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Bank Regulation and the Resolutionof Banking Crises

Course Introduction and Overview

Contents

1 Course Objectives 32 The Course Author 33 Course Content 44 The Course Structure 55 Learning Outcomes 76 Study Materials 77 Assessment 8

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Bank Regulation and the Resolution of Banking Crises

2 University of London

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Centre for Financial and Management Studies 3

1 Course Objectives

Welcome to this course, Bank Regulation and the Resolution of Banking Crises.The course has been designed to introduce you to some of the key concepts,

principles and practices in modern banking regulation and the resolution ofmodern banking crises. The literature on these subjects is vast so, in ap-proaching the material, we will be selective, focusing on a selection of keyissues of relevance to the topic.

The link between regulation and crises has recently moved from abstractdiscussion and specialists technical papers to popular debate and headlinenews, and the regulatory objective of achieving systemic stability. Thesurprising change in its status results from the widespread perception thatthe systems of bank regulation carefully constructed up to 2007 failed toachieve the objective of systemic stability; the regulators have been seen as

having been blind to the problems that were revealed by the 2007 financialcrisis, or even having had a regulatory system that contributed to the crisis.The financial crisis that emerged in the US in early-2007 has since spread to anumber of countries, with worldwide effects on real economic activity.

In this course we will often refer to this crisis as the 2007 financial crisis asit commenced in that year, although it continued into 2008 and took adramatic turn for the worse as a result of the failure of Lehman Brothers

bank in September 2008, and the resolution of the banking crisis will takeyears to complete. Faults in bank regulation were not the direct or onlycause of the financial crisis, but the crisis has led policy makers and academ-

ics to attempt to restructure regulation systems so as to overcome the faultsrevealed by the crisis. This course introduces some of the reform proposalsbut, as debates continue, none is final.

2 The Course Author

Dr Cyrus Rustomjee is currently Director, Economic Affairs Division,Commonwealth Secretariat and head of the Centre for Economic Training inAfrica (CETA) based in Durban, South Africa. In South Africa he has beenChairperson of the Policy Board for Financial Services and Regulation,

which advises the Minister of Finance on all aspects of the South Africanfinancial system; Chairperson of the Financial Services Board, which regu-lates the countrys non-bank financial sector, and member of the StandingCommittee for the Revision of the Banks Act. He has served as ExecutiveDirector for 21 African countries in the Executive Board of the IMF (19982002). He has also been a member of the World Bank Executive Board (199698); Advisor to the Deputy Minister of Finance in South Africa (19941996);Corporate Bank Manager (198491); and Technical Expert in drafting thefinancial clauses of South Africas new Constitution (1995/96). Dr Rustomjeeholds graduate and post-graduate qualifications in economics, law, politics,

banking and finance.

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3 Course Content

This course enables you to study principles of bank regulation and supervi-sion as they have developed over many decades, and especially since the1980s. Those principles - and illustrative examples are intended to have

general applicability and to be able to evolve gradually to keep up with theevolution of banking.

However, confidence in regulation and supervision was severely shaken bythe banking crisis that started in 2007 and sharply worsened in 2008 and thatcrisis puts the principles and their application into sharp focus. As thecourse proceeds, we will frequently reflect on the lessons of the 2007 bank-ing and financial crisis. Unit 1 points out that the recent crisis has revealedmany weaknesses in the framework for bank regulation and has promptedsome to argue that it requires significant reform.

One issue concerns the quality of lending and the assessment of risk by

banks when lending. Clearly, banks did not consider the quality of theirmortgage lending carefully enough. Yet as we will note in Units 2 and 3,there are in fact many formal regulations and banking supervisory practicesthat banks were expected to follow and which regulators and supervisorswere expected to enforce, to ensure that banks carefully consider lendingquality and adequately assess the risks involved in lending. In the firstphase of the 2007 financial crisis, it is clear that banks and mortgage lendershad little effective incentive to ensure sound lending and risk managementpractices; their new business model of originate and distribute meant that.

A second issue is the quality of supervision of financial institutions. Poor

supervision of bank lending activity clearly played a part in fuelling thereckless lending which seems to have taken place across large parts of thehousing mortgage market in the US. Are there guidelines that can help bankregulators and supervisors in their work? You will see in Unit 3 that thereare many guidelines for helping supervisors conduct their work, both innormal times when no crisis is present, as well as in periods when banks areweak and financially stressed.

A third issue is whether there should be safety nets to minimise failurewhen banks experience liquidity problems, or minimise the effects when

banks fail through becoming insolvent. The roles that regulators, central

banks, and the states budget can or should have in such circumstances iscontentious and involves difficult issues such as how to judge whether abank is insolvent rather than being solvent but experiencing liquidityproblems. These problems are examined in Unit 4, when you will studylender-of-last-resort facilities, typically by central banks, as well as otherforms of emergency liquidity support.

Unit 5 continues the discussion of the regulatory and supervisory treatmentof financially distressed banks by focusing on two sets of issues that occurwhen a bank ultimately fails, or after it has been declared insolvent. In theseinstances, the standard regulations have clearly proved inadequate toaddress the banks financial weaknesses and to avoid insolvency. The firstissue focuses on the approach to dealing with a failed banks assets and

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liabilities; the second focuses on approaches to protect depositors in theevent of failure.

A fourth theme is the structure of regulation: which institutions, at whichlevel city, state or national/federal regulate the banking sector? In

both the US and the UK regulation is fragmented between different

authorities, although the nature of the fragmentation is very different inthe two countries. But fragmented authority is not the case in most othercountries. Does the structure of regulation have an impact on the effective-ness of regulation? And could a different regulatory framework have helpedavert the crisis? We will consider these issues in Unit 6, when we examineregulatory structure.

A fifth issue highlighted by the 2007 financial crisis is the need for farstronger and more effective market conduct and conduct of businessregulation. For example, the crisis highlights that the conduct of some ofthe originating banks and mortgage institutions was unscrupulous and in

some instances illegal. Through their marketing strategies and their lendingpractices, millions of prospective homeowners were tempted into long-term

borrowing on the strength of short-term benefits, including fee-waivers anddeferred instalment payments. But when they experienced difficulty inmeeting their instalments, huge penalty fees were imposed and they foundthemselves trapped. Yet others were tempted to switch their loans on thepromise of a better deal and evidence later shows that many, including theelderly and the vulnerable, were coerced, but unscrupulous lenders.

