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Moral Hazard
Sergio Lugaresi, Public Affairs
Milan, 8 November, 2012
AGENDA
 The issue
 From “too big to fail” to systemic relevance
 SIBs additional capital requirements
 The main issue: still unsolved
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Moral hazard: the issue
 Government interventions have been of three kinds: guarantees, recapitalisation, and
impaired assets relief.
 In many countries government guarantees have been extended to banks’ liabilities:
this has been the most cost-effective way for restoring confidence of investors as it
is a contingent liability which does not imply any immediate government outlay and
whose “take-up rate” has been relatively low.
 Recapitalization schemes have been provided in some countries either for the
bank sector as a whole or as an ad hoc measure for individual troubles institution.
 In a few countries (including UK and Ireland) government have either provided an
insurance against assets devaluation or directly bought some bank troubled
assets.
 Financial markets perceived all these government measures as an implicit bail-out
guarantee to the financial sector, linking the financial risk to the sovereign risk.
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Moral hazard: public aids to the financial sector in percentage of
GDP (June 2007–June 2009)
Guarantees
Recapitalisation Troubled asset
purchase
Total
Countries
Euro Area
15.8
1.9
1.1
18.7
Japan
-
0.0
0.0
0.0
Switzerland
-
1.1
7.9
8.9
10.9
2.2
38.9
52.0
2.2
3.2
3.6
9.0
United Kingdom
United States
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From “too-big-to-fail” ……
 In Pittsburgh (November 2009) the G20 Leaders asked to
“create more powerful tools to hold large global firms to account for the risks they take.”
They also stated that “Standards for large global financial firms should be
commensurate with the cost of their failure”.
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“Too big” to manage in time of crisis
 This is particularly true for cross-border financial institutions operating in different
jurisdictions.
 International coordination of authorities would ease the solution of the issue;
 a facilitator would be a firm contingency plan for orderly wind-up (Recovery and
Resolution Plan).
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Recovery and Resolution Plans (“living wills”)
 The first step taken by the authorities has been to request SIFIs to set out a recovery
plan, (i.e. the set of measures that the bank could take to recover from a crisis scenario
while still a going concern) and
 ..provide information for authorities to draw up a resolution plan, (i.e. the set of
measures they could take to wind up or resolve the failed bank while minimising
systemic contagion).
 If a firm cannot demonstrate its structures enable orderly, cross-border resolution in its
recovery and resolution plan (RRP) (or “living will”), it could be required to change its
business organisation.
 Following the FSB recommendations in 2010, national European authorities (including
UK and Spain) requested their major banks develop RRPs. The Bank of Italy also
requested that the Italian major banks develop possible Recovery and Resolution Plans.
 The results of these exercises are still unknown. However, the picture, particularly in the
resolution phase, is still likely to be confusing, which only highlights the need for
legislative changes and international coordination.
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UK
Switzerland
Sweden
Spain
Slovenia
Slovakia
Romania
Portugal
Poland
Netherland
Malta
Luxembourg
Lithuania
Latvia
Ireland
Italy
Hungary
Greece
600%
Germany
France
Finland
Estonia
Denmark
Cyprus
Czech
Bulgaria
Belgium
Austria
“Too big” with respect to what?
700%
Tot Assets of the first three
banking group over domestic GDP
Tot Assets of the first three
banking group over EU27 GDP
500%
400%
300%
200%
100%
0%
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Interconnectedness
 Even if the bank size could be managed, financial institutions may be too
interconnected to fail (i.e. exposed to each other in such a way that the failure of one
of them may trigger the failure of all the others).
 Financial institutions, no matter what size, may be so exposed to each other that the
default of one, results in the failure of all.
 Securitisation and off-balance-sheet vehicles have allowed individual lenders to divide
and repackage their initial risks for sale and distribution to other investors, often
generating maturity mismatches.
 Financial activities in unorganized and unregulated market were traded on a bilateral
basis: this means that the counterparty risk is widespread and it is impossible to net
operations with third parties.
