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Future Risks and Fragilities for Financial Stability
F UTURE RISKS AND FRAGILITIES
FOR F INANCIAL S TABILITY
Edited by
David T. Llewellyn and Richard Reid
Introduction by:
Stefano Pagliari
Chapters by:
Clive Briault
Alistair Milne
Patricia Jackson
Vicky Pryce
David T. Llewellyn
Thorsten Beck
David Lascelles
SUERF – The European Money and Finance Forum

Vienna 2012
SUERF Study 2012/3

CIP
Future Risks and Fragilities for Financial Stability
Editors: David T. Llewellyn and Richard Reid

Authors: Stefano Pagliari, Clive Briault, Alistair Milne, Patricia Jackson, Vicky Pryce,
David T. Llewellyn, Thorsten Beck, David Lascelles
Keywords: Financial Stability, Incentive Structures, Market Discipline, Bank Disclosure

Councils, Basel III, Shadow Banking, Regulation, Competition, Bank Business Models
JEL Codes: G1, G20, G21, G28, G38
Vienna: SUERF (SUERF Studies: 2012/3) – June 2012
ISBN: 978-3-902109-63-7
© 2012 SUERF, Vienna
Copyright reserved. Subject to the exception provided for by law, no part of this publica-
tion may be reproduced and/or published in print, by photocopying, on microfilm or in
any other way without the written consent of the copyright holder(s); the same applies to
whole or partial adaptations. The publisher retains the sole right to collect from third
parties fees payable in respect of copying and/or take legal or other action for this purpose.
1
TABLE OF C ONTENTS
List of Authors. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Stefano Pagliari
2. Incentive Structures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Clive Briault
2.1. Which Incentives Have Worked?. . . . . . . . . . . . . . . . . . . . . . 11
2.2. What Has Not Worked? . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
2.3. Missing Incentives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
2.4. Creating New Perverse Incentives . . . . . . . . . . . . . . . . . . . . . 16
2.5. Lessons for Future Risks and Fragilities. . . . . . . . . . . . . . . . . 17
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
3. Supporting Market Discipline: The Case of a Bank Disclosure

Council . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
Alistair Milne
3.1. The Role of Accounting. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
3.2. Two Interpretations of the Crisis: Inadequate Disclosure and
Systemic Risk Externalities . . . . . . . . . . . . . . . . . . . . . . . . . . 24
3.3. The Way Forward . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
3.4. Conclusions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
4. Basel III and Shadow Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29

Patricia Jackson
4.1. Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
4.2. Costs of Regulatory Change . . . . . . . . . . . . . . . . . . . . . . . . . 32
4.3. Changes in Banking Models . . . . . . . . . . . . . . . . . . . . . . . . . 35
4.4. Shadow Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
4.5. Way Forward . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
5. Regulation and Competition in the Financial System. . . . . . . . . . . . 41

Vicky Pryce
5.1. Competition as a Policy Objective . . . . . . . . . . . . . . . . . . . . . 41
5.2. Will Regulation Increase Competition in the UK Financial
System? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
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2 FUTURE RISKS AND FRAGILITIES FOR FINANCIAL STABILITY
5.3. Is there a Trade-off between Financial Stability and

Competition?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
5.4. Conclusions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
6. The Evolution of Bank Business Models: Pre- and Post-crisis . . . . . 45

David T. Llewellyn
6.1. The Context of Business Models . . . . . . . . . . . . . . . . . . . . . . 45
6.2. The Traditional Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
6.3. Pre-crisis Banking Model. . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
6.4. Post-crisis Pressures on European Banking . . . . . . . . . . . . . . 59
6.5. The Crisis as Transformational . . . . . . . . . . . . . . . . . . . . . . . 63
6.6. Assessment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66
7. Banking Banana Skins – Brief Remarks. . . . . . . . . . . . . . . . . . . . . . 69

David Lascelles
8. Concluding Observations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
Thorsten Beck
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75
International Centre for Financial Regulation (ICFR) . . . . . . . . . . . . . . . 77
SUERF – Société Universitaire Européenne de Recherches Financières . . 79
SUERF Studies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79
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3
L IST OF A UTHORS
Thorsten BECK
Professor of Economics and Chairman of the Board, European Banking
Center, Tilburg University
Clive BRIAULT
Senior Adviser on regulation at KPMG in London
Patricia JACKSON
Partner, Ernst & Young LLP, London; Adjunct Professor, Imperial College,
London and Centre for Economic Policy Research
David LASCELLES
Senior Fellow of the Centre for the Study of Financial Innovation (CSFI)
David T. LLEWELLYN
Professor of Money and Banking, Loughborough University and the Vienna
University of Economics and Business
Alistair MILNE
Professor of Money and Banking, Loughborough University
Stefano PAGLIARI
Ph.D. candidate at the Balsillie School of International Affairs and Research
Analyst at the International Centre for Financial Regulation (ICFR).
Vicky PRYCE
Senior Managing Director at FTI Consulting and formerly Joint Head of the
UK Government Economic Service
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5
1. I NTRODUCTION
Stefano Pagliari
Richard Reid, Director of Research at ICFR welcomed the speakers and partici-
pants at the conference held in Friends House, Euston Road, London and
expressed his enthusiasm for the ICFR-SUERF partnership in organising this
important event on the key issue of financial stability. Explaining the reason for
the conference he suggested that the regulatory response to a crisis may have the
effect of setting the parameters for the next. It is starting from this insight that
this conference, organised jointly by the ICFR and SUERF, on “Future Risks and
Fragilities for Financial Stability”, explored what the next pressure points for
financial stability might be, how these may arise from the response to the last
financial crisis, and how the industry and the regulators can prepare for them.
In order to discuss this theme, the conference brought together a select group of
academics, industry practitioners and policymakers to discuss a range of con-
nected issues, mainly incentives and market discipline, regulation, competition
and shadow banking, and size and structure of business models.
The paper presented by Clive Briault (Senior Adviser, KPMG), which appears as
Chapter 2, discussed the role of incentive structures in driving the conduct of the
financial sector in the run-up to the crisis. During this period, the financial sector
frequently responded to incentives originating outside the financial sector itself,
such as global imbalances, loose monetary policies, and loose fiscal policies, as
well as tax incentives. These external incentives interacted with, and were magni-
fied by, incentives internal to the financial system, such as the targeting of return
on equity and a reliance on short-term remuneration packages. The crisis also
demonstrated how the impact of these incentives within financial institutions can
survive the combined scrutiny of management, internal control systems, internal
audit, as well as the discipline imposed by financial markets, for a significant
length of time. Briault discussed different approaches to strengthen those incen-
tives faced by financial firms and their management that seemed to have gone
missing ahead of the crisis, as well as ways to encourage firms to internalise their
negative externalities. The final part of Briault’s presentation discussed the regu-
latory response to the crisis and highlighted how there is significant scope for
well-intended regulatory initiatives to generate perverse incentives. These are
already visible in the reaction of banking institutions seeking to implement
Basel III, but also in the conduct of regulators who may become excessively risk-
averse in order to meet their statutory objective.
The second paper, appearing in this study in Chapter 3, presented by Professor
Alistair Milne (Professor of Financial Economics, Loughborough University) sug-
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gested a more hopeful view of the role that market discipline can play in promot-
ing the safety and soundness of the financial sector. According to Milne, the fail-
ure of market discipline in the lead-up to the crisis could be attributed to the
failure in making information available to investors in an appropriate form.
Accounting returns cannot provide a complete view of the situation of firms as
complex as major international banks, while the performance measures upon
which investors rely to assess the performance of financial institutions, such as
return on equity and related techniques of economic capital allocation, have
proved to be inadequate.
Building upon this analysis, Milne discussed the need to supplement international
accounting standards and existing performance measures with additional disclo-
sures to allow investors to better understand the internal functioning of banks.
More specifically, Milne advocated that move closer to an ‘open-source’ banking
system, allowing investors to request, and to obtain on demand, complete infor-
mation on bank exposures along any appropriate dimension so as to enable com-
parison to be made between different financial institutions. In order to achieve
this objective, Milne endorsed the shift towards ‘contingent reporting’, expecting
banks to be responsible for providing relevant information at reasonably short
notice to either regulators or to investors, as well as the establishment of a private
sector disclosure council to determine such contingent disclosures, and regular
stress testing as demanded by the same investors.
Patricia Jackson (Ernst & Young LLP) discussed the implications that Basel III
and other recent regulatory reforms have on the banks and the ‘shadow banking’
sector, and these appear as Chapter 4 of this Study. Jackson argued that the
request for banks to increase the quantity and quality of equity capital against
different activities will have deep behavioural impacts on the business models of
banks, which are already meeting their new obligations by retreating from differ-
ent lending activities. She argued that the costs of increasing capital so substan-
tially had been underestimated by the authorities because of the focus on Mod-
igliani Miller. The Modigliani Miller theorem did not really apply to banks
because of the substantial asymmetry of information between a bank and an
investor or counterparty on the risks being carried. To understand the true risk
profile an investor has to understand the hedging, collateral taken, markets in
which the bank operates and so on. The changes in bank capital (up to 100%
increases for some banks) will change behaviour and it could take a very long
time before institutional investors become fully convinced that the higher capital
translates into a commensurate increase in safety. This is likely to mean that the
cost of capital and the cost of funding do not fully adjust to the higher capital for
many years. This will change the economics of various banking businesses leading
to a withdrawal from some activities.
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INTRODUCTION 7
With banks capital constrained, hedge funds are already moving into lending
activities alongside private equity firms, asset manager and lending between com-
panies. Jackson raised the issue of the extent to which this expansion in financial
intermediation occurring within the shadow banking sector is sustainable. If
macroeconomic or regulatory changes led to a contraction in some lending chan-
nels, this shortfall in the shadow banking sector will not necessarily be met by an
expansion in the balance sheet of banks, which will remain constrained by the
newly-imposed capital and leverage ratios, as well as by the new stable funding
liquidity ratio. This reduction in the provision of credit to the economy may neg-
atively affect the real economy.
The proposal presented by Jackson to avoid this outcome is to regenerate the
securitisation market around stricter rules, limited tranching much higher risk
disclosure, rand standardised structures to prevent the failures that characterised
these markets in the past. However, according to Jackson, measures to restart the
securitisation markets are unlikely to succeed without the intervention of regula-
tory authorities, for instance by allowing financial institutions to count the new
style securitisation as part of the liquidity pool under Basel III.
Vicky Pryce (FTI Consulting) discussed the issue of competition in the financial
system, and the extent to which this will be affected by recent regulatory reforms,
with her remarks appearing as Chapter 5 of this Study. Increasing competition
within the financial sector was one of the explicit goals that informed the work
of the UK’s Independent Commission on Banking, which identified different
measures to enhance the level of competition in the UK. According to Pryce the
impact of these measures on the level of competition is uncertain and the level of
competition within the UK banking sector may not change significantly over the
next few years.
According to Pryce, the outcome is not necessarily a negative one. While the pro-
motion of competition is generally associated with greater efficiency of markets,
in the case of finance this objective needs to be weighed against other concerns
such as ensuring the stability of vital functions, services and the protection of
consumers. At the present moment, allowing existing financial institutions to
recover may be a greater priority. Moreover, according to Pryce, both theory and
empirical evidence remain ambiguous regarding the nature of the payoff between
financial stability and competition, and some countries with heavily concentrated
banking sectors have weathered the financial crisis better than other less concen-
trated countries. Indeed, the level of concentration in the financial sector should
not be equated with the lack of competition, which still remains possible amongst
a small number of incumbents.
The paper presented by Professor David Llewellyn (Loughborough University
and the Vienna University of Economics and Business), which appears as Chap-
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ter 6 explores the evolution of bank business models before and after the crisis.
Indeed, a complex two-way causation exists between business models and regu-
latory policies where the change in business models over time is influenced by,
and in turn influences, the content of regulatory policies. This is the ‘endogeneity’
problem. Regulatory policies such as the original Basel Agreement, together with
other factors, contributed to an important evolution in bank business models,
creating incentives for banks in the years before the crisis, including the move-
ment of assets off their balance sheet, and an increasing reliance on securitisation
and on credit risk shifting instruments, and a departure from the traditional busi-
ness model where banks accept originated loans and accept the risk in their bal-
ance sheet. Some of the by-products of this change in business models, such as an
over-reliance on wholesale funding and increased gearing into higher risk assets,
have been closely associated with the origin of the financial crisis.
According to Llewellyn, the financial crisis has generated new pressures upon
banks to further adjust their business models. The unique conditions in the mar-
kets generated by the financial crisis, as well as changes in the regulatory environ-
ment, have generated a massive tightening in credit conditions and a contraction
in the inter-bank markets, and forced the European Central Bank (ECB) to
become a semi-permanent financer of commercial banks in Europe. According to
Llewellyn this model is unsustainable. Indeed, while it is still unclear how the
adjustment process will take place, Llewellyn argues that the crisis will be trans-
formational although banks are unlikely to converge on a single business model:
diversity in business models will continue.
Other challenges for financial stability that may emerge from the crisis were dis-
cussed by a panel including David Lascelles (Centre for the Study of Financial
Innovation), Emil Levendoğlu (HM Treasury) and Thorsten Beck (Tilburg Uni-
versity). In his discussion, a brief summary of which appears as Chapter 8, Beck
pointed to the risks emerging from the growth in the size of the financial sector
relative to the rest of the economy, arguing that there may be no additional ben-
efit from the growth of financial lending after a certain level. According to Beck,
regulatory policies should not be designed with the objective of avoiding bank
failure, but rather of ensuring that bank failures do not create significant costs for
the rest of the economy. He also pointed out that the relationship between com-
petition and stability is not a linear one but depends on the regulatory framework
in which banks operate. Finally, Beck discussed the benefits of cross-border bank-
ing, and argued that to preserve financial stability policymakers may be forced to
choose between increasing the international coordination of regulatory policies
and segmenting cross-border banking activities.
Emil Levendoğlu discussed the reforms being introduced to redesign the British
regulatory architecture. Levendoğlu highlighted the importance, when develop-
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INTRODUCTION 9
ing new regulatory systems (such as the incoming macro-prudential framework)