Unit 7 considers some of these recent challenges to financial sector regula-tion and supervision. The regulations developed prior to 2007 represent

powerful tools for supervisors seeking to improve the condition of weakbanks. Yet these steps can only be effective if the supervisor has the powerto take such actions and if the supervisor has the capacity to enforce suchmeasures. In Unit 7, we will consider the various models of regulatorystructure and the implications these have for supervisory capacity

Regulation of banks lending to households and non-financial firms is onething, and it has been a regulatory issue since the beginning of regulation.The problems for regulators thrown up by banking innovations such ascollateralised debt obligations, credit default swaps at the start of thetwenty-first century are of a different order and require different reforms.

Unit 8 examines trade-offs between competition and financial stability inbanking.

4 The Course Structure

Unit 1 Why and How Should Banks Be Regulated?

1.1 Key Objectives of Bank Regulation

1.2 Regulatory Issues Illuminated by the 2007 Banking Crisis1.3 The 2007 Crisis Analysis and Response by the UK Financial Regulation Body1.4 Lessons for Regulators from the 2007 Crisis1.5 Other Types of Bank Regulation1.6 Conclusion

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Unit 2 Banking Supervision and Regulation

2.1 Key Phases in Bank Regulation (Part 1)2.2 Regulating Bank Capital Adequacy (Part 2)2.3 Background The 1988 Basel Accord2.4 The Basel II Accord2.5 Conclusion

Unit 3 The Prudential Supervision of Banks

3.1 The Prudential Supervision of Banks3.2 Basel Core Principles for Effective Banking Supervision3.3 The Effectiveness of Different Supervision Approaches3.4 Case Study Turkey3.5 Conclusion

Unit 4 Bank Crises Weak Banks and Lender-of-Last-Resort Support

4.1 Introduction4.2 Lender-of-Last-Resort Facilities (LOLR)4.3 LOLR to Illiquid But Solvent Banks4.4 LOLR to Illiquid, Possibly Insolvent, Banks4.5 Recent Developments Modifying Thornton and Bagehots Principles4.6 Conclusion

Unit 5 Restructuring Failed Banks and Protecting Depositors

5.1 Resolving Bank Failures

5.2 Resolving Systemic Banking Crises

5.3 Deposit Insurance5.4 Mandates and Powers of Deposit Insurance Agencies

5.5 Public Awareness

5.6 Conclusion

Unit 6 The Institutional Structure of Financial Regulation

6.1 Approaches to Institutional Structure for Financial Regulation

6.2 Why is Regulatory Structure Important?

6.3 Regulatory Structure and the Role of the Central Bank

6.4 Two Contrasting Models of Financial Regulation The US Regulatory System

6.5 The UKs Financial Services Authority Lessons from 200720086.6 Criticisms of the Single Regulatory Structure

6.7 Conclusion

Unit 7 Regulation, Supervision and Financial Stability

7.1 Financal Stability and Systemic Risk

7.2 Recent Developments in Financial Markets

7.3 Is Modern Regulation Keeping Pace with Developments in Financial Markets?

7.4 Some Policy and Institutional Responses to the 2007 Financial Crisis

7.5 Recommendations of the Financial Stability Forum

7.6 Conclusion

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Unit 8 Issues in International Supervision and Regulation

8.1 Offshore Financial Centres

8.2 Regulation, International Institutions and Standards and Codes

8.3 Proposals for International Regulatory Agencies

8.4 A World Financial Authority

8.5 An International Lender of Last Resort

8.6 Conclusions

5 Learning Outcomes

When you have completed your study of this course, you will be able to

outline key objectives of bank regulation describe some of the linkages between regulation and regulatory

practice, on the one hand; and banking crises on the other

describe in detail how the 2007 banking crisis originated in the UnitedStates and United Kingdom, how it developed and how it escalatedthrough the wider financial system

outline the major early lessons the crisis has yielded, for strengtheningbanking and financial sector regulation

explain the importance of bank capital adequacy and its relevance tothe prudential regulation of banks

list some of the challenges arising from the original Basel I CapitalAccord

explain the key elements of the Basel II capital adequacy framework

describe the major components of modern bank prudentialsupervision, using the financial soundness indicator and CAMELSframework

distinguish between lender-of-last-resort support for liquidity andsupporting the bank through investing new capital

discuss the concept of too big to fail and the difficulties related to it outline the various approaches to resolving failed banks and

managing the consequences of their failure

highlight the key principles supporting the establishment of a depositinsurance system

distinguish between the various approaches used by countries, whenstructuring their regulatory institutions

outline key changes in banking and financial markets, particularlysince the mid-1990s, that have increased the prevalence of systemicrisk

outline the main arguments for and against the establishment of aglobal financial regulator.

6 Study Materials

This Study Guide is your central learning resource as it structures yourlearning unit by unit. Each unit should be studied within a week. It is

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designed in the expectation that studying the unit and the associated corereadings will require 15 to 20 hours during the week, but this will varyaccording to your background knowledge and experience of studying.

Textbooks

In addition to the Study Guide, you should read the assigned chapters in thefollowing report and textbooks, which are provided for you.

Financial Services Authority (2009) The Turner Review: A regulatory response tothe global banking crisis, London: Financial Services Authority

Kern Alexander, Rahul Dhumale and John Eatwell (2006) Global Governanceof Financial Systems: The International Regulation of Systemic Risk, Oxford UK:Oxford University Press

C. Enoch, D. Marston and M. Taylor (2002) Building Strong Banks throughSurveillance and Resolution, Washington DC: International Monetary Fund.

Course Reader

The additional reading you are required to complete, in concert with yourreading of the Study Guides Course Units, is a selection of academic articlesand extracts from books and documents. These are provided for you in theCourse Reader. The Course Reader articles are often more technical, oradopt a more in-depth approach on particular topics than the text of theStudy Guide. This should not put you off, as many were written with anacademic audience in mind. These articles were selected so that the centralarguments and concepts can be understood and appreciated at a level

appropriate to this course.Optional Reading

You are provided with all the reading essential for this course, and we donot expect you to undertake extra reading on your own, partly because notall students have ready access to good libraries or bookshops. However, thereference section of each unit lists academic articles, book chapters or web

based sources that you can choose to read if you wish to further investigatea particular topic. Many of these readings can be accessed on the internet,

but it is important to note that they will not be assessed in examination orassignments.

