitored) and an overpaid management (who would want such a job?...).

Priority: remove moral hazard

The argument rehashed by policymakers and regulators is that the liquidation of a failed financial institution may have uncontrollable financial and economic consequences. The Lehman Brothers case is quoted more than often. This situation leads to an asymmetry: shareholders enjoy the profits, but when serious losses occur, taxpayers are quickly called in, despite themselves. This is called the "moral hazard". The absolute priority is to suppress it.

Its main beneficiaries are the banks too big to fail, the "Sifi's". With the implicit protection of the States, these banks benefit from low refinancing rates while taking significant risks. The IMF [2] estimates they have benefited in 2012 alone from 110 to 430 billion euros of hidden subsidies, with more than half in the euro area.

Also, keeping alive institutions which do not contribute anymore to the economy cost taxpayers considerable amounts; we are well aware of the tens of billions of euros in aid and recapitalization provided by the States during the crisis; less is known about the even more lavish State’s guarantees because these off-balance sheet commitments are well hidden and have no effect on the deficit: they are more than 10 times higher [3]! For instance, a bank currently in resolution that was recapitalized 5.5 billion euros in 2012 (o/w 2.6 by France) also benefits from issuing bonds guaranteed by France; as of end of 2013, this single hidden exposure had reached over 75 billion euros [4]!

Is it possible to get rid of moral hazard? In practice, this would mean that the failure of a financial institution would impact only its shareholders or bondholders, not depositors nor taxpayers.

The benefits would be huge, starting with a renewed vitality of the banking system; Are the new prudential rules going this direction?

Despite good intentions, the regulation reinforces moral hazard

As an answer to the 2007 and 2011 crises, and pushed by the G20, world regulators have massively reinforced banks’ operating constraints: more capital, liquidity and leverage constraints, and a funeral plan. The logic is that more robust banks will less likely default, hence reducing moral hazard. The principle makes sense but its implementation is flawed, reversing the effect.

When facing difficulties, the bank’s increased solvency constraint will hasten its equity shortfall; and as no private investor with common sense will hurry to recapitalize an ailing institution, the State will have to step in. Also complying with the liquidity constraint will be harder for a bank losing its customers and their deposits: it will have to buy government securities, which will have to be funded! And as private refinancing are scarce in uncertain times, the State (again) will forcefully have to fill in the liquidity gap, for instance by guaranteeing the debt issued. Thus, paradoxically, by reinforcing the need for State intervention and therefore the taxpayer, the new regulatory constraints increase moral hazard.

What about the new resolution rules, which aim at an orderly liquidation of troubled institutions, will they relieve the burden on taxpayers? Well, probably not, because the European legislator proved shy, which opened the door for untimely and costly resolutions. Delays will result from having imprecise intervention triggers; indeed they include almost any damaging event, in addition to the SREP scores assessed by the regulators on the basis of historical data, several months old at best [5]. And resolution will be expensive because, if it does include the threat of takeover by the authorities in case of difficulty, it is clearly stated that this will under no circumstance be automatic; hence tense discussions are to be expected between the shareholders who will want to protect their investment, and supervisors trapped with a challenge they can only alleviate with fresh public money.

As a consequence, the combination of late identification of failing institutions and the cost of their unjustified continued operation will increase moral hazard!

First step: remove the moral hazard

Moral hazard can be removed by a similar mechanism to that which applies to corporate failures. In general, once a payment is missed, the management has two weeks to seek the protection of the court; beyond that, its responsibility is extended to include their personal wealth.

This logic hardly applies to banks, as they can remain liquid by using customer deposits, even when insolvent. Thus a liquidity threshold would not be effective. But a solvency threshold could be. A good candidate is the Liquidation Net Asset Value (= fair value of assets – fair value of liabilities). The aim being to allow a liquidation of the bank without the taxpayer having to make up for losses, the fair value of assets must remain higher than the fair value of liabilities at all time. This appraisal of solvency differs from IFRS equity, which is a measure in going concern based with assets values sometimes far away from their fair values.

On this basis, a cheap and efficient resolution trigger would be to automatically withdraw the banking license of a bank if its Liquidation Net Asset Value falls to zero.

The liquidation process can be quick and at a limited cost: The teams are scaled down so as to manage only the existing loans, liquidity is allocated in priority to the repayment of deposits, and market positions are closed out at a proper pace. Such a process was applied to the Scandinavian insurance companies in the 90’s; final losses for insurance policy holders were limited to 0.1% of their assets; shareholders lost their investment but taxpayers were not called to the rescue. And companies born from the ashes of the formers are better managed.

The implementation of such a trigger raises multiple questions: what is the liquidation value of each asset and liability? How to avoid fire sales? Etc. But the expected benefits are enormous.

Second step: restore banks and regulators into their respective roles

First, the dynamics of the banking system is restored: Enabling banks to die opens opportunities for creating new ones, smaller and more flexible, which will improve the biodiversity and effectiveness of the banking system.

As for the supervisory authorities, they no longer have to worry about the solvency of banks since moral hazard is terminated. Consequently, most of Basel III becomes obsolete at once! The regulatory straightjacket loosens up. Risk teams can dump the multiple reports and the simplistic models used solely for regulatory compliance. They can resume investing in internal risk frameworks such as economic capital, the engine that drives the allocation of savings to capital consumers. The bank's management can focus on implementing the business model defined by the shareholders. The banking system opens up, its competitiveness and dynamics are restored at the service of the Nation's development.

The regulator retains three major responsibilities: To guarantee the proper protection of deposits through a mandatory insurance financed by banks at a premium inversely proportional to their creditworthiness, on the model of the US FDIC; To guarantee, jointly with the Market Authority, the quality of risk disclosures in the same way auditors guarantee the sincerity and transparency of financial accounts; And finally to continuously check the Liquidation Net Asset Value of each bank, a key to their banking license and public deposits ... when positive.


Conclusion: A matter of emergency

The banking system must be able to finance the share of the economy not funded by financial markets, notably its long term components by using households and businesses savings. According to the Group of 30 [6], these long term needs (infrastructure, communication, health, energy, etc.) increase around 5% per year. But since 2010, the balance sheet of European banks has shrunk -11%. This unexpected scissors effect leaves around a third of long term needs without proper funding; it results from banking regulation that repels banks away from their economic role.

Removing moral hazard and restoring banks and regulators in their natural roles will restore vitality to the banking system and the economy in general. But it will be a daunting task. To succeed, it will have to be understood as what it really is, a true emergency that threatens both the banking system and economic growth. Still, no single authority will be able to toggle the prudential doctrine to the right path because despite the conceptual simplicity of the proposed solution, its implementation would reduce the power of supervisors, which they will probably oppose fiercely. Still, removing moral hazard and drastically reducing the regulatory pressure will be the price for banks to recover one day their role as pillars of economic growth and job creation.


[1] Source Fed (WP2014-113).

[2] IMF, World Financial Stability Report, March 31st, 2014, chapter 3.

[3] “Identifying and accounting for the State’s off-balance sheet commitments”, Report of the French Court of National Auditors to the French Senate Finance Commission, examined and approved on April 13, 2013.

[4] French National Accounts 2013, p. 179

[5] Banks must hand over their Pillar2 ICAAP reporting by April 30th, on the basis of December 31st data; then regulators start their analysis.

[6] “Working Group on Long term Finance and Economic Growth”, The Group of Thirty / Mc Kinsey Global Institute, 2013


  • Caen
    • Institutional Advisor
    • Board member of the French Association of ALM Profesionnals
    • Executive Committee member of PRMIA France and leader of the MIT Club de France Finance Group


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