of policy-makers proceeding in a proportionate and evidence-led manner. A
related issue to keep in mind is finding the right balance between generalised
legislative provisions – which offer greater flexibility but less statutory detail –
and more prescriptive and detailed legislation which appears to provide greater
legal certainty up front, but carries the greater risk of regulatory inflexibility and
ineffectiveness. This is an issue which is currently being considered during Parlia-
mentary scrutiny of the Government’s Financial Services Bill.
David Lascelles in his remarks discussed what the major sources of future risks
are as perceived by the banking community, and his summarised comments
appear in Chapter 7. While the macroeconomic environment and the Eurozone
crisis are perceived as the major present risks, followed by the sovereign and con-
sumer credit risk, regulation also continues to be perceived by banks as a high risk
area given the costs it imposes and the competition issues it generates. However,
this perception is not shared by market players outside of the banking community
which continue have a more positive view of regulation.
In conclusion to the conference, Michael Saunders (Citigroup) spoke on the chal-
lenges for financial stability that are emerging in this phase from the overall eco-
nomic outlook. The global economic outlook is currently threatened by the inter-
action of three different processes: the deleveraging taking place in the private
sector, the deleveraging by the public sector, and the existing weaknesses in the
banking system. Indeed, the extent of these challenges is clearly tied to the size of
the credit boom before the crisis, a process whose origins can be found in the
regulatory policies introduced over that period.
Given the major costs that credit boom/bust cycles pose in terms of bank recapi-
talisation costs, as lost jobs, business failures, and public spending, Saunders con-
cludes that one of the major aims of economic and regulatory policies should be
that of dampening credit cycles and of minimising the losses that result from
them.
According to Saunders policymakers need to pay close attention to credit, hous-
ing and balance sheets during the boom. Sharp rises in debt and leverage are
warning signs that should not be overlooked. Policy makers need to act to
dampen this through monetary tools, as well as through the use of different mac-
roprudential regulatory tools such as variable capital weights and LTV ratios, as
well as through traditional monetary policy instruments. Saunders also called for
ending the tax advantages of debt finance. However, these lessons have not been
fully learnt yet. In his concluding remarks, Saunders called on policymakers to be
more forceful in demanding banks to recognise their losses and recapitalise in a
timely manner, while not allowing them to aggressively deleverage to meet capital
targets.
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The conference was concluded by Barbara Ridpath, Chief Executive of ICFR, and
Catherine Lubochinsky, President of SUERF. They thanked the speakers, chair-
persons and the participants for their contributions to a very interesting event.
Catherine Lubochinsky expressed the hope that this successful joint venture
between the two organisations would lead to further collaboration in the future.
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11
2. I NCENTIVE S TRUCTURES
Clive Briault
Thank you for asking me to talk about incentive structures at today’s conference
on future risks and fragilities for financial stability. This will not be an academic
presentation, but rather a more practical set of observations on:
– some incentives that do seem to have driven behaviour;
– some incentives that have not worked so well;
– some incentives that have gone missing;
– some incentives that have emerged as the unintended consequences of regu-
latory and supervisory initiatives since the financial crisis; and
– some lessons for future risks and fragilities.
2.1. Which Incentives Have Worked?

I begin with some incentives that did drive behaviour ahead of the current crisis.
I do so with one eye firmly on the lessons that need to be drawn for the future,
rather than with the intention of providing an overly-long list of the causes of the
financial crisis. I highlight these incentives in three main categories.
My first category here is the incentives that derive from macro-economic and tax
policies1. One of the main lessons that we need to learn for future financial sta-
bility is that the financial sector responds – both directly and through its interac-
tions with the rest of the economy – to incentives that are determined outside the
financial sector itself. These include:
– global imbalances – in both stocks and flows;
– loose monetary policy (as some have argued was the case in the US, the UK
and some eurozone countries during much of the 2000s decade);
– loose fiscal policy;
– tax incentives in many countries that favour the issuance of debt over raising
equity capital – encouraging both banks and their borrowers to take on
more debt and less equity than might be optimal; and
– tax incentives that encourage the purchase of residential property and the
development of commercial real estate.
Second, once these external incentives begin to take hold through the under-pric-
ing of risk and the creation of asset price bubbles, their impact can be magnified
through incentives that operate within the financial system. These incentives
encourage higher gearing and leverage to boost the return on equity. They encour-
1
These are discussed in more detail in C. BRIAULT (2009).
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age high sales and high levels of trading that are rewarded in short-term remuner-
ation packages that do not properly reflect long term risk-adjusted returns. And
they mislead banks, investors and bank supervisors through the procyclical
impact of both fair value accounting standards and internal model or ratings
based capital adequacy calculations.
Third, the impact of these incentives can also be observed at a more micro level.
These incentives can survive for a long time despite the combined scrutiny of
management, internal control systems, internal audit and supervision. The stories
abound, but some good examples are:
– the credit granting procedures of Anglo Irish Bank to property developers,
where the bank prided itself on being to decide on whether to lend to a
borrower much quicker than other Irish banks, and where credit officers
were paid bonuses depending on how much they lent;
– the CEPR study2 that found that US banks that securitised more of their sub-
prime mortgage lending also had lower lending standards;
– the catalogue of perverse incentives described in the excellent report that
UBS published in April 2008 to explain why it had been forced to write off
$48billion against securitised US sub-prime mortgages and other similar
exposures. These incentives included paying bonuses on ‘day one’ expected
profits when triple-A rated mortgage backed securities were bought by the
bank to be held on its own books; allowing risky trading areas to fund them-
selves for internal purposes at the rate that the UBS group could borrow
short-term from other banks in the interbank market; and only stress-testing
its portfolio of mortgage-backed securities up to the rate of loss predicted
by value at risk models using historic data from a benign period of rising US
house prices and strong economic growth;
– the paying of high bonuses or other rewards to the branch and call centre
staff of many UK retail banks for the selling of payment protection insur-
ance, even when the purchaser of this protection would be ineligible to claim
against it because of their age or employment status.
2.2. What Has Not Worked?

But not all incentives work well. Alistair Milne will talk next about market disci-
pline, and I will be interested to hear what he has to say on this important subject.
My own take on market discipline is that it turned out to have very little impact
on behaviours in much of the financial sector ahead of the crisis. That is the
conclusion I would draw from every chart that I have seen of share prices, credit
default spreads, interbank lending rates, bond yields, credit ratings and the like,
2
G. DELL’ARICCIA et al. (2008).
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INCENTIVE STRUCTURES 13
all of which show no signs of market concerns about banks and other financial
institutions ahead of the summer of 2007, and in some cases not much concern
until after the collapse of Lehman Brothers in September 2008. At best, the mar-
ket seemed able only to make what turned out to be very small and not always
reliable distinctions among individual banks through very small pricing differ-
ences around the generally highly complacent picture. The market therefore did
as badly as central banks, regulators, the IMF and politicians in failing to predict
the events of 2007 and 2008.
Of course it could be argued here that the market was reflecting the belief that
governments would intervene to support failing financial institutions. But this is
a flimsy argument – it does not explain why prices did not move against smaller,
less systemic, financial institutions, or against financial institutions such as AIG,
where the extent of official intervention surely came as a major surprise.
Similarly, despite the importance placed on transparency and disclosure by banks
through ‘Pillar 3’ of the Basel 2 capital accord, I see little evidence that the market
can use such information to make accurate judgements on the financial condition
of banks.
What about other incentives on firms and their management? Some claim that
limited liability (and a similar mechanism for shareholders because losses are lim-
ited at the zero bound for share prices) has both dulled the senses around the
consequences of failure and encouraged risk-taking to exploit the unlimited
upside possibilities. But it is not clear that limited liability has acted as a major
incentive in practice, if only because ahead of the crisis there was very little rec-
ognition of even the possibility of the magnitude of losses that followed. Leverage
and position-taking seemed to be driven much more by the widely and eagerly
expected gains, rather than a calculated gambit on the asymmetry of gains and
liability for losses. Nevertheless, this is not to say that the introduction of greater
personal liability for losses would have no effect on behaviours.
Similarly, there seems little evidence that the prospect of supervisory or enforce-
ment actions against firms or individuals has had much effect on behaviours. At
best the jury is still out on whether even the higher levels of fines and the repeated
refrain of ‘credible deterrence’ seen in recent years in the UK has stemmed the
flow of poor standards of systems and controls, selling, advice or insider dealing.
2.3. Missing Incentives