Although not mandatory, we think that you will enrich your study of thiscourse by looking at such articles. Indeed, you are encouraged to chooseyour own additional reading on topics related to corporate governance. Youcan do this through searching the internet and by making use of the onlineacademic journals through the Library resources on the CeFiMS OnlineStudy Centre.

7 Assessment

Your performance on each course is assessed through two writtenassignments and one examination. The assignments are written after

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week four and eight of the course session and the examination is writtenat a local examination centre in October.

The assignment questions contain fairly detailed guidance about what isrequired. All assignment answers are limited to 2,500 words and are markedusing marking guidelines. When you receive your grade it is accompanied

by comments on your paper, including advice about how you might im-prove, and any clarifications about matters you may not have understood.These comments are designed to help you master the subject and to improveyour skills as you progress through your programme.

The written examinations are unseen (you will only see the paper in theexam centre) and written by hand, over a three hour period. We advise thatyou practice writing exams in these conditions as part of you examinationpreparation, as it is not something you would normally do.

You are not allowed to take in books or notes to the exam room. This meansthat you need to revise thoroughly in preparation for each exam. This isespecially important if you have completed the course in the early part ofthe year, or in a previous year.

Preparing for Assignments and Exams

There is good advice on preparing for assignments and exams and writingthem in Sections 8.2 and 8.3 ofStudying at a Distanceby Talbot. We recom-mend that you follow this advice.

The examinations you will sit are designed to evaluate your knowledge andskills in the subjects you have studied: they are not designed to trick you. Ifyou have studied the course thoroughly, you will pass the exam.

Understanding assessment questions

Examination and assignment questions are set to test different knowledgeand skills. Sometimes a question will contain more than one part, each parttesting a different aspect of your skills and knowledge. You need to spot thekey words to know what is being asked of you. Here we categorise the typesof things that are asked for in assignments and exams, and the words used.All the examples are from CeFiMS examination papers and assignmentquestions.

DefinitionsSome questions mainly require you to show that you have learned some concepts, by

setting out their precise meaning. Such questions are likely to be preliminary and be

supplemented by more analytical questions. Generally Pass marks are awarded if the

answer only contains definitions. They will contain words such as:

Describe Define Examine Distinguish between Compare

Contrast Write notes on

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Outline What is meant by List

Reasoning

Other questions are designed to test your reasoning, by explaining cause and effect.Convincing explanations generally carry additional marks to basic definitions. They will

include words such as:

Interpret Explain What conditions influence What are the consequences of What are the implications of

Judgment

Others ask you to make a judgment, perhaps of a policy or of a course of action. They will

include words like:

Evaluate Critically examine Assess Do you agree that To what extent does

Calculation

Sometimes, you are asked to make a calculation, using a specified technique, where the

question begins:

Use indifference curve analysis to Using any economic model you know Calculate the standard deviation Test whether

It is most likely that questions that ask you to make a calculation will also ask for an

application of the result, or an interpretation.

Advice

Other questions ask you to provide advice in a particular situation. This applies to law

questions and to policy papers where advice is asked in relation to a policy problem. Your

advice should be based on relevant law, principles, evidence of what actions are likely tobe effective.

Advise Provide advice on Explain how you would advise

Critique

In many cases the question will include the word critically. This means that you are

expected to look at the question from at least two points of view, offering a critique of

each view and your judgment. You are expected to be critical of what you have read.

The questions may begin Critically analyse

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Critically consider Critically assess Critically discuss the argument that

Examine by argument

Questions that begin with discuss are similar they ask you to examine by argument, todebate and give reasons for and against a variety of options, for example

Discuss the advantages and disadvantages of Discuss this statement Discuss the view that Discuss the arguments and debates concerning

The grading scheme

Details of the general definitions of what is expected in order to obtain a

particular grade are shown below. Remember: examiners will take accountof the fact that examination conditions are less conducive to polished workthan the conditions in which you write your assignments. These criteriaare used in grading all assignments and examinations. Note that as thecriteria of each grade rises, it accumulates the elements of the grade below.Assignments awarded better marks will therefore have become comprehen-sive in both their depth of core skills and advanced skills.

70% and above: Distinction As for the (60-69%) below plus:

shows clear evidence of wide and relevant reading and an engagementwith the conceptual issues

develops a sophisticated and intelligent argument shows a rigorous use and a sophisticated understanding of relevant

source materials, balancing appropriately between factual detail andkey theoretical issues. Materials are evaluated directly and theirassumptions and arguments challenged and/or appraised

shows original thinking and a willingness to take risks60-69%: Merit As for the (50-59%) below plus:

shows strong evidence of critical insight and critical thinking shows a detailed understanding of the major factual and/or

theoretical issues and directly engages with the relevant literature on

the topic develops a focussed and clear argument and articulates clearly and

convincingly a sustained train of logical thought

shows clear evidence of planning and appropriate choice of sourcesand methodology

50-59%: Pass below Merit (50% = pass mark)

shows a reasonable understanding of the major factual and/ortheoretical issues involved

shows evidence of planning and selection from appropriate sources, demonstrates some knowledge of the literature the text shows, in places, examples of a clear train of thought or

argument

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the text is introduced and concludes appropriately45-49%: Marginal Failure

shows some awareness and understanding of the factual or theoreticalissues, but with little development

misunderstandings are evident

shows some evidence of planning, although irrelevant/unrelatedmaterial or arguments are included

0-44%: Clear Failure

fails to answer the question or to develop an argument that relates tothe question set

does not engage with the relevant literature or demonstrate aknowledge of the key issues

contains clear conceptual or factual errors or misunderstandings[approved by Faculty Learning and Teaching Committee November 2006]

Specimen exam papers

Your final examination will be very similar to the Specimen Exam Paper thatyou received in your course materials. It will have the same structure andstyle and the range of question will be comparable.