 The sophistication and opacity of financial instruments traded in unorganized and
unregulated markets prevented supervisory authorities from tracing the risks and
mapping the interconnections.
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….. to “systemic relevance”
 In Toronto (2010) the G20 Leaders identified the third pillar of financial reform in
“resolution and addressing systemic institutions. We are committed to design and
implement a system where we have the powers and tools to restructure or resolve all
types of financial institutions in crisis, without taxpayers ultimately bearing the burden,
and adopted principles that will guide implementation.”
 In Seoul (November 2010) they asked for “measures to better regulate and effectively
resolve systemically important financial institutions, complemented by more effective
oversight and supervision”.
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Systemic risk
 Endogenous: Idiosyncratic crises may propagate through contagion and be amplified by
interconnection and so generate a systemic crisis
 capital requirements,
 Micro-prudential supervision
 crisis management
 Exogenous: systemic risks generated by macro-imbalances and interconnectedness
 Macro-prudential supervision (European Systemic Risk Board and US Financial
Service Oversight Council) and
 countercyclical buffers (Basel 3)
 Is this enough?
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Systemic risk
 ‘The optimal policy response is not to increase capital requirements, as the current
fashion has it, but to remove the aggregate risk from systemically important leveraged
financial institutions’ balance sheets. […] This should be done by public private
partnerships whereby the government explicitly assumes most of the macro risk, while
the private sector provides the capital necessary to deal with microeconomic risk and
small aggregate shocks’. This would avoid ‘crippling the financial industry with the
burden of brute-force capital requirements.’ (Caballero 2010).
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Systemic relevance
The authorities response: Basel 3 is not enough
 Negative externalities (systemic risks) to be internalised
 Dimensions of systemic relevance:
 Size. SR = PD * SLGD. Does PD increase with size? Does SLGD increase
disproportionately with size? NO evidence.
 Interconnectedness
 Complexity
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G-SIBs additional capital requirements
 SIFIs = G-SIBs + other G-SIFIs + D-SIFIs
 For G-SIBs additional capital requirements (from 1 to 3.5% of RWA) based on:
 Size (measured by total assets),
 interconnectedness (i.e.: volume of interbank lending / borrowing; correlation in
equity prices, in the return on equity, in CDS prices, etc.)
 complexity
 Global activity (measured by cross-border claims)
 Substitutability, i.e. product specialization and market share (measured by assets
under custody, the values of payment system settlements, bond/loan/equity
underwritings, etc).
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The main issue: crisis management and resolution
All the discussion went around the real issue:
 how to manage and with which institutions the crisis and the resolution of cross border
banks?
 This need international coordination, legal expertise, trust among authorities.
References
 Caballero, Ricardo, Crisis and Reform: Managing Systemic Risk, MIT and NBER,
February 13, 2010
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Next
 Th. 11 Oct. h 10.30-12.15, aula 3
1. Introduction. Cross-border banking and regulation
 Wed. 17 Oct. dalle 14.30 alle 16.15, aula seminari
2. Prudential Regulation: Lessons from the Crisis
 Fri. 26 Oct. h 10.30-12.15 aula 3
3. From Basel 2 to Basel 3
 Thu. 8 Nov. h 10.30-12.15 aula 3
4. Moral hazard
 Thu. 15 Nov. h 10.30-12.15 aula 3
5. Crisis Management and Resolution
 Thu. 22 Nov. h 10.30-12.15 aula 3
6. Shadow Banking
 Thu. 29 Nov. h 10.30-12.15 aula 3
7. Rules and supervision
 Thu. 6 Dec. h 10.30-12.15 aula 3
8. Overall assessment of the regulatory reform
 Thu.13 Dec. h 14.30-16.30 aula 20
9. The Euro debt crisis and the Banking Union
 Mon.17 Dec. 10.30-12.15 aula seminari
10. Wrap-up and conclusion
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