Meanwhile, are there incentive structures that have simply gone missing? Cer-
tainly ahead of the financial crisis there were far too few remuneration policies
within financial institutions that rewarded long-term and risk-adjusted profitabil-
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ity; that took account of compliance and risk management records; and indeed
that rewarded anything that could not be easily measured in terms of short-term
profits and short-term sales figures. Even after the crisis and all the noise from
politicians and regulators world-wide there is still far too much emphasis on
rewarding what can be measured in narrow financial profit and loss terms, rather
than any measures that are more closely related to compliance, good risk man-
agement, integrity and ethics.
Those who dislike the return on equity as an incentive tend to focus on return on
assets as a better measure of performance3. But those of us with experience of
customer treatment issues will worry here about the temptation to boost the
return on assets by raising charges, reducing the quality of service to reduce costs,
and cross-selling products that do not increase leverage – indeed the mis-selling
of PPI might be a perfect example of what could go wrong if the return on assets
became the new basis for performance-related incentives. There is also the more
basic point here that attempts to maximise the return on assets might have a
significant impact on the choice of assets that financial institutions would hold.
So, again, the key missing incentive here seems to be something that links more
closely with desired end-outcomes, not one that simply replaces one financial
variable with another.
Another suggested missing incentive is to increase the liability faced by the share-
holders, directors and/or managers of financial institutions that fail. This could
take a purely financial guise, in terms of somehow finding a way to load some of
the financial losses of failed institutions onto their former shareholders, directors
and managers. In addition, or alternatively, this could take the form – as sug-
gested by the FSA in its report on the failure of RBS4 – that individuals with
responsibility for such a failure could face a strict liability judgement of their guilt
and thus an automatic consequence of disciplinary financial penalties and a ban
from performing any future role in the financial services industry. This would
certainly concentrate minds, although the practicalities would raise some difficult
legal issues.
Some argue that establishing a more credible threat that large and systemically
important financial institutions could be allowed to fail would have a positive
impact on the incentives facing both the directors/managers of these institutions
and the uninsured and unsecured senior creditors with most to lose from such a
failure. This could be reinforced by the introduction of so-called ‘bail-in’ debt,
which would identify in advance the specific categories of senior creditors who
would be wiped out first (or, rather, first after shareholders and holders of subor-
3
A. HALDANE, “Control rights (and wrongs)”, Wincott Annual Memorial Lecture, London, Westminster,
October 2011.
4
“The failure of the Royal Bank of Scotland”, Financial Services Authority Board Report, December 2011.
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dinated debt) in order to prevent losses falling on taxpayers, even if the authori-
ties did intervene to limit the systemic consequences of a failure. The question
here is whether this would represent a genuine introduction of a powerful new
incentive, or would just increase the price of uninsured and unsecured senior
debt, thereby increasing the cost and reducing the volume of financial intermedi-
ation but without necessarily providing strong incentives for individual financial
institutions to adopt significantly less risky strategies.
However, none of these ‘missing’ incentives go beyond reducing the probability
of the failure of a financial institution. They do not provide a mechanism to inter-
nalise the negative externalities that are created by the failure of a systemically
important financial institution, through the potential direct and indirect conta-
gion effects of such a failure on other financial institutions and on the real econ-
omy.
In the early post-crisis days some of the official thinking did seem optimistic that
this could be achieved through regulation and taxes – Pigouvian taxes for those
who had remembered their economic theory – that incentivised financial institu-
tions not to become too large; not to become too complex and interconnected;
and not to dominate a market such that other firms would not be able to substi-
tute quickly for the services and products that the failed institution had been
providing.
But for whatever reason, no-one could work out how such Pigouvian taxes
could be levied in practice to address the problem of negative externalities in the
financial sector, so the focus shifted to more directly interventionist approaches.
These include the frameworks being developed for the authorities to construct
a ‘resolution’ plan for each major financial institution, under which it could fail
and be resolved without generating significant negative externalities on the rest
of the financial sector or more directly on the real economy. This might require
individual financial institutions to change their structures, their business activi-
ties and their interconnectedness with other financial institutions until a suffi-
ciently credible and effective resolution plan can be constructed for that institu-
tion.
Are there alternative ways of internalising the negative externalities? One idea
would be to link this with the proposal to increase the potential liability on direc-
tors and managers, but with less emphasis on the punishment for failure and a
more positive emphasis on the objectives of those running systemically important
financial institutions. For example, Jonathan Macey and Maureen O’Hara5 sug-
gested a few years ago that the Boards of banks should have a statutory duty to
take account of depositor interests and of the potential impact of the failure (or
5
J. MACEY and M. O’HARA (2009).
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other actions) of their bank on financial stability. It would be useful to revisit this
idea, and to consider other possible incentive structures to internalise the poten-
tial for financial institutions to generate system-wide instability.
A final missing incentive here is the now discredited and much maligned (not least
in the FSA’s report on the failure of RBS) notion of a ‘regulatory dividend’ that
could be offered to a financial institution that goes beyond mere compliance with
regulatory requirements. I hesitate to resurrect such a notion, since ‘regulatory
dividend’ was one of only four factors described as ‘dangerous’ in the FSA report
(along with the Basel 2 prudential requirements, leverage and VaR models), and
there should not be rewards for individuals and firms doing what they are sup-
posed to be doing in any case. But it does seem to me that if a firm or its directors/
management incur costs for going beyond the call of duty – particularly where by
doing so they contribute positively to financial stability by recognising and reduc-
ing potential negative externalities – then there could and should be some reward
to recognise and incentivise such behaviour.
2.4. Creating New Perverse Incentives

The next aspect of incentives I would like to touch on is the scope for well-
intended regulatory initiatives to generate perverse incentives. Unfortunately we
are seeing too many of these emerging under the current breadth and weight of a
‘more of everything’ approach to regulatory reform. For example:
– the Basel 3 proposals6 for two new minimum liquidity ratios will lead to a
scramble by banks to raise more retail deposits, the supply of which is noto-
riously price-inelastic in most countries. The result will be to increase the
cost of such funding to the banks, and to make retail deposits less stable
(because they will become more prone to move around between banks in
search of higher interest rates), without having much effect on the amount
of such deposits in the banking system as a whole. Similarly, the regulatory
value placed on more than one year maturity bonds and other wholesale
funding – for the purposes of liquidity management and to provide ‘bail in’
debt to be written down if a bank needs to be put into resolution – will drive
up its cost and make it even less available to all but the major players in
these markets;
– market and regulatory pressures on banks to meet now the higher minimum
capital ratios supposedly being phased in by 2019 under Basel 3 and the
European Capital Requirements Directive (CRD4) have incentivised
another scramble by the banks, this time to sell assets and reduce the growth
of their loan books in order to meet the required capital ratios without rais-
6
BASEL COMMITTEE OF BANKING SUPERVISORS (2010).
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ing new capital. The stress tested capital requirements currently being
imposed by the European Banking Authority7 – which demand that major
European banks meet a minimum common equity capital ratio of 9% by
mid-2012 – are a good example of this pressure for early adoption of higher
capital ratios. Banks are not being given the time to build up their capital
through lower dividends and lower bonus payments, and to maintain their
lending to individual and corporates (including SMEs) at reasonable levels;
– the move to tougher, more intrusive, more challenging and more judgement-
based supervision – in the UK and elsewhere8 – has also incentivised super-
visors to become very risk-averse, and indeed to ‘just say no’ rather than to
exercise genuine judgement under a clearly defined risk appetite;
– similarly, there is a risk that the post-crisis mood will incentivise regulators
to take a risk-averse approach to fulfilling their statutory objectives to
deliver safety and soundness, financial stability and high standards of con-
duct. The risk here is that these incentives will lead to an imbalance between
these regulatory objectives and the costs of regulation on the ability of the
financial sector to contribute to economic growth and on the ability of con-
sumers to make adequate provision for saving, investment and protection.
As Alan Greenspan9 observed more than ten years ago, he could deliver a
safe banking system, by restricting US banks to holding only US Treasury
bills as assets. But such banks would not be doing the economy or their
shareholders any good.
2.5. Lessons for Future Risks and Fragilities

The purpose of this conference is to look forward. So I conclude with five sugges-
tions.
First, we must not allow the narrow focus of the new macro-prudential bodies
being established – such as the Financial Policy Committee here in the UK – on
risks to financial stability that arise from within the financial sector to detract
from the equally important risks that arise from outside the financial sector. In all
the post-crisis outpourings from the G20, the Financial Stability Board, and the
national authorities in the UK and elsewhere, I fail to detect much recognition of,
let alone any initiatives to tackle, the incentives for financial instability that can
be generated by monetary policy and tax policy in particular.
Second, while a lot of effort has been directed towards removing or reducing
some of the pro-cyclical elements of the Basel 2 prudential requirements, many
7
EUROPEAN BANKING AUTHORITY (2011).
8
VINALS and FIECHTER (2010).
9
GREENSPAN (2001).
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such elements still remain. And it remains doubtful whether a counter cyclical
capital buffer, some as yet ill-defined macro-prudential tools and a tougher
approach on remuneration policies, will be sufficient to reduce or mitigate the
strong incentives for pro-cyclical behaviours.
Third, if market discipline remains a weak incentive, and if the introduction of
enhanced ‘liability’ incentives would have only a limited impact when everyone is
focusing on the upside gains and discounting the downside, then are we left with
any other incentives to focus attention on prospective losses – as opposed to
direct regulatory and other interventions to limit the actions of financial institu-
tions?
Fourth, the discussion of incentives needs to be broadened beyond incentives to
reduce the probability of failure to incentives to limit the negative externalities
that would emerge in the event of the failure of a major financial institution. But
can any incentives make significant inroads into this desired alignment of private
and social interests? And if not, do we have to rely again on the generally unat-
tractive prospect of regulatory and other interventions in an attempt to deliver
such an alignment through restrictions on the size, structure and business activi-
ties of financial institutions? Is there value in exploring whether there is a ‘third
way’ here, which builds on some approach to a private/public partnership and
recognises more explicitly that neither the addition of new incentives designed to
take the market to the right solution nor ever more intrusive regulation are the
best ways of identifying and building a ‘public’ role for financial institutions? Can
we base this on strategies, risk appetites and risk management that properly
reflect social objectives and are rewarded accordingly?
Finally, let us not lose sight of the unintended consequences of regulation, espe-
cially during a period of massive regulatory change. If we give our regulators too
much of an incentive to meet one-sided statutory objectives, without taking
account of the wider costs to the economy and to users of financial services, then
we run the risk of paying too high a price for safety. And we run the risk of
achieving financial stability only in the limited sense of a financial system in
which not much happens, rather than in the sense of providing the flows of credit
to households, to SMEs and to other corporates, and all the other financial serv-
ices on which economic growth depends.
References
BASEL COMMITTEE OF BANKING SUPERVISORS (2010), A global regulatory frame-
work for more resilient banks and banking systems, Basel Committee of
Banking Supervisors, December, 2010
larcier
C. BRIAULT (2009), Fixing Regulation, Centre for the Study of Financial Innova-
tion, October 2009
G. DELL’ARICCIA, D. IGAN and L. LAEVEN (2008), “Credit Booms and Lending
Standards: Evidence from the Subprime Mortgage Market”, CEPR Discus-
sion Paper 6683, 2008.
EUROPEAN BANKING AUTHORITY – EBA (2011), “The EBA details the EU meas-
ures to restore confidence in the banking sector”, European Banking
Authority, 26 October 2011.
FINANCE SERVICES AUTHORITY (2011), “The failure of the Royal Bank of Scot-
land”, Financial Services Authority Board Report, December 2011. http://
www.fsa.gov.uk/static/pubs/other/rbs.pdf
A. GREENSPAN (2001), Remarks at a Conference of State Banking Supervisors,
Traverse City, Michigan, May 2001.
A. HALDANE, “Control rights (and wrongs)”, Wincott Annual Memorial Lecture,
London, Westminster, October 2011. http://www.bankofengland.co.uk/
publications/Documents/speeches/2011/speech525.pdf
J. MACEY and M. O’HARA (2003), “The Corporate Governance of Banks”,
FRBNY Economic Policy Review, April 2003.
J. VIÑALS and J. FIECHTER (2010), “The Making of Good Supervision: Learning
to Say ‘No’“, IMF Staff Position Note, May 2010.
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21
3. S UPPORTING M ARKET D ISCIPLINE :

T HE C ASE OF A B ANK D ISCLOSURE C OUNCIL
Alistair Milne
Market discipline has a major potential role to play in promoting both the safety
and soundness and the efficiency of the financial sector. This point of view is
deeply embedded in both regulatory and academic thinking.
To give two examples, the Basel accords envisage market discipline as the ‘third
pillar’ of effective regulation, working alongside the first pillar – capital and
liquidity regulation – and the second pillar – management and supervisory review.
There is a nice mechanical analogy: a stool with only two legs is unstable and
cannot stand on its own; but with three strong legs it will stand without addi-
tional support. If this analogy holds then market discipline is essential to financial
stability.
The second example, a perennial in policy debates for at least two decades, has
been the potential role for contingent liabilities in promoting financial stability.
So we have had, successively, proposals for subordinated debt (in the hope that
the pricing of subordinated debt would be an effective warning signal of future
risks); the idea of ‘pre-commitment’ in the setting of trading capital (with the idea
that appropriate penalties – most obviously equity dilution – can make truth
telling incentive compatible, and thus strengthen external discipline on firm
behaviour); and most recently since the crisis various proposals for debt to equity
conversion of contingent capital or debt bail-in that can be exercised prior to
resolution (so ensuring that investors, not taxpayers, carry the financial costs of
maintaining essential bank services).
This paper takes as a premise the view that market discipline has, indeed, a major
potential role in promoting financial stability. It explores a simple practical issue:
is the information available to investors – both equity and debt holders – suffi-
cient and in an appropriate form to enable them to exert market discipline?
The conclusion reached here is no, they do not have the information they need in
the form they need it; but the situation is not hopeless. Steps can be taken correct
this situation, notably through the creation of a ‘Bank Disclosure Council’ to
promote disclosure to investors.
3.1. The Role of Accounting