CeFiMS does not provide past papers or model answers to papers. Ourcourses are continuously updated and past papers will not be a reliableguide to current and future examinations. The specimen exam paper isdesigned to be relevant to reflect the exam that will be set on the currentedition of the course

Further information

The OSC will have documentation and information on each yearsexamination registration and administration process. If you still havequestions, both academics and administrators are available to answerqueries.

The Regulations are available at www.cefims.ac.uk/regulations.shtml,setting out the rules by which exams are governed.

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UNIVERSITY OF LONDON

Centre for Financial and Management Studies

MSc Examination

MBA Examination

Postgraduate Diploma Examination

for External Students

91DFMC356

FINANCE

BANKING

Bank Regulation & Resolution of Banking Crises

Specimen Examination

This is a specimen examination paper designed to show you the type of examination

you will have at the end of the year for Bank Regulation & Resolution of

Banking Crises. The number of questions and the structure of the examination

will be the same but the wording and the requirements of each question will be

different. Best wishes for success in your final examination.

The examination must be completed in THREE hours. Answer THREE questions.

The examiners give equal weight to each question; therefore, you are advised to

distribute your time approximately equally between three questions

PLEASE DO NOT REMOVE THIS PAPER FROM THE EXAMINATION ROOM.

IT MUST BE ATTACHED TO YOUR ANSWER BOOK AT THE END OF THE

EXAMINATION.

University of London, 2009 PLEASE TURN OVER

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Answer THREE questions.1. Explain the key regulatory issues arising from the banking crisis,

which started in 2007, and discuss the key lessons learned bybank regulators.

2. Write an essay explaining the importance of bank capitaladequacy and its relevance to the prudential regulation of

banks. Illustrate your answer with reference to the Basel CapitalAccords.

3. Describe the CAMELS framework for the prudential supervisionof individual banks.

Illustrate your answer with reference to country examples.

4. Explain how bank supervisors address the challenges posed by

banks that are weak but not facing financial distress.

5. Most countries have established deposit insurance systemsbecause the benefits are obvious and the systems are easy todesign and implement.

Critically discuss this statement.

6. Compare and contrast fully unified and other models of regula-tory structure. Which model is best equipped to address systemicrisk and financial stability?

7. The financial crisis from 2007 has shown that bank regulatorsare well-equipped to adapt to changes in financial markets andcan effectively address systemic risk and threats to financialstability.

Discuss this statement.

8. Describe the advantages offered and the challenges posed byoffshore financial centres

[END OF EXAMINATION]

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Bank Regulation and the Resolutionof Banking Crises

Unit 1 Why and How Should BanksBe Regulated?

Contents

1.1 Key Objectives of Bank Regulation 31.2 Regulatory Issues Illuminated by the 2007 Banking Crisis 61.3 The 2007 Crisis Analysis and Response

by the UK Financial Regulation Body 71.4 Lessons for Regulators from the 2007 Crisis 81.5 Other Types of Bank Regulation 131.6 Conclusion 14References and Websites 14

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Unit Content

This introductory unit has been divided into three parts. We start by dis-cussing the rationale for and the major objectives of banking regulation. We

will refer to these throughout this course. Secondly, we examine how bothparts of the courses subject matter banking regulation and banking crises are closely linked, with bank regulators responding to banking crises withnew approaches to regulation.

Learning Objectives

By the time you have completed Unit 1, you can expect to be able to:

outline key objectives of bank regulation describe some of the linkages between regulation and regulatory

practice, on the one hand; and banking crises on the other

describe in detail how the 2007 banking crisis originated in the UnitedStates and United Kingdom, how it developed and how it escalatedthrough the wider financial system

outline the major early lessons the crisis has yielded, for strengtheningbanking and financial sector regulation

discuss the major regulatory steps being considered to try to avoid arepeat of the circumstances that have brought about the current crisis.

Reading for Unit 1

Course Reader

Mathias Dewatripont and Jean Tirole (1994) The Nature of Banking andthe Rationale for Regulation, in Dewatripont and Tirole, The PrudentialRegulation of Banks, Cambridge, MA: MIT Press

Report

Financial Services Authority (2009) The Turner Review: A regulatory responseto the global banking crisis, London: Financial Services Authority

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1.1 Key Objectives of Bank Regulation

Bank regulation has, until recently, been a subject for specialists. The generalpublic and even most economists have given little thought to the work of

bank regulators, perhaps seeing them as specialists working within a closedcircle on a worthy but obscure and uninteresting task. The crisis of 2007 haschanged that and thrust bank regulation into the limelight. Public debate hasrevolved loudly around basic questions: Was the regulation system in theUnited States, the United Kingdom and elsewhere fundamentally flawed?Were regulators themselves asleep on the job? How could changes inregulation prevent future crises?

If we take a step back from the headline questions, a more basic questionbecomes apparent. Before we can consider whether regulation failed andhow it should be reformed, we have to ask what regulation is for:

What are the objectives of bank regulation?Or, more fundamentally:

Why does bank regulation exist? Exercise

Please pause briefly and reflect on those questions. Try to make a note of the reasons you

would give for bank regulation to exist, or of the objectives you think it should have.

Nowadays it is commonly accepted that some form of bank regulation isneeded, but regulation needs to be justified; over the centuries severalarguments against regulating banks have surfaced.

Today the main issues derive from the fact that banking involves severaltypes of risk, and the main debates concern regulation of risk taking. That isknown as prudential regulation and is the subject of most of this course. Laterin this unit we shall describe some other types of banking regulation, too,

but let us keep focused on prudential regulation for now. The risks banksface include these three types, and others:

Credit risk the risk of default by borrowers (which would giverise to losses through having non performing loans on the banks

balance sheet)

Interest rate risk the risk that interest rates received on assets and paidon liabilities might move in unexpected directions

Market risk the risk of a decline in the market values of a banksassets such as foreign currency and derivatives.

Any risk such as those could lead to losses so large that the bank fails, entersbankruptcy and is liquidated and, in fact, bank failures do regularly occurin many countries even when banking as a whole is not in crisis.

A failure of an individual bank usually causes losses to1 the shareholders,

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2 holders of the banks debt, and3 depositors.

We could extend the list to include bank employees, borrowers from thebank who are unable to renew their financing routinely, and others, but letus stick with the three types we have identified, all of whom lose because

they own forms of bank liabilities.