This issue, of whether the information available to investors is appropriate, is
hardly new. It keeps re-surfacing in a number of contexts.
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First most obviously it arises in connection with bank accounting statements. A

fruitful exchange of views took place, at an Institute of Charted Accounts of Eng-
land and Wales meeting last December, between Christian Laux of the Vienna
University of Economics and Business and Andrew Haldane of the Bank of Eng-
land. Both are available on the web and will be published in final form in
Accounting and Business Research1.
Laux puts forward a detailed and thoroughly researched assessment of the role of
accounting in the global financial crisis. His views seem to be the intellectual
consensus of the accounting profession, both of practitioners in industry and aca-
demics working on accounting issues. Accounting – especially the practice of val-
uing assets according to ‘fair value’ and where possible with reference to market
prices – has been rather unfairly accused of causing the financial panic of 2007-
2008. The charge is that the write-downs of assets, through the application of fair
value accounting rules, overstated bank losses and this exacerbated the wide-
spread liquidity problems. But the evidence does not suggest that the outcome
would have been very much different under more lenient accounting rules; the
most likely outcome would have been to simply delay the response of banks and
regulators to the crisis and this would have led to the eventual losses being even
worse than they actually were.
No-one has ever pretended that international accounting standards provide a
complete view of the financial and business situation of a firm, certainly not of
any firm as complicated as our major international banks. The solution therefore
would appear to be not to tinker with accounting rules, but rather to supplement
accounting statements with additional disclosures.
To quote from Laux “It is important that disclosures allow investors to form their
own expectations. This applies to disclosing the assumptions underlying the mod-
els as well as disclosure of individual exposures. Netting exposures is often not
sufficient. For example, in the first quarter of 2007, Merrill Lynch reported a
potential exposure of $15.2 billion to certain subprime investments, but revised
this number to $46 billion three months later (Story 2010). Merrill Lynch thought
that it protected itself against the difference through hedges and therefore did not
report it; many of these hedges later failed. If it had reported the gross positions
and the hedges separately, the market could have made its own judgment... The
difference between disclosure and recognition may not always be of prime impor-
tance for informing investors, provided that they obtain the relevant informa-
tion.”
1
Preliminary versions of the papers are available as Laux (2012) and Haldane (2011). The quote here is taken
from an earllier version of Laux (2012) which is no longer publically available.
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SUPPORTING MARKET DISCIPLINE: THE CASE OF A BANK DISCLOSURE COUNCIL 23
Haldane places these issues in a broader historical and regulatory context. As he

points out, whenever there is an uncomfortable message about the financial safety
and soundness of firms, then doubts have often been expressed about the messen-
ger, i.e. accounting valuations, especially when based on market prices. This has
happened before in the US, both in the face of the banking problems of the 1930s
and during the real estate crash of the early 1990s. As a further example I can add
that the same complaints about fair value accounting arose with reference to US
bank exposure to Latin America in the 1980s (for discussion and references see
Chapter 3 of Milne (2009)).
Haldane is much more critical of current accounting rules than Laux, asserting
the common view amongst regulators that financial reporting standards contrib-
uted to pro-cyclicality. He argues that in order to mitigate this pro-cyclicality
accounting standards need to reflect the critical differences between banks and
non-banks, in particular the uncertainties about asset valuations and the degree
of maturity mismatch in bank balance sheet. He endorses the recent Financial
Services Authority (2011) consultation paper, suggesting the introduction of val-
uation ranges to highlight valuation uncertainties in bank assets. This is similar
to the ‘confidence accounting’ proposals put forward by Gifford and Mainelli
(2009).
The position put forward here is somewhere between those of Laux and Haldane.
It seems clear that accounting standards did contribute to pro-cyclicality in the
years before the recent crisis (to give two less well known examples, banks could
inflate their profits in securitisations by selling relatively small shares of the equity
or mezzanine tranches of structured credit securities to third parties, valuing their
retained holdings at this ‘market price’; and it was possible to value trading book
deals by discounting back hedged future cash flows to present values using a risk-
free rate of interest, with no allowance for counterparty risk).
But Laux is surely correct that the key issue is information disclosure – i.e. Basel
Pillar III – not accounting recognition. Provided investors have adequate informa-
tion then we need not be too concerned about flaws in inevitably imperfect
accounting standards. But there is a catch. If information is inadequate then
accounting numbers with very low information content can have a substantial
impact on beliefs and behaviour.
It is evident that many investors had doubts about the sustainability of the credit
boom even in 2005 and 2006. They could not make much sense of the high levels
and apparent stability of reported bank earnings. But because of lack of other
information this gave investors a false sense of security, they underestimated
exposure to structured credit risk and this in turn encouraged the boom.
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3.2. Two Interpretations of the Crisis: Inadequate

Disclosure and Systemic Risk Externalities
Investor information is also critical in relation to another even more critical
aspect of regulation post-crisis, the extent to which we should focus regulator
efforts on identifying and addressing systemic risk externalities.
This point is developed more fully in Milne (2012). That lecture points out (in
similar vein to the Haldane speech of December) a crucial difference between
banks and insurance companies and non-financial companies. To quote two key
paragraphs:
“The measurement of success or failure in banks and other financial com-
panies is much, much more difficult than in non-financial companies. The
problem is there is no satisfactory accounting measure of current per-
formance. Operating profits – revenue less costs of wages and raw mate-
rials – are reported in the same way as for other companies, but the rev-
enues do not arrive at the time when sales are made. Instead revenues
come in gradually in the months and years after the original contracts are
made. So accounting returns do not give a clear indication of how a finan-
cial company is currently doing.
Worse still it is easy to generate a temporary but unsustainable increase
in accounting performance, through rapid growth in lending, trading or
insurance underwriting. This means that banks and insurance companies
must supplement their accounting systems with performance measure-
ment systems that adjust for risk. These are essential tools for guiding
management and employee decisions and for reporting to investors.”
The performance measures on which bank investors relied before the crisis –
‘return on equity’ and related techniques of ‘economic capital allocation’ – were
entirely inadequate. The risk-adjustment largely depended on (misleading) regu-
latory measures of bank risk. Banks were strongly incentivised to report illusory
improvements in performance by such stratagems as lowering capital charges
through a shift of exposures from banking book to trading book (a major driver
of the securitisation boom) and inflating their balance sheets through the use of
unstable wholesale funding.
Thus it seems that inadequate disclosure and performance measurement was at
the heart of the crisis. A separate issue is whether investors were being duped by
clever and manipulative bank management who knew full well that they were
taking on excessive risks, but hid these risks from the rest of the world; or
whether bank managers were also fooled by inadequate disclosure and perform-
ance measurement, into thinking that high levels of bank earnings were sustaina-
ble. The truth here is probably that it was a bit of both.
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Despite the plausibility of this view, that inadequate information was a key vul-
nerability before the crisis, it is not the mainstream view. The much more com-
mon interpretation, the one espoused by much of the regulatory community, is
that of ‘systemic risk externalities’ i.e. that bank management, investors and reg-
ulators had a good understanding of the risks and performance of individual
institutions taken in isolation; but that they failed to take into consideration the
impact that individual bank decisions were having on the risk to the system as
whole.
These are complementary explanations: both inadequate disclosure and system-
atic externalities can have played a role in the crisis. Still it can be argued that
policy post-crisis has put too much stress on systemic risk externalities, and not
enough to improving disclosure and performance measurement.
Policy to date has certainly done a lot to address systemic financial risk – through
much more stringent capital and liquidity regulation; through the development of
orderly resolution; through structural measures such as those recommended by
the Vicker’s Independent Commission on Banking in the UK or the passing of the
so called Volcker rule in the Dodd-Frank act in the US; and also in the develop-
ment of the new macroprudential policy function.
The authorities are making vigorous efforts to ensure that never again will the
financial system be able to turn to the taxpayer for support. Going forward
(periphery Europe perhaps excepted) investors not taxpayers are bearing the costs
of risk i.e. we are turning to market discipline. It is tempting to declare ‘job
(nearly) done’.
But to think that the task is nearly complete is premature. As yet very little has
been done to prepare investors for their new responsibilities. In particular they
still have inadequate disclosure and performance measurement from banks. As a
result market discipline – having been inadequate before the crisis because inves-
tors did not understand what banks were doing – now threatens to be an exces-
sive discipline after the crisis. The likely consequence, without complementary
action to improve disclosure and transparency, is therefore a sharp contraction of
bank balance sheets.
3.3. The Way Forward

The remainder of this paper discusses how this challenge of improved disclosure
and transparency can be met, first in general terms and then with some more
specific policy suggestions.
The appropriate general direction of travel is towards what can be described as
an ‘open source’ banking system. Banks should be held to strict standards for
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recording of their positions with appropriate identifications, allowing and any

external party – regulator, customer, investor – to request and obtain on demand
a summary of that institutions exposures along any appropriate dimension. This
is not something to be achieved overnight; but – beginning with current develop-
ments for the setting of standards for recording OTC derivative positions in trade
repositories – there can be considerable movement in this direction over coming
years. Eventually all bank positions, both trading book and banking book, should
be continuously open to scrutiny (subject only to the usual requirements of cus-
tomer confidentiality)
Ultimately any investor should be able to obtain information and rework bank
books, so that they can make like for like comparisons, between institutions and
between business lines in different institutions.
What about specific practical steps? Here are three:
First we need to shift to what has been called ‘contingent reporting’ – to both
regulators and the investment community. We need much simpler and less bur-
densome reporting requirements. But at the same time we should expect manage-
ment to take responsibility for providing relevant information at reasonably short
notice to either regulators or to investors.
Such contingent reporting is already being explored here in the UK – it is likely to
be the preferred approach to regulatory reporting when the new Prudential Reg-
ulation Authority is fully established as a Bank of England subsidiary (for exam-
ple see the remarks of Mervyn King to a Joint Committee of the UK Houses of
Parliament, where he stated “Rather than burdening the banks with a massive
data reporting requirement, we should make it clear to them, ‘We think you
ought to know the answers to the following questions, and from time to time we
will want to know the data, too, but do not send it to us until we ask for it.’”
(King (2011)).
The same approach can be used on behalf of investors. What this needs is the
establishment of an umbrella body – something that could be called The Bank
Disclosure Council – representing all investors in UK bank equity and debt. Such
a body, given powers to request standardised information from banks, can allow
investors to adequately assess bank risk exposures and prospective performance.
Then second – once we have such a body representing investors views on disclo-
sure and performance measurement – we can also require banks to publically
report – annually – their own assessment of their exposures to major systemic
risks: sovereign debt, real estate prices, and indicate how well placed they are to
absorb such risks if they materialise. This is not an accounting but a disclosure
requirement, and since the principal beneficiaries are investors the disclosures
should be subject to standards set by the Bank Disclosure Council. To date such
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stress testing is viewed as part of the regulatory domain; but this responsibility
for the design and construction of such tests can, over time, be shifted to inves-
tors. This is incentive compatible because it is investors ultimately who will be
bearing the costs of bank stress, under the new resolution arrangements.
Third and finally – this is discussed in more detail in Milne (2012) – we need more
sensible performance measures than return on equity. Return on equity is woe-
fully inappropriate measure for banks. It encourages banks to undercapitalise and
therefore increase systemic risk; and to excessively contract their balance sheets
when capital requirements are increased.
The obvious cure is to shift towards the more appropriate performance based on
the same models routinely used by equity analysts, distinguishing systematic (beta
or priced) risk and the risk of bank failure. A key point is that risk priced in
financial markets and risk of bank safety and soundness are quite different things.
When bank capital increases, the risk of bank failure is reduced, but the risk of
bank assets – the systematic priced risk – is not changed at all. In fact investors
are better off because their exposure to priced risk remains the same while their
exposure to the costly bank distress is reduced. Yes bank shareholders have lost
the benefit of the bank safety net, but if they want they can adjust their perform-
ance measures to factor this in as well. Milne (2012) – and some related academic
work cited there – consider how this can be done in practice.
3.4. Conclusions
This paper has argued that market discipline failed, before the crisis, because of
inadequate disclosure and performance measurement. This was not a problem
with accounting statements per se – standard accounting statements can never
provide a full picture of financial institution performance, but the lack of supple-
mentary information that allowed investors to properly assess the risk exposures
of banks. It is disclosure not recognition that matters.
We need to do a great deal of work yet to ensure that this information is available
in a form that investor can use to make comparisons between institutions, and
they have adequate and appropriate measures for summarising bank perform-
ance.
This paper envisages us moving eventually to ‘open source’ banking, where inves-
tors have complete information on bank exposures in a fully disaggregated form,
broken down by standard identifiers, so that they can assemble any like for like
comparison between institutions that they choose.
As for practical steps towards this long term goal, this paper makes three specific
recommendations: a shift to contingent reporting for both regulatory and invest-
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ment purposes; the establishment of a private sector Bank Disclosure Council,