In your response to the question above you might have answered that banksshould be regulated in order to control the degree of risk they take becausesociety should protect people from the risk of losing all. But let us reflect onthat.

It is unlikely that you would argue for the protection of shareholders, for, inprinciple, modern capitalism rests on the legal rule that holders of commonstock or equity invest their money in the knowledge that they are the first to

bear loss in the event of bankruptcy. Generally, that accords with mostpeoples ethical judgements too, although its fairness is arguable if shares

are held by a managed pension fund, insurance company or other institutionon behalf of small savers who have imperfect information and no effectivecontrol over investment decisions.

It is also unlikely that you would argue for regulators to protect holders of abanks debt (bonds and other securities) from the risk of a banks bank-ruptcy. One reason is that they may be assumed to be sophisticated andinformed investors who have invested in those instruments at a price (or,inversely, interest yield) that compensates them for taking the risk whichthey have calculated.

However, you might have argued that regulation is required to protect theholders of small (retail) deposits. That is generally recognised to be animportant reason and objective for regulation, for small depositors do nothave the information on which to judge a banks riskiness, nor do they havean incentive to acquire the information or the skills to be able to judge it.

Let us agree that the protection of small depositors is one principal reason forregulation the regulators act as their representatives. At the end ofSection 1.1 we will suggest that you read an article by Dewatripont andTirole which presents reasoned arguments in favour of that view as well asdiscussing criticisms of that view.

The idea that regulation exists to protect small depositors is usually framedin terms of the regulation of a single bank. But in the wake of the 2007 crisis,which went on to affect whole banking systems, other financial institutionsand financial markets, your answer to that question might have focused onthe broader system rather than an individual bank.

From that point of view, a second principal reason for bank regulation is thesystemic effect that a banks failure might have. Regulators should oversee

banks riskiness in order to prevent the failure of an individual bank damag-ing the financial system as a whole. And from that perspective a view thathas been strengthened by the 2007 crisis is that bank regulation and

supervision should occur within a framework that takes account of theriskiness of the financial system as a whole.

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Some might argue that those two reasons are not sufficient to justify orexplain the regulation of banking, for similar reasons could (at a stretch) beput forward for regulating some industrial firms, yet they would not beconvincing for non-financial firms. Why not regulate a car firms financial

behaviour? Its collapse would directly or indirectly damage thousands of

small suppliers who could not have been expected to monitor the firmsfinancing, and its collapse might cause other car manufacturers in thatcountry to suffer severely as a result of reputational damage to that coun-trys industry. What makes banks special?

1.2.1 Why are banks special?

The most widely accepted answer is that banks are special because theirfinancial services are central to the whole economy and the collapse of amajor bank or of many banks would have severe repercussions across theeconomy. In particular, bank deposits are the main element of a countrysstock of money, and the stock of money has a relation with economic ac-tivity albeit a complex relation, the nature of which is contested. In aclassic book published in 1963 Milton Friedman and Anna Schwartz arguedthat in the United States bank failures that reduced the stock of money,rather than the 1929 stock market crash, were a major cause of the GreatDepression of the 1930s.

Now that we have discussed the reasons for prudential regulation we wouldlike you to read an authoritative academic article on the subject by MathiasDewatripont and Jean Tirole, two economists who have led modern think-ing on regulation of all types. The article is, in fact, based on a prestigiouslecture given in 1992 at the University of Lausanne and although it is now

many years since its publication and the world has experienced at leasttwo great financial system crises since then it provides a classic discussionof principles which still apply.

When you read the article you might note three things. The article wasprompted by then recent crises, for the 2007 crisis was not the first big

banking crisis of modern times. In an Introduction to the reading De-watripont and Tirole (1994: 23) wrote:

renewed interest in academe for banking regulation (or deregulation)was generated by the large-scale banking problems experienced by manycountries. For most of the World War II era bank regulation proceeded

smoothly: Few failures occurred, and the topic was not of widespreadinterest to academics and to the public. Due to a number of factorsbank failures became more common in the 1980s. The impact of therecent banking crises on the taxpayers will often be tough. It is, forexample, estimated that the U.S. government will spend hundreds of

billions of dollarscleaning up the [Savings and Loans, thriftinstitutions] and commercial banks wreckage. Nordic countries havespent $16 billion propping up their banks from 1989 through 1992

Japan is now searching [for] remedies for its banking crisisA number ofLatin American countriessupply yet another illustration of the extent of

banking crises they experienced in the 1980s large scale bank failures thatled to (at least temporary) nationalization of many of their largest banks.

The authors provide a simplified outline of a typical banks balance sheetand its income statement. And in that context they discuss the differentelements of banks business. Because they were writing more than a decade

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before the banking boom of the early twenty first century which spawnedthe 2007 crisis they do not discuss the new types of business that have beenimplicated in that crisis. You will read about those new types of bank

business later in this unit.

ReadingPlease read Dewatripont and Tiroles article on banking and regulation now.

While reading it, make notes of the arguments the authors give for and againstparticular rationales for regulation.

Note that the data given in their Tables 2.3 through 2.5 can be ignored, for they are now

relevant only for historians.

1.2.2 The state as ultimate guarantor

In the wake of the crisis of the US and UK banking systems which began in2007, we would emphasise one reason for bank regulation more than wemight have done in 1994 when Dewatripont and Tiroles paper was pub-lished. The current crisis has demonstrated that, in a systemic breakdown,the state is the ultimate guarantor of the banking system. As it demonstratedas the recent crisis worsened, the state will not allow the system to fail

because of its economic and social importance, and many individual bankswithin it are considered to be so large and important for the system that theyindividually warrant the states acting to prevent their failure, by injectingstate funds as liquidity, or as capital, or taking over their ownership the

too-large-to-fail banks.If the state is the ultimate guarantor, this means that the state ultimately

bears the banks risks. Since, in normal times, the banking system is onlyable to operate because it has that implicit guarantee behind it, the stateas the ultimate bearer of the systems risks should have the means to regu-late banks risky behaviour. That is a powerful argument for regulation.Please note, however, that it does not itself define the objectives of regula-tion, or the detailed rules or institutional system of regulation, and it doesnot by itself recognise that regulation may be ineffective and, even if effec-tive, is costly.