that will determine such contingent disclosures including regular tests of exposure
to systemic financial risk; and finally encouragement (by regulators and this dis-
closure council) of better performance measures distinguishing the two quite dis-
tinct components of bank risk – priced systematic beta risk on the asset side of
their balance sheet and risks of financial distress determined by choice of liability
structures.
These are appropriate steps to ensure that market discipline does not lead to an
unnecessary contraction of bank balance sheets as new more demanding regula-
tory measures are introduced over the next few years.
References
FINANCIAL SERVICES AUTHORITY (2011), Proposed Regulatory Prudent Valuation
Return, December, www.fsa.gov.uk/library/policy/cp/2011/11_30.shtml.
HALDANE, A. (2011), Accounting for bank uncertainty: Remarks given at the
Information for Better Markets Conference, www.bankofengland.co.uk/
publications/Documents/speeches/2012/speech540.pdf.
GIFFORDS, B. and MAINELLI, M. (2009), The Road to Long Finance: A Systems
View of the Credit Scrunch, Centre for the Study of Financial Innovation,
No. 87.
KING, M. (2011), Evidence given the Joint Committee of the Houses of Parlia-
ment, Q841, www.parliament.uk/documents/joint-committees/Draft-
Financial-Services-Bill/webwrittenevidence.pdf.
LAUX, Ch. (2011), Financial Instruments, Financial Reporting and Financial Sta-
bility (February 22, 201).
Available at SSRN: http://ssrn.com/abstract=1991825.
MILNE, A. (2009), The Fall of the House of Credit, Cambridge University Press.
MILNE, A. (2012), Risk appetite, Risk Aggregation: Do Banks know what they are
Doing?, Inaugural Lecture, Loughborough University, www.lboro.ac.uk/
service/publicity/inaugural/2012/inaugural_alistair-milne.html.
STORY, L. (2010). “Merrill’s Risk Disclosure Dodges Are Unearthed”, New York
Times, August 9.
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29
4. B ASEL III AND S HADOW B ANKING

Patricia Jackson1
In the aftermath of the financial crisis, regulators and governments have agreed a
substantial tightening in the prudential requirements for banks globally. The
Basel Committee on Banking Supervision (BCBS), through Basel 2.5 and III, will
require much larger equity buffers to be utilised to back exposures as well as new
liquidity buffers (BCBS, 2010) and the Financial Stability Board (FSB) has agreed
new even tighter requirements for global systemically important institutions. This
new ‘framework’ will lead to a profound reshaping of the banking industry over
at least a 10 year period but probably even longer because the new requirements
are high enough to alter substantially the economics of different activities. There
is, however, limited agreement about the size of the change and the likely effect
on shadow banking (quasi banking activities carried out outside the banking sys-
tem). This is to a large degree because there is little agreement about the costs of
the regulatory changes and also what drives behaviour in the financial institu-
tions. This paper seeks to analyse these various aspects and identifies a number
of fallacies in the current thinking:
(1) that the Modigliani Miller theorem means that requiring higher capital
charges of banks will not affect their costs;
(2) in particular an implicit assumption that the adjustment phase to the regu-
latory changes will be quite short enabling the cost of equity and funding to
fall sufficiently;
(3) that shadow banking poses risks under only particular circumstances –
maturity or liquidity transformation or exposure of banks, incomplete
credit risk transfer and leverage.
4.1. Background
Following the crisis there have been a series of changes to bank capital under
different Basel Accords. Basel 2.5 tightened trading book requirements, covering
stress VaR (value at risk) and securitisations in particular. Basel III which, intro-
duces higher quality bank capital (deducting items such as deferred tax assets,
good will and different types of hybrid capital instrument), creates an increased
focus on common equity and much higher capital buffers, a leverage ratio and
liquidity requirements as well as yet higher trading book requirements for coun-
terparty risk. The key features of the capital buffers are as follows:
1
The views expressed are mine and do not necessarily reflect those of Ernst & Young. I thank the participants at
the joint ICFR/ SUERF conference on “Future Risks and Fragilities for Financial Stability”, and Urs Birchler in
particular, for useful comments.
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• The minimum common equity levels are to be increased from 2% to 4.5%

(and this is after increased deductions from capital).
• A further 2.5% will need to be held in the capital conservation buffer –
banks can dip into this layer in periods of stress but then face limitations on
earnings distribution through dividend payments, share buy backs or discre-
tionary bonuses.
• An additional countercyclical buffer of between 0% and 2.5% will be
required according to national circumstances. This will be for overheating
markets and will apply to all banks lending into that market. An example
might be lending to UK housing in a protracted boom.
• These requirements will be supplemented by a non-risk based leverage ratio,
which will run in parallel from 2013 to 2018 when it will be become a Pillar
1 requirement.
Over and above these buffers, globally systemically important banks (GSIBs) will
have to maintain a further buffer (BCBS, 2011) of potentially up to 3.5%
(currently it is set between 1% and 2.5%). Overall, major banks are looking at
the need to increase the ratio of equity capital to risk weighted assets to around
12%, and some even higher, to maintain headroom over the sum of the regulatory
buffers.
There is a long phase in period for the new buffers from 2013 to 2018 and non
complying capital instruments will be phased out up to 2023. However, market
expectations and regulatory requirements in some countries have pushed the
industry to achieving the higher capital buffers much earlier. The timelines are set
out below.
Industry costs are also being pushed higher by the liquidity rules which will also
be phased in but again banks have already started to comply. The costs are cre-
ated by the need for a high quality liquid assets buffer to enable a bank to meet
stress liquidity outflows. This must be held in higher quality liquid instruments
which are therefore lower yielding. The industry will also have to meet a stable
funding ratio which will act as a restriction – without sufficient stable funding a
bank will have to reduce longer term lending.
Overall it has been estimated by some private sector sources that the European
banks need around Euro 1 trillion more capital just to meet Basel III without the
inclusion of the extra requirement for systemically important banks.
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Basel Capital Buffers, Leverage and Liquidity Requirements
Phase-in arrangements (shading indicates transition periods)

(All dates are as of 1 January).
2011 2012 2013 2014 2015 2016 2017 2018 2019
Parallel run 1 January 2013 – 1 January 2017 Migration to
Leverage ratio Supervisory monitoring
Disclosure starts 1 January 2015 Pillar 1
Minimum common equity capital ratio 3.5% 4.0% 4.5% 4.5% 4.5% 4.5% 4.5%
Capital conservation buffer 0.625% 1.25% 1.875% 2.5%
Minimum common equity plus capital conservation 3.5% 4.0% 4.5% 5.125% 5.75% 6.375% 7.0%
BASEL III AND SHADOW BANKING
buffer
Phase in of deductions from CET1 20% 40% 60% 80% 100% 100%
Minimum Tier 1 capital 4.5% 5.5% 6.0% 6.0% 6.0% 6.0% 6.0%
Minimum total capital 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0%
Minimum total capital plus conservation buffer 8.0% 8.0% 8.0% 8.625% 9.25% 9.875% 10.5%
Capital instruments that no longer qualify as non-core Phased out over 10-year horizon beginning 2013
Tier 1 or Tier 2 capital
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Liquidity coverage ratio Observation Introduce
period begins minimum
standard
Net stable funding ratio Observation Introduce
period begins minimum
standard
31
4.2. Costs of Regulatory Change

Thinking in the official sector about the costs of Basel III, and therefore the likely
effects, has been driven by a belief that the Modigliani and Miller theorem (1958)
demonstrates that increases in equity capital are effectively costless (and therefore
equity capital can rise to any level). Modigliani Miller argue that the expected
yield on common stock will depend on leverage and as an organisation increases
the level of equity capital backing the business the costs will fall, reflecting the
greater safety in the organisation. This is because the expected yield of a stock is
equal to the appropriate rate of return for the equity of that type of company plus
a premium related to financial risk reflecting the debt to equity ratio. The paper
assumes that a homogeneous group has been identified where the shares are per-
fect substitutes for each other – i.e. the shares are perfectly correlated. As leverage
falls, the safety of debt increases and the cost of debt falls as well as the cost of
equity. However, it is recognised that the tax deductibility of interest on debt does
give an advantage over equity finance. Bank of England research (Financial Sta-
bility Report June 2011) demonstrates a statistically significant positive relation-
ship between equity beta and leverage although there is a wide spread of results.
Kashyap, Stein and Hanson (2010), following Modigliani and Miller, estimate
that in the long-run steady state (assuming banks use the higher equity to replace
debt finance and that the only net difference in financing costs related to this shift
is the tax advantage of debt) a 10 percentage point increase in equity capital will
require loan rates to increase by only 24-45 basis points. Similarly, Miles, Yang
and Marcheggiano (2011) using equity market returns for the period 1992-2010
estimate that a doubling in capital (halving leverage from 30 to 15 basis points)
would require loan rates to increase by only 18 basis points.
The issue which needs to be considered is whether backward-looking results such
as Miles et al. will hold going forward and how long the adjustment period to a
long-run steady state might be. Here the issues start to become more complicated.
Firstly, making regulatory capital a binding constraint is likely to affect behav-
iour. Under Basel I and Basel II the capital requirements were a backstop with
almost all banks choosing to hold higher capital than the regulatory minimum.
Going forward this switches round – regulatory requirements will be higher than
the amount of capital a bank would choose to hold and this will affect behaviour.
The change is radical – banks estimate that 30% – 100% or more equity capital
may be required under Basel III (Ernst & Young, 2012).
Secondly, leverage is only one aspect of the riskiness of one bank relative to
another – in that sense banks are not a homogeneous class as identified by Mod-
igliani and Miller. The asset base of two banks, or one bank over time, can differ
hugely. Even for a given asset profile, the amount and type of risk can differ
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BASEL III AND SHADOW BANKING 33
markedly depending on the profile of individual borrowers, types of collateral