1.2 Regulatory Issues Illuminated by the 2007 Banking

Crisis

The course has been written in the midst of a global banking and financialcrisis. The crisis commenced in the US from early 2007 and quickly spread toother parts of the US financial sector. Subsequently, it spread to the bankingsectors of the UK and several European countries and caused a majordisruption in global credit markets effectively, major financial marketsceased to function for a period and for a significant period operated only

with dysfunctionally high risk premiums. As the crisis deepened, the inter-bank market, on which major banks relied to access a large share of their

Mathias Dewatripont

and Jean Tirole (1994)

The Nature of

Banking and therationale for

Regulation, reprinted

in the Course Reader

from The Prudential

Regulation of Banks.

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financing, and which provides the liquidity needed to maintain the pay-ments system, broke down. Participants in this market withdrew lending totheir peer banks and forced immediate and massive intervention by theauthorities to inject liquidity into the banking system.

Inter-bank lending declined for two broad reasons:

firstly, fears by banks that their peers had been deeply affected by thecrisis and that lending to them might therefore be risky

secondly, all of the large banks that are key participants in the USinter-bank market were affected by the crisis; and many requiredurgent and immediate sources of additional funding to bolster theirown liquidity and also their capital base.

With large parts of the financial system affected, the sources of funding forcapital have narrowed, with those providing capital being called upon by

banks, insurance companies, pension funds, hedge funds and many others.As a consequence, the cost of capital increased, with both developmentsputting further pressure on the weakened financial institutions balancesheets and also initially raising the cost of capital for industry or, in a classiccredit crunch, denying credit to industry. The repercussions were felt indeclining world trade and falls in many countries Gross Domestic Productin 2008 and 2009.

It would be a convenient and indeed stimulating start to a course onbanking sector regulation and the resolution of banking crises to be able tosay at the very beginning that you are studying banking crises and bankingregulation at a particularly interesting, but unique, period in modern his-tory. In part, that is correct, as the recent turmoil did rapidly call into

question many previously established practices and principles of bankingconduct. But in part, it is also not. For in this context it is an inconvenientreality that banking sector crises and the responses to these crises, by bank-ing sector regulators, are as old as the practice of banking itself. And whilemany rules, regulations, practices and principles of banking may alter whenthe current crisis has run its full course, a very much larger proportion willremain.

1.3 The 2007 Crisis Analysis and Response by the UK

Financial Regulation AuthoritiesThe many failures of large banks, famous names which have disappeared,kept alive only with government funding, or been forced into acquisition bystronger banks Bear Stern, Lehman Brothers, Northern Rock, Royal Bankof Scotland, Citigroup, Countrywide, Fannie Mae, Freddie Mac are only the

best known make one conclusion about the 2007 crisis inescapable: itshows that prudential regulation of banking in the years preceding the crisishad failed. Failed big time! as a New York bank employee might say.

To say that the crisis which started in the United States and United Kingdom

in 2007 shows that the system of prudential regulation in those countries, orinternationally had failed does not mean that the faults in those systemswere the cause of the crisis. In order to discuss how bank regulation should

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be reformed in order to avoid similar crises it is important to consider whatthe causes of the crisis were. Bank regulators, as well as other public bodies,politicians, academics and others, responded to the crisis by rapidly at-tempting to analyse its causes. In this section we would like you to read thestudy presented by Adair Turner who, in the wake of the crisis, was ap-

pointed to head the United Kingdoms regulatory body, the FinancialServices Authority. We have provided his study, The Turner Review, for you.

Reading

First we would like you to read Chapter 1 ofThe Turner Review, entitled What went

wrong? It presents an analysis of the causes of the crisis which is representative of the

consensus opinion that had formed by early 2009.

While reading it, we hope you will note its basic idea that the causes of the bankingcrisis are to be found in the nature of the boom that preceded it. That leads to further

questions which we would like you to think about and try to answer from your reading: How important were macroeconomic imbalances in contrast to banks own

decisions for the crisis that started in 2007?

What were the main macroeconomic imbalances in the boom years?

What were the main changes in banks business model the way that they handledloans and the risk on them in the years preceding the crisis?

What was the relative importance of each of the following banking innovations inthe years leading up to the crisis:

sub-prime mortgages

securitisation using collateralised debt obligations

structured investment vehicles SIVs (or conduits) credit default swaps?

What were the faults in banks own estimates of risk?

How did the system of prudential regulation banking innovations create incentivesfor banks to innovate in order to minimise the costs of meeting regulatoryrequirements?

1.4 Lessons for Regulators from the 2007 Crisis

The crisis, which began in 2007, quickly led to intense debate about howsystems of bank regulation should be changed to minimise the risk of futuresystem-wide banking crises. As this course is being written, it is too early tosay what precise changes will result, but we can put forward several lessonsthat have been drawn. First, we shall outline some of the lessons that weidentify as important; then we shall ask you to read Chapter 2 of The TurnerReview for the lessons and proposals which Adair Turner has focused on.

One trigger for the crisis lay at the heart of banking, even the most tradi-tional type of banking it was the way in which loans, such as mortgages,are assessed, originated, and financed. Oversight falls within the remit of

regulators and supervisors, so what lessons can they learn from the sub-prime lending that triggered the crisis?

Financial Services

Authority (2009) The

Turner Review: A

regulatoryresponse to the

global banking

crisis, Chapter 1

What went wrong?

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One concerns the quality of lending and the assessment of risk by bankswhen lending. Clearly, banks did not consider the quality of their mortgagelending carefully enough. Yet as we will note in Units 2 and 3, there are infact many formal regulations and banking supervisory practices which

banks are expected to follow and which regulators and supervisors are

expected to enforce, to ensure that banks carefully consider lending qualityand adequately assess the risks involved in lending. In the first phase of the2007 financial crisis, it is clear that banks and mortgage lenders had littleeffective incentive to ensure sound lending and risk management practices;their new business model of originate and distribute meant that.

A second issue is the quality of supervision of financial institutions. Poorsupervision of bank lending activity clearly played a part in fuelling thereckless lending which seems to have taken place across large parts of thehousing mortgage market in the US. Are there guidelines that can help bankregulators and supervisors in their work? We will see in Unit 3 that there are

many guidelines for helping supervisors conduct their work, both in normaltimes when no crisis is present, as well as in periods when banks are weakand financially stressed.

A third issue is whether there should be safety nets to minimise failurewhen banks experience liquidity problems, or minimise the effects when

banks fail through becoming insolvent. The roles that regulators, centralbanks, and the states budget can or should have in such circumstances iscontentious and involves difficult issues such as how to judge whether a

bank is insolvent rather than being solvent but experiencing liquidityproblems. The problems are examined in Unit 5, when we study lender-of-last-resort facilities, typically by central banks, as well as other forms ofemergency liquidity support; and when we consider deposit insurance, or asafety net arrangement for individual depositors affected by financial crises.

A fourth theme is the structure of regulation: which institutions, at whichlevel city, state or national/federal regulate the banking sector? In boththe US and the UK regulation is fragmented between different authorities,although the nature of the fragmentation is very different in the two count-ries. But fragmented authority is not the case in most other countries. Doesthe structure of regulation have an impact on the effectiveness of regulation?And could a different regulatory framework have helped avert the crisis?We will consider these issues in Unit 6, when we examine regulatory struc-

ture.

A fifth issue highlighted by the 2007 financial crisis is the need for farstronger and more effective market-conduct and conduct-of-businessregulation. For example, the crisis highlights that the conduct of some of theoriginating banks and mortgage institutions was unscrupulous, and in someinstances illegal. Through their marketing strategies and their lendingpractices, millions of prospective homeowners were tempted into long-term

borrowing on the strength of short-term benefits, including fee-waivers anddeferred instalment payments.

But when they experienced difficulty in meeting their instalments, hugepenalty fees were imposed and they found themselves trapped. Yet otherswere tempted to switch their loans on the promise of a better deal, and

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evidence later shows that many, including the elderly and the vulnerable,were coerced, but unscrupulous, lenders. What role do regulators andsupervisors have in ensuring sound market conduct? And what role is therefor consumer protection in the financial services sector and who shouldguide and govern this? We will examine some useful supervisory guidelines

in Unit 3, which addresses market conduct regulation.Regulation of banks lending to households and non-financial firms is onething, and it has been a regulatory issue since the beginning of regulation.But the problems for regulators thrown up by banking innovations such ascollateralised debt obligations, credit default swaps at the start of thetwenty-first century are of a different order and require different reforms.

Today much debate over reform concerns improvements to the require-ments for banks capital adequacy regulatory capital. We will examinewhy banks are required to maintain regulatory capital, in Unit 2, in con-siderable detail. And we will consider how regulatory standards for capital

provisioning have evolved in the past two decades. The recent, crisisspurred, since mid-2008, new global efforts to strengthen capital adequacyof banks. And in Unit 2, we will examine closely the proposed content of theproposals that have been discussed for strengthening capital adequacyamong banks all over the world.

A more fundamental modern debate focuses on the capacity of banks andthe financial engineering experts within them to innovate. It concerns therole of regulation in balancing two competing forces:

the need to protect the financial system from undue or uncalculatedrisks, and

the need to allow the financial sector to innovate and grow.It was widely believed before the crisis that innovation and growth in thefinancial sector promoted growth across the broader economy and thereforeregulation should occur in ways that do not restrict it. In the light of thecrisis many writers would qualify that view, and argue that only certaintypes of innovation might stimulate economic growth and regulation shouldoccur in such a way as to permit such good banking development. Both thedebate over capital adequacy regulations and that over the desirability orundesirability of regulations that restrict innovation refer to the fact thatregulation of any kind imposes direct and indirect costs both on the banks

and on society. Consequently, although a crisis is often followed by apolitical and popular demand for more and better regulation, it is necessaryto balance the potential benefits against the costs when assessing regulatoryreform.

From your reading about innovation in Chapter 1 ofThe Turner Review youhave seen that through securitisation banks had transformed mortgages intoasset-backed securities. Through this process, they were able to shift keyrisks to other parties, including the risk of default by homeowners on theirmortgages, as well as the risk that the value of the collateral would collapse.Shifting these risks may in itself not be hazardous; but if those acquiring the

risks do not understand the investments they are purchasing and do notunderstand or are not capable of assessing the risks that underlie them

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new sources of risk to financial stability can emerge. The transactions whichappeared to be good for an individual bank because they transfer risk toother willing holders of the risk turned out to have increased the risk to thefinancial system as a whole (and, in fact, in several cases proved not to haveremoved the risk from the original bank). Regulation which seeks to ensure

that the process of risk transfer is adequately assessed by both parties, basedon sufficient and readily available information, is widely agreed to benecessary now, although its design involves difficult challenges. Here is anoutline list of some of the challenges:

Understanding the risks

Firstly, the complexity of the collateralised debt obligation (CDO) derivativeproducts had made it almost impossible for all but the most sophisticatedinvestors to understand the risks they were assuming when investing in aCDO. In the absence of effective regulation, there was no incentive for CDOunderwriters to disclose who had invested in CDOs, or the tranches in

which they had invested.

Transparency in risk pricing

Secondly, in the absence of regulations requiring comprehensive disclosureof information about the nature and types of risks being assumed, there wasalso no incentive to explain how risks had been priced. And in the absenceof regulation there was no compulsion on the CDO underwriters to high-light the types of risk investors were assuming. In hindsight, as is now beingproposed by regulators and global regulatory agencies, after some US$ 500

billion in losses, far-strengthened regulation of complex structured products

such as CDOs is considered to be urgent and necessary, to better serve boththe manufacturers of these products, as well as investors, and to reduceuninformed risk taking.

Adequate regulatory capital

Thirdly, the creation of CDOs and bank SIVs highlights the explicitefforts by banks to avoid regulatory capital. The housing of substantialinvestments, with very real risks, in SIVs, allowed the banks to avoid regula-tory capital provisions. Once the crisis hit, many banks were forced to bringthese SIVs back on balance sheet, not because they were legally obliged todo so for they were separate legal entities supposedly with no responsi-

bility to each other but because banks feared that the reputational risk ifthey abandoned their SIVs would cause them far greater losses. Strength-ened regulation, it is now argued, is required to ensure that both the on-

balance-sheet and off-balance-sheet activities of banks are fully disclosedand that adequate regulatory capital, assessed separately for each typelending instrument and attendant risk, is provided for both sets of activities.