taken, amount of collateral, amount of hedging and so on.
The experience in the US of Basel I, which had limited risk differentiation (and
was combined with the leverage constraint which had no risk differentiation),
was that it affected behaviour even though it was not a binding constraint. The
US authorities became convinced that it was so distorting behaviour (Jackson
et al., 1999) it was imperative that risk based requirements should be introduced
through Basel II. In effect for the same Basel I ratio or leverage ratio banks over
time had substantially increased the amount of risk being held. The Basel III buff-
ers are based on the risk weighted assets (RWAs) calculated under Basel II and
therefore are risk based (as the average riskiness of the portfolio rises capital
requirements rise) but clearly industry-wide requirements cannot reflect every
aspect of the risk profile of an individual firm. The Basel II capital curves used for
the internal ratings based system assume all banks are diversified for example –
i.e. risk concentrations are not recognised. Also there is considerable freedom
regarding the approach with which the risk weights are calculated, given that
banks in different countries are allowed to use point in time or through the cycle
modelling for borrower PD (probability of default) which produces very different
answers (Jackson 2011). The position, given Basel II, is much better than under
the limited risk differentiation of Basel I but even so it may be difficult to see in
all cases if a bank is responding to the higher capital required by increasing risk
taking.
The determining factor behind the outcome across the industry is likely to be the
view that equity holders, in particular institutional investors, take of the likely
risk adjusted return on their investment. Currently the indications are that inves-
tors have not reduced expected returns to reflect lower expected risk going for-
ward. A number of banks have announced that they have reduced target rate of
return on equity (ROE) to 12%-15% but are facing pressure from institutional
investors to increase targets. Some banks estimate that the cost of new capital is
around 12% and a number of banks are finding it difficult to raise new capital.
Differing patterns of equity holding internationally may affect the outcome. In
the UK, bank equity holdings are strongly concentrated in institutional hands and
the Basel III increases in bank equity required will increase concentrations in
holdings by funds overall, pushing up required returns by some fund managers to
cover the extra risk. This is less so in the US where the preponderance of holdings
is in the hands of individual investors.
Simons (Simons 2000) reports that one metric used to assess the riskiness of invest-
ment portfolios is VaR – which measures risk from the past price history of the
securities being held. It measures the loss on the portfolio that will not be exceeded
on say 5% of occasions based on the distribution of profit and loss the current
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portfolio would have sustained on say daily periods in the past. Going forward,
the VaR calculated for portfolios including bank shares will reflect both the vola-
tility in bank share prices over the past 5 years and the increased concentration in
holdings as equity in issue increases. Taking risk-adjusted performance in terms of
a Sharpe ratio (Sharpe 1966), which can be expressed as the ratio (excess return
over the benchmark)/(tracking error), where the tracking error is the risk calcu-
lated using the standard deviation of the portfolio returns relative to the chosen
benchmark, portfolios with sizeable holdings of bank equity will fare poorly.
The question is how will risk-adjusted performance be viewed going forward
given the higher capital employed in the industry and lower leverage? As far as
returns are concerned, Modigliani Miller make the point that the market is likely
to place very heavy weight on current and recent past earnings in forming expec-
tations of future returns. In the current environment, the view taken of future
returns will be depressed by uncertainty regarding the outcome for the real econ-
omy and the possibility of a sovereign debt crisis – despite the measures taken.
This lack of clarity about returns will persist as long as the economic uncertainty
continues.
The core question is how will institutional investors risk adjust the expectations
of future returns? The past is not a guide to the risk because of the new con-
straints in terms of limits on leverage and higher capital to risk adjusted assets.
But how long will it take for investors to be convinced that the industry is safer
going forward? If institutional investors wait for the lower risk to be demon-
strated, given the long cycles which affect banks and the relative rarity of inter-
national banking crises, they could remain uncertain about the effects of the
Basel III changes on bank safety for a long period. This could delay, perhaps for
many years, a full adjustment in the cost of capital. In effect, investors would be
discounting possible future earnings more heavily to reflect the uncertainty.
The uncertainty could be fuelled by several new elements in the treatment of
banks. The authorities are making clear in some countries that public funds will
not be used to resolve future banking crises. This creates a break with the past.
Also new bail-in arrangements are being considered which would affect share-
holders.
Fundamentally though the issue is about the capacity that institutional investors
have to assess how much risk is being taken by banks. Banks are far harder than
industrial companies to assess because of the effect of hedging/collateral etc on
their risk profile. Here there is a ‘Catch 22’. If banks are pressed to deliver too
high a return (because institutional investors have still to be convinced that they
are safer), some may gear up by increasing risk taking. As set out above, the
Basel II risk-based requirements help to prevent this but cannot capture all differ-
entiation in risk profile across banks. Pillar II of Basel II, which is an overarching
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risk assessment by a bank and the supervisors, attempts to fill the gap but it too
is imperfect.
If some banks seem to be taking more risk, for example moving exposures from
G10 to emerging markets, then (following Akerlof, 1970) the information asym-
metries between banks and investors would mean that all banks would pay the
price – borrowing costs and equity yields would remain high for the whole indus-
try and this would not be transitional. It would continue while the information
asymmetry remained in place unless another mechanism could be found to deal
with the market imperfection. That mechanism would have to be substantially
enhanced risk disclosure or some kind of guarantee which of course the authori-
ties are trying to move away from. In theory credit ratings sift banks by riskiness
but by and large investors are reducing reliance on external ratings and question
their ability to identify all the risks.
All these factors mean that a full adjustment of risk adjusted return on capital and
cost of new capital to the lower leverage levels could be very long indeed. This
will alter the economics of different businesses. Pending full adjustment of risk
adjusted expected returns, banks will probably have to make a four way adjust-
ment of the business model. Returns to shareholders will have to fall to a degree
(reflecting the lower risk – but not fully reflecting it while uncertainty remains),
costs will have to be reduced, margins will have to be increased and activities
changed. Banks will exit from some businesses and restructure others.
4.3. Changes in Banking Models

The changes in business models will have a different effect on different activities
because the Basel 2.5 and Basel III requirements do not have an equal effect
across all business units. Trading activities are hit relatively hard. Initial estimates
were that regulatory capital on trading books increased as much as 3 times. How-
ever, banks are already adjusting and reducing the effects. A recent small survey
carried out by Ernst & Young indicated that increased hedging of CVA was
reducing the estimated increases substantially – although one question is whether
to hedge the economics or the accounting effect. In some areas the requirements
are therefore leading to risk reducing behaviour and this will increase going for-
ward. Overall more collateral is likely to be taken to reduce counterparty expo-
sures as well as earlier close out of derivatives contracts with positive values to
achieve the same effect. There is a general expectation that banks will move away
from proprietary trading and towards facilitating transactions. This will reduce
exposures in the banks but could also affect the efficiency of markets. It will
remove arbitragers from the market and, although some trading will move to
non-bank players, this could affect the liquidity of some markets.
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Although equity increases for banking books are less they are still substantial.
Here too banks will seek more collateral but even so the economics of different
businesses will be affected. Banks are already starting to withdraw from business
lines and some banks are pulling out of certain countries.
With deleveraging needed, businesses such as wealth management which do not
utilise the balance sheet start to look very attractive.
4.4. Shadow Banking

One question the authorities have been grappling with is will Basel III drive busi-
ness into the shadow banking world and what would this do to systemic risk? The
FSB has defined shadow banking as “credit intermediation involving entities and
activities outside the regular banking system” (FSB, 2011) although some defini-
tions of shadow banking include trading activity by hedge funds. The paper by
the FSB working group cited above identifies the following as systemic risk fac-
tors if business does move to shadow banking:
– maturity transformation – funding longer term assets with shorter term lia-
bilities;
– liquidity transformation – e.g. depth of markets for financial instruments;
– incomplete credit risk transfer – e.g. to off balance sheet vehicles but where
risks could fall back on the bank;
– leverage.
This list is almost certainly not complete. One issue is sustainability. If a non-bank
channel for lending develops and is substantial what happens if it collapses?
Could the banks facing leverage ratios, net stable funding ratios and pressure on
capital quickly take up the slack in lending? The answer is almost certainly no
and this in turn could cause widespread pressure on the corporate sector and the
real economy. This could be a system wide problem even though it did not man-
ifest itself in a traditional run or pressure on the banks.
Current pressure on the banks (reflecting efforts to increase capital and deal with
tight funding) is leading to deleveraging in the banking system and private equity
companies, hedge funds, asset managers and insurers are moving into direct lend-
ing to corporates. Some market participants put volumes at hundreds of billions
of dollars already. If this channel grows substantially (because the economics are
fundamentally different in an unregulated non-bank model compared to a bank
model) what would happen if it suddenly switched off?
A number of different types of shock could lead to the withdrawal of non-bank
lenders from the market. Regulation could be tightened – the FSB does envisage
extending the boundary of regulation further in some circumstances, for example,
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if shadow banking seems to be becoming systemic. Currently non-bank lenders

calculate capital need through economic capital models not regulatory capital.
Expansion of the regulatory capital boundary would change the economics of the
activity leading to the pursuit of different activities. A further factor could be
rebalancing of shadow banking portfolios, if the securities markets have become
far more buoyant, to reflect expected profitability of different activities. Alterna-
tively, if a significant corporate to corporate lending channel develops (and that
too is growing) then greater indebtedness of the sector as investment plans
become more attractive could lead to this activity drying up.
Another trigger could be funding pressures – for example, if an idiosyncratic
event affecting one or more non-banks led to uncertainty about the riskiness of
the shadow banking sector as a whole, making new money costly or unavailable,
lending would contract. The history of non-bank lending is fraught with diffi-
culty. The secondary banks in the UK failed in the early 70s, savings and loans
companies (S&Ls) in the US, which were funded by deposits and largely provided
mortgages, failed in the 1980s (through poor interest rate risk management and
then high yield activities such as the purchase of junk bonds), the non-bank banks
in Japan which held significant property exposures failed in the early 90s and the
retail mortgage brokers in the US played a core role originating loans for retail
mortgage backed securities in the run up to the crisis. The common strand
through the non-bank problems, was poor risk management and lending stand-
ards.
One theme in the official literature is that as long as the banking system can be
insulated, the effects of failure of non-bank lenders could be contained. Higher
capital charges and large exposure rules on bank lending to the shadow banking
system have been proposed but this argument ignores the second and third round
effects. If a large lending channel slowed down causing problems in the corporate
sector, the banks would not be insulated because they too would have exposures
to the same corporates. As the real economies weakened bank defaults would
rise. Even if the effect was not overnight, as in a classic bank systemic run, system-
wide damage could be sustained. Another theme in the official literature is that
the non-bank lending channel cannot grow substantially unless it is bank funded.
This too is not correct. Non-bank lenders can use bond finance and commercial
paper which will become easier as the world economy starts to grow. They can
also channel funds from large investors, sovereign wealth funds and corporates
and institutions into non-bank lending.
This leaves the question, if a large channel of non-bank ending grew up could it
disappear without a ripple? Here the various Basel III limits on the banks would
make it difficult for them to step in. The parallel is with the securitisation market
pre crisis which brought funding from a variety of sources into lending. The
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banks are not able to provide funding for the necessary volume of lending cur-
rently with the securitisation market closed, requiring substantial funding sup-
port from the central banks. In effect the closure of the securitisation market
requires a liquidity recycling function to be provided by the central banks. In
future the constraints on the banks will reduce their capacity to substitute for
non-bank lenders.
4.5. Way Forward

The authorities need to be cautious in putting too much reliance on the Mod-
igliani Miller theorem when the full adjustment to lower required returns (to
reflect lower risk) could be many decades long. This is particularly the case in an
environment still recovering from the most severe banking crisis in 80 years and
when a very strong message about no future bailouts of banks going forward is
being given. However, the difficulty in assessing risks in banks is at the heart of
the issue. This does mean the costs of Basel III and the GSIB buffers are likely to
have been underestimated.
A priority should be a focus on building clear/comparable disclosure that will give
investors more comfort that the banking system is safer – covering standard
tables and standard definitions. But even so expected returns will take time to
adjust not least because information asymmetries between banks and investors
cannot completely be eradicated even by improved disclosure.
There also needs to be a safety valve to enable deleveraging in the banks by pro-
viding a long-term channel to move investor money into lending. Non-bank chan-
nels relying on hedge funds, for example, or corporate to corporate lending could
be temporary – they could build up while investment choices are limited and fall
away as markets become more buoyant.
The solution probably needs to be much greater official sector focus on a sustain-
able low risk securitisation model. The FSB working group paper (October 2011)
suggests a review of securitisation activities and transparency as well as standard-
isation of securitisation products. IOSCO and the Basel Committee are also
focussed on this. But much more urgency should be placed on the development
of a new securitisation market, with new instruments, containing features making
them less risky and more transparent – limited tranching, standard prospectuses,
a summary of risk factors, transparency on risk in the pools, loans going through
bank lending standards, cross market default data and clear disclosure. It will
take a push equivalent to that provided by the central banks in the early days of
the swap market which achieved standard contracts, netting agreements etc. As
was the case then, a strong regulatory carrot needs to be offered. Allowance to
include the simple, high quality, securities in the banks’ new liquidity pools to be
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held under Basel III and also allowance to use them as collateral in the central
counterparties (CCPs) would provide such an incentive.
The advantage of an active and high quality securitisation market is that it would
enable banks to deleverage to meet the higher capital requirements without dam-
aging lending to sectors which cannot themselves tap the securities markets.
References
AKERLOF, G. A. (1970), “The Market for ‘Lemons’ Quality Uncertainty and the
Market Mechanism”, The Quarterly Journal of Economics, Vol. 84, No. 3,
pp. 488-500.
BANK OF ENGLAND (2011), Financial Stability Report, Issue No. 29.
BASEL COMMITEE ON BANKING SUPERVISION (2010), Basel III: A global regula-
tory framework for more resilient banks and banking systems, Bank for
International Settlements.
BASEL COMMITEE ON BANKING SUPERVISION (2011), Global systemically impor-
tant banks: assessment methodology and the additional loss absorbency
requirement. Rules text, Bank for International Settlements.
ERNST & YOUNG LLP (2012 forthcoming), Survey of risk management.
FINANCIAL STABILITY BOARD (2011), Shadow Banking: Strengthening Oversight
and Regulation, Recommendations of the Financial Stability Board.
FINANCIAL STABILITITY BOARD (2010), Intensity and Effectiveness of SIFI Super-
vision. Recommendations for enhanced supervision.
JACKSON, P. (2011), A false sense of security: Lessons from the Crisis for Bank
Management and Regulators, SUERF study 2011/2: Regulation and Bank-
ing after the Crisis, chapter 7, pp. 101-115.
JACKSON, P., FURFINE, C., GROENEVELD, H., HANCOCK, D., JONES, D., PERRAU-
DIN, W., RADECKI, L. and YONEYAMA, M. (1999), Capital requirements and
bank behaviour: The impact of the Basle Accord, Bank for International
Settlements.
KASHYAP, A. K., STEIN, J. and HANSON, S. (May 2010), An analysis of the impact
of ‘substantially heightened’ capital requirements on large financial institu-
tions.
MILES, D., YANG, J. and MARCHEGGIANO, G. (2011), Optimal Bank Capital,
Bank of England, External MPC Unit Discussion paper.
MODIGLIANI, F. and MILLER, M. (1958), “The cost of capital; corporation
finance and the theory of investment”, The American Economic Review,
Vol. 48, No. 3, pp. 261-297.
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SHARPE, W. F. (1966), “Mutual Fund Performance”, Journal of Business,

pp. 119-138.
SIMONS, K. (2000), “The Use of Value at Risk by Institutional Investors”, New
England Economic Review, pp. 21-30.
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41
5. R EGULATION AND C OMPETITION IN THE F INANCIAL

S YSTEM
Vicky Pryce
The UK is implementing a set of reforms to UK financial services industries,

including the recommendations of the Independent Commission on Banking
(ICB) chaired by John Vickers, together with a set of other changes in supervisory
institutions. The question is what will these changes do to competition in the
industry? And, from a broader public policy perspective, will this matter?
5.1. Competition as a Policy Objective

I will begin by taking a step back to the broader policy context. When I was in
Government, I co-chaired with John Fingleton of the OFT a group called the
competition forum, which brought together economists and policy officials from
a range of Whitehall Departments that were involved in, or affected by, competi-
tion policy decisions. In 2009, we took a paper from the OFT on the role of
government interventions and how they affected competition, and a paper was
subsequently published by the OFT as a guidance for policy makers1.
The OFT guidance re-affirmed the importance of competition as an economic
policy objective:
“At their most basic, markets are a mechanism for allocating resources.
Well-regulated, competitive markets can maximise consumer welfare,
and, by raising economic growth, also increase total welfare”2.
Other procedural changes reinforced this. For example, competition features in

the guidance for Impact Assessments of proposals for new regulation3.
However, there are other legitimate policy objectives, which may include:
– continuity and stability of vital functions and services;
– protection of vulnerable consumers;
– employment;
– distributional concerns;
– broader social or environmental effects.
1
Office of Fair Trading (2009).
2
Op.cit., p. 1.
3
The latest version of the BIS Impact Assessment toolkit states that effects on competition must be considered,
although there is no longer a requirement for an explicit test of whether competition is affected by a regulatory
proposal.
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Policy makers need to balance these against the objective of competitive markets,
as they doing in re-designing the regulatory structure for the financial system.
Changes to regulation can enhance competition – but they can also distort it. The
OFT guidance reminds us that changes in regulation designed to increase compe-
tition can have positive as well as negative effects.
• The opening up of European aviation markets in the 1990s and the ending
of bilateral agreements had the expected positive effects. It led to the entry
of low cost carriers and more flights at lower prices. The lowest non-sale
flight price fell by 66% on average between 1992 and 2002 while flight
availability increased by 78%. There was no evidence of adverse effects,
such as on safety – apart from to the economics rents enjoyed by employees
of, or shareholders in, one of the incumbent flag carriers.
• In contrast, the opening up of the UK domestic retail electricity market in
1988-89 had some negative repercussions which required corrective action.
There were subsequent concerns about doorstep selling, misleading infor-
mation, switching without consent and the proliferation of tariffs. Regula-
tors have had to take steps through self-regulation and licensing to provide
more and simpler information to consumers. The parallels with some
aspects of financial services are fairly obvious.
5.2. Will Regulation Increase Competition in the UK

Financial System?
Turning now to the banking and financial system, we see that the proposals in the
ICB report – to ring-fence retail banking operations and greater capital and other
loss absorbing capacity requirements for banks-will raise the costs of doing busi-
ness for the big banks. The ICB’s own estimate is a cost of some £10 billion to the
four major banks with the cost to other banks proportionately less. Other esti-
mates of course put that cost at much higher than that and there will also be
indirect costs such as knock-on effects on customers through higher interest rates,
although the ICB claims these will be small. Effectively, there is a cost for society
as a whole as we forgo certain opportunities [to borrow and consume or invest]
in order to reduce the risk of future financial crises.
The ICB believes that its recommendations are “aimed to create a more stable but
also more competitive basis for UK banking in the longer term”. Indeed it argues
that the new capital requirements make the playing field more level for smaller
new entrants by reducing the gap in regulatory requirements between large banks
and small banks. However it is perfectly possible to argue that the proposals if
implemented will reduce rather than increase competition as the higher cost of
entry will in fact make it harder for new firms to enter the market. Another ques-
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REGULATION AND COMPETITION IN THE FINANCIAL SYSTEM 43
tion is what happens if the combination of changes to supervisory regulation and

taxation causes one or more of the big UK banks to move offshore? They can of
course still do business in the UK but will there be subtle and perhaps gradual
changes to the way they approach the UK market.
As for the ICB recommendations designed to increase competition, they may have
limited effect.
Although the FCA has been given an explicit duty to “promote effective compe-
tition in the interests of the consumer” the specific competition power still
appears limited and the impact of this in practice is likely to depend on how well
it works with the OFT.
In addition a lot of attention has focused on the Lloyds Banking Group divest-
ment. It is very debatable if this is of sufficient scale to create a real competitor to
the Big 4 in terms of another ‘challenger bank’. Access to the payment mechanism
and a branch network remain important barriers to entry and growth – Virgin
Money’s acquisition of Northern Rock is, presumably, in part because acquisition
of the branch network is preferable to growing one from scratch.
The lack of customer switching has also been seen as evidence of a lack of com-
petition but it is possible that it reflects brand loyalty, customer inertia and con-
siderable effort by incumbents to retain customers. In this context, the proposals
on switching are untested.
Putting these together, it is difficult to see how a Competition Commission review
in 2015, should it happen, could come to wildly different views from the ICB –
and indeed, how, short of ordering a break-up of the big banks, it could do any-
thing more radical.
5.3. Is there a Trade-off between Financial Stability and

Competition?
But if we conclude that the impact of intended regulation on competition, while
uncertain, is not positive, does this matter? Other policy objectives are important
and the last few years have been enough to ensure that financial stability is near
the top of policy makers’ minds.
The underlying question is whether [more] competition is good or bad for stabil-
ity of the financial system? Unfortunately, this is one of those perennials in eco-
nomics where the theory is ambiguous, with competing hypotheses. Furthermore,
a recent review of the evidence by a CEPR team led by Thorsten Beck found
similar ambiguity in the empirical evidence4.
4
BECK et al. (2010).
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They and other authors have noted an important point in assessing the evidence
– concentration is not the same as competition. It is possible to have fierce com-
petition between a few large incumbents.
The CEPR team did note that the quality and effectiveness of the regulation of the
financial system did influence how banks behave in competitive market condi-
tions, so regulation – its design and its implementation – is important.
An illustration of these points can be found in a 2010 OECD Policy Round Table
report. This compares the performance of the banking systems during the crisis
in the UK, Australia and Canada. Compared to the UK, Australia and Canada
weathered the financial crisis well – not a single institution failed or required a
bail out in Canada. Yet their retail banking systems look very similar to the UK –
with a few large banks accounting for the lion’s share of customers. However, the
difference is – either because of a lack of competition or because of stronger reg-
ulatory oversight – banks in Australia and Canada financed much more of their
loans from retail deposits than UK banks did, and they indulged in less risky
business lines5.
5.4. Conclusions
Competition in the UK banking sector is unlikely to change greatly in the next
few years – so we might all be debating the outcome of a future Competition
Commission review in five years’ time. This is not necessarily a bad thing. A few
years stability while the industry adapts to changing regulatory requirements, and
the economy recovers from the recession, might on balance be in the broader
public interest at the current time.
References
BECK, T., COYLE, D., DEWATRIPONT, M., FREIXAS, X. and P. SEABRIGHT (2010),
Bailing out the Banks: Reconciling Stability and Competition, CEPR.
HM GOVERNMENT (2011), IA Toolkit: How to do an Impact Assessment,
August 2011, London see http://www.bis.gov.uk/assets/biscore/better-regu-
lation/docs/i/11-1112-impact-assessment-toolkit.pdf
OECD (2010) Competition, Concentration and Stability in the Banking Sector,
OECD, 2010, see http://www.oecd.org/dataoecd/52/46/46040053.pdf
OFFICE OF FAIR TRADING (2009), Government in Markets.
5
OECD (2010).
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45
6. T HE E VOLUTION OF B ANK B USINESS M ODELS :

P RE - AND P OST - CRISIS
David T. Llewellyn
This paper offers reflections on the evolution of bank business models in the pre-
and post-crisis period. In many respects, new business models became an integral
part of the crisis scenario and to some extent changed the underlying economics
of banking (Llewellyn 2010). The structure of the paper is as follows. Section 6.1.
considers the evolution of business models since the early 1990s with four sub-
periods identified. Section 6.2. outlines the basic tenets of the ‘traditional model’
of banking followed in Section 6.3. by a review of how business models changed
in the period running up to the crisis. The post-crisis period is subdivided into
two: the short term (section 6.4.) and medium term (section 6.5.). Section 6.6.
concludes.
6.1. The Context of Business Models

Bank business models are not static and evolve over time and under the influence
of a complex mix of exogenous and endogenous pressures. The more powerful of
these pressures include: the structural evolution of the financial system and finan-
cial markets; the macro-economic environment in which banks and their custom-
ers operate; regulation; the competitive environment in banking markets; finan-
cial innovation, and the chosen business objectives of banks (e.g. asset growth,
market share, ROE, etc.).
All of these featured as central aspects of the banking crisis (Llewellyn, 2010).
With respect to regulation, it is evidently the case that detailed rules at the time
did not prevent the crisis and, as argued elsewhere (Llewellyn, 2011), created
incentives to change business models in a way that contributed to the crisis. The
impact on business models of regulation, and the incentive structures it creates,
can be seen in the Basel capital arrangements which created incentives for banks
to, inter alia, move assets off the balance sheet, to increase their gearing levels, to
securitise assets and create various forms of SIVs to facilitate this, and to make
increasing use of credit risk-shifting instruments and derivatives. It is argued
below that there is a two-way causation between regulation and bank business
models: the endogeneity problem (Llewellyn, 2011).
6.1.1. Bank Business Models

The paper adopts a particular concept of ‘business models’ which might offend
management science purists. It has five core components: (1) the range of business
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undertaken (e.g. bank-assurance, securitisation and derivatives trading, etc.),