Ratio of risk assumed to the capital provided

Fourthly, the establishment of synthetic CDOs or insurance contracts forspecific forms of risk, significantly raised leverage or the ratio of riskassumed to the capital provided in the US financial system, and high-

lighted the ease with which new leverage can be created and the ease withwhich risks can be originated and sold on to unsuspecting investors. The

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origination for sale of synthetic CDOs also highlights the gap betweenfinancial innovation and the ability of regulators to keep pace with andaddress the regulatory challenges posed by innovation and, indeed,signals the possibility that this gap has significantly, and possibly perma-nently, widened.

Reading

Now please read Chapters 2 and 3 of The Turner Review.

Compare Turners approach to reforms of the regulatory system with the elementswe have listed in this section.

The reforms suggested by Turner, including those that the United King-doms Financial Services Authority had instituted before publication, areone regulators response to the needs highlighted by the crisis. Other writers

and policy makers and various banks and banking organisations them-selves have their own perspectives, which partly coincide with Turnersand partly diverge. For the present, your main task has been to compareTurners views on reforms with the reform needs we have listed.

We hope you identified one major difference between the reforms con-sidered by Turner and those we have listed. Turner gives great emphasis todeveloping systemic regulation and supervision, as compared with thepoints we discussed concerning regulation and supervision of individual

banks. Regulation of individual banks to control their riskiness was theprinciple behind traditional bank regulation, but, in line with the analysis of

the causes of the crisis that you read in Chapter 1 ofThe Turner Review,Turner believes that regulators must deal with systemic risk.

Moreover, that includes a concern with the effects on the activity of firmsand households the real economy for prudential regulation itself has

been shown to have a potentially pro-cyclical effect, as prudential capitalrequirements on banks can lead to a feedback which heightens a realeconomy boom and worsens a downturn. Turner discusses proposals forchanging the system of capital adequacy requirements to prevent that pro-cyclical feedback effect.

Turners concern with systemic and macroeconomic effects complements

rather than replaces attention to micro matters the detailed reform ofprudential regulation governing the riskiness of individual banks. You arelikely to have noted the attention that Turner gives to new approaches tothree important issues:

the significance of common equity in regulatory (risk-weighted capitaladequacy)

the problem of risk attached to derivatives and other items recorded inthe banks trading book, and

the possibility of regulators influencing remuneration schemes of bankemployees to ensure that the design of bonus schemes and otherelements do not create incentives for taking excessive risk.

Financial Services

Authority (2009) The

Turner Review: A

regulatory

response to the

global banking

crisis, Chapter 2

What to do andChapter 3 Wider

issues open

questions.

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1.5 Other Types of Bank Regulation

In this unit we have concentrated upon one type of regulation, prudentialregulation, which is concerned with banks riskiness. Prudential regulation isat the forefront of modern regulatory concerns and the principal subject of

this course, but there are other types of regulation which complement it.One is regulation and supervision of banks business conduct and marketconduct. That seeks to ensure that the behaviour of supervised institutions isconsistent with the other objectives of banking supervision, includingprudential regulatory and supervisory objectives.

Examples of market conduct and conduct of business regulation include theregulatory requirements for proper disclosure of information regarding

bank lending, ensuring that bank management possess the necessary skillsto manage the deposits of individual members of the public and of institu-tional investors and that the systems and practices used by the bank are

sound. The soundness of bank practices incorporates the soundness ofbanks behaviour in selling their products to retail\customers, and ensuringthat customers for various types of deposits and loans are not the subject ofunfair trading practices.

Although the core of this course is focused on prudential regulation, we willexamine various aspects of business and market conduct regulation as weprogress through the course, particularly in Units 3 and 4, for it comprisesan important part of the overall framework for banking regulation; as wenoted earlier, it can be argued that the expansion of sub-prime mortgages,which proved to be systemically risky, was often based upon selling in an

unfair way to ill-informed households. And in Unit 6, when examininginstitutional arrangements for regulation, we will note that some countriesplace business and market conduct regulation in a separate regulatoryinstitution, while others combine this set of responsibilities, as well asprudential regulation, in a single regulatory institution.

Other regulations are not concerned with banks risk or banking practices assuch, but address other economic and social concerns. Examples includeregulations requiring financial institutions to maintain a physical presencein relatively poor areas, or to provide a minimum level of finance for hous-ing or other sectors.

An example in the United States is Community Reinvestment Act of 1977,which requires banks to lend without discrimination; it was especiallydesigned to curb discrimination against borrowers in so-called bad or red-lined areas. Other regulations with social objectives require certain mini-mum safety nets for small depositors and investors whose loss of depositsand investments may prove catastrophic to them when financial institutionsfail. Further regulations with social objectives are those requiring banks tocooperate in preventing money laundering by criminals and political out-casts. We will not examine this collective set of objectives further in thiscourse, although we will examine some specific elements in Unit 5, includ-ing the provision of financial safety nets that are designed to protect certaincategories of investors and depositors.

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1.6 Conclusion

In this unit you have studied some of the major issues concerning bankregulation. For much of the unit we have placed these issues in the contextof the banking crisis which began in 2007, for, since the crisis represents a

major failure of regulation, it highlights the character of bank regulation andit has stimulated renewed interest in reform of regulation. However, regula-tion is important in normal times when banks are operating smoothly andthe difficult questions about regulation are relevant whether or not thesystem is in crisis.

In the remaining units of the course we shall be examining detailed aspectsof regulation and supervision and considering them both in the context ofcrises and in contexts when bank distress is only a potential future danger.

References and WebsitesDewatripont M and J Tirole (1994) The Nature of Banking and the Rationalefor Regulation, in Dewatripont and Tirole, The Prudential Regulation of Banks,Cambridge, MA: MIT Press, 13-45; website:

http://www.cefims.ac.uk/pdfs/U1Dewatripont.pdf

Financial Services Authority (2009) The Turner Review: A regulatory response tothe global banking crisis, London: Financial Services Authority, March, Web-site: www.fsa.gov.uk/Friedman M and AJ Schwartz (1963) A Monetary History of the United States

18671960, Princeton, NJ: Princeton University Press, 299407.

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