(2) the banks’ ultimate business objectives, (3) balance sheet management and in
particular funding, gearing and liquidity strategies, (4) the way that the core inter-
mediation business of banks is conducted (e.g. securitisation, use of credit risk-
shifting instruments, etc.), and (5) the management of regulation and in particular
how banks respond to regulation through, for instance, regulatory arbitrage. We
find that all of these changed, in some cases radically, in the pre-crisis period. The
concept of business models in this paper relates to the range of business under-
taken, and how the core financial intermediation business is undertaken.
Although there can be no precision in identifying specific turning points in the
evolution of bank business models, for purposes of exposition and analysis four
sub-periods are identified: (1) the ‘traditional’ model of banking in the period
from around 1990 to the early part of the 21st century, (2) the immediate pre-
crisis period from around 2000 to 2008, (3) the years immediately following the
crisis period, and (4) a medium-term post-crisis period. The dates for locating (3)
and (4) are necessarily uncertain.
6.1.2. Context of Structural Change

Different business models do not emerge in a vacuum and the antecedents need
to be considered. Several structural changes in the global financial system set the
background to the emergence of new business models that preceded the crisis:
– a defining feature of the pre-crisis period was a sharp rise in the pace of
financial innovation, and especially with respect to the emergence of credit
derivatives designed to shift credit risk from loan originators (credit risk-
shifting instruments);
– at the same time, there was a massive rise in the volume of trading in com-
plex, and sometimes opaque, derivatives contracts, and in the amounts out-
standing. The BIS estimates that the outstanding value of Credit Default
Swap (CDS) contracts rose to over $60 trillion;
– an increasing ‘financialisation’ of economies (sharp growth in the value of
financial assets and liabilities relative to GDP);
– a more market-centric structure of financial systems which implied a rise in
the role of financial markets relative to institutions in the financial interme-
diation process. Furthermore, banks and markets became increasingly inte-
grated (Boot and Thakor, 2009). One of the many implications of this trend
was that losses incurred in markets could be translated into funding prob-
lems for banks. Furthermore, financial systems became more susceptible to
shocks emanating in financial markets;
– an increase in inter-connectedness and resultant network externalities;
– so-called (and largely unregulated) ‘shadow banks’ (such as hedge funds and
SIVs) emerged as major new players in the financial intermediation process
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THE EVOLUTION OF BANK BUSINESS MODELS: PRE- AND POST-CRISIS 47
(Tett, 2008). In effect, a shadow banking system emerged. As argued in

Turner (2012), however, there were close and inextricable links between
banks and ‘shadow banks’;
– an increased globalisation of finance and financial markets. The impact of
globalisation was particularly powerful in the propagation of the crisis:
what started as a local mortgage problem in parts of the US was generalised
to a wide range of asset classes, the interbank market, several countries, and
to several different types of financial institution;
– a sharp rise in gearing and leverage both by banks (including intra-financial
sector gearing) and households;
– a sharp fall in the holdings of liquid assets by banks and an increased reli-
ance on wholesale markets for liquidity and funding requirements;
– higher degrees of maturity transformation by banks;
– diversification of banks into different business areas with the result that they
became increasingly similar to each other. Thus, while individual institu-
tions diversified (which could be regarded as making them less risky through
the spreading of different risks), the result was a less diversified system.
The emergence of credit risk-shifting derivatives had several important properties
with respect to: the underlying economics of banking, bank business models, the
distribution of credit risks, the generation of credit, and the structure of financial
intermediation in the financial system. They also produced a more market-centric
financial system. In particular, instruments designed to shift credit risk produced
new banking models (originate and distribute, for example) that changed in a
fundamental way the underlying economics of banking and also made the system
more crisis-prone (Llewellyn, 2010). We argue that such business models were
central to the origin of the financial crisis. It is also evident that the implications
of new models were not fully understood by credit originators, users or supervi-
sors. The main focus is on credit risk-shifting instruments which enabled credit
risk to be shifted, traded, insured, and taken by institutions without the need for
them to make loans directly to borrowers. Although this proved to be crisis-
prone, such credit risk-shifting instruments had the potential to enhance the effi-
ciency in the financial system (Llewellyn, 2009a).
6.2. The Traditional Model

It is instructive to begin with a stylised review of the traditional model of the
banking firm that was the dominant model for decades and formed the basis of
standard text-book analyses of the banking firm (see Llewellyn, 1999 for a fuller
discussion). In this traditional model, financial intermediation is the dominant
business of banks which have information, risk analysis, and monitoring advan-
tages which enable them to solve asymmetric information problems and hence
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mitigate adverse selection and moral hazard. Banks accept deposits and utilise
their comparative advantages to transform deposits into loans. In this model, the
bank accepts the credit (default) risk, holds the asset on its own balance sheet,
monitors its borrowing customers, and holds appropriate levels of capital to
cover unexpected risk. It also effectively ‘insures’ its loans internally through the
risk premia incorporated into the rate of interest on loans. This is described in the
traditional model in table 1. In this process, the bank offers an integrated service
in that it performs all the core functions in the financial intermediation process.
Table 1. Alternative Bank Models
Traditional Securisation CDS

(1) Accept deposits 9 (9) 9
(2) Originate loans 9 9 9
(3) Utilise comparative advantage:
– Information 9 9 9
– Risk analysis 9 9 9
– Monitoring 9
(4) Transform into loans 9 9 9
(5) Accept risk 9
(6) Hold on balance sheet 9 9
(7) Capital Backing 9
(8) Insurance Internal Shift Insure
Traditional: Originate and hold
Securisation: Originate and sell
CDS: Originate and insure
Furthermore, in this traditional model the bank is not able to shift credit risk to
other agents because of its asymmetric information advantages: a potential buyer
or insurer of bank loans might judge that, because of the bank’s information
advantage, there is an adverse selection and moral hazard problem in that the
bank might select low-quality loans to pass on and, if it knew that it could pass
on risk, it might be less careful in assessing the risk of new loans and would
conduct less intensive monitoring of borrowers after loans have been made. For
the same reason, the traditional view of the bank is that it is unable to externally
insure its credit risks and instead applies a risk (insurance) premium on loans and
holds capital as an internal insurance fund. The reason for this is that, given the
uncertainties outlined above, an external insurer would reflect this uncertainty in
excessive insurance premia charged to the bank which in turn would incorporate
such premia in the interest rates charged on loans. Clearly, if these external
premia are greater than the internal risk premium the bank would charge borrow-
ers in the absence of external insurance, it would be more efficient for the bank
to internally insure its loans. In this traditional view of the bank, credit risk can-
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not be shifted or insured, there is no liquidity in bank loans, and banks are locked
into their loan portfolios.
6.3. Pre-crisis Banking Model

As suggested at the outset, the emergence of new business models focussed on the
range of business undertaken and the extent of diversification, and the way that
core financial intermediation business was undertaken. Our central theme is that
financial innovation, and the emergence of new banking models, were major fac-
tors in the emergence of the current crisis.
Banks developed new business models and moved away from the traditional
model of originate-to-hold. The emergence of new business models focussed
largely, though not entirely, on new credit risk-shifting instruments. Several
trends in bank business models emerged in the years leading up to the crisis:
– banks increasingly diversified into more lines of business activity some of
which had previously been inhibited by regulation;
– bank assets expanded at a substantially faster rate than that of retail depos-
its creating an ever-widening ‘funding gap’ (chart 2);
– the rise in bank loans substantially exceeded the rise in banks’ risk-weighted
assets held on the balance sheet;
– securitisation of loans became a central business strategy for many banks;
– investment and trading activity increased sharply, and the proportion of
traded assets in the total balance sheet rose substantially in many cases;
– banks reduced their holdings of liquid assets as they developed greater
access to wholesale funding markets;
– the extent of maturity transformation also increased sharply as increasing
use was made of short-maturity money market funding sources;
– an increased dependency on wholesale and money market funding;
– a powerful trend emerged towards using credit derivatives as a means of
supposedly shifting credit risk.
Over-arching all of this was a clear shift in overall business strategy towards a
focus on the rate of return on equity (Llewellyn, 2007).
As noted by Borio. “the two most salient idiosyncratic aspects of the current
turmoil are the role of structured credit products and that of the O&D (originate
and distribute) business model” (Borio, 2008). The Bank of England also noted
that, on the basis of increased gearing, banks expanded into higher-risk assets
whose underlying value, quality and liquidity were unknown (Bank of England,
2008). The use of securitisation and credit derivatives were themselves vehicles
for an excessive expansion of bank lending.
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As part of this overall strategy, banks substantially increased their leverage prior
to the onset of the crisis. Banks became extremely profitable though, as noted by
Alessandri and Haldane, 2009), this was because of excess gearing and risk-tak-
ing. In its Financial Stability Report, the IMF noted “a collective failure to appre-
ciate the extent of the leverage taken on by a wide range of institutions and the
associated risks of a disorderly unwinding.” In addition, there was an increasing
volume of trading in credit risks in a situation where it had become evident that
the risks in such trading were not always clearly understood.
A central theme is that, in some important respects, financial innovation (and
most especially the emergence of credit derivatives) changed the underlying eco-
nomics of banking. For illustrative purposes, a distinction is made in table 1
between the traditional model of the bank (originate and hold), the securitisation
variant (originate and sell), and the use of credit default swaps (originate, hold
and externally insure).
As already noted, many aspects of the traditional model came to be questioned.
In the securitisation model in table 1, the process of securitisation (including via
CDOs) meant that banks were able to sell loans (which the traditional model
denies) and hence did not hold the loan asset on their own balance sheets, did not
absorb the credit risk, and hence did not need to hold capital against credit risk.
However, this depended upon precisely how the securitisation was conducted and
most especially whether the SPV was truly bankruptcy-remote from the bank and
vice versa.
The CDS model was similar to the securitisation model except that, while the
credit risk was passed to the protection seller, the asset remained on the balance
sheet of the originating bank. In this model there was explicit external insurance
of bank loans which, in the traditional model, was judged to be uneconomic com-
pared with internal insurance.
The two simplified examples of financial innovation in table 1 related to credit
risk illustrate that the traditional model of the banking firm came to be modified.
In particular, these examples of financial innovation meant that banks were no
longer required to perform all the functions in the bank intermediation business.
Furthermore, banks were also able to outsource some of their other activities such
as loan administration, credit assessment through credit scoring models of other
banks, etc. This further challenged the traditional view of the integrated bank.
Banking was no longer a totally integrated process whereby banks conduct all the
functions in the loan process. Credit risk transfer facilities and instruments
changed the relationship between borrowers and lenders and created different
incentive structures than those contained in the traditional model of the banking
firm.
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As a result of all this, banks in effect came to act as brokers in credit risk between
ultimate borrowers and those who either purchased asset-backed securities or
who offered CDS insurance, rather than their traditional role as market-makers
in credit risk.
Our theme is that a major contributory cause of the banking crisis was that banks
changed their business model in a fundamental way: banks stopped behaving like
banks! It is interesting to note that in three countries which escaped the crisis
largely unscathed (Canada, Australia, and South Africa), banks stuck to the tra-
ditional model and remained conservative institutions with comparatively little
use of securitisation and credit derivatives. Furthermore, a recent study by the
Centre for European Policy Studies (Ayadi et al., 2010) finds that cooperative
banks in Europe were also considerably less affected by the crisis than many other
banks in Europe largely because they maintained the traditional business model
of banking. Similarly, in the UK mutual building societies were also less affected
by the crisis though some did get into difficulty and needed to be supported
(Llewellyn, 2009). Interestingly, those building societies that needed support were
those which deviated most from the traditional business model. Furthermore, the
two banks that failed completely (Northern Rock and Bradford & Bingley) were
both former mutual building societies that had converted to bank status largely
in order to change their business model.
6.3.1. Risks in New Business Models

The nature of risks also changed in the process of developing new business mod-
els. Securitisation and other credit derivatives are designed to shift credit risk and,
for some years, they did so successfully. However, they also changed the nature
of risks and, in particular, transformed credit risk firstly into liquidity risk (buyers
of the securities issued to purchase securitised assets from banks being unable to
trade them), then into a funding risk (the securitising banks being unable to either
sell assets at other than fire-sale prices or roll-over maturing debt), and ultimately
into a solvency risk. The last-mentioned arose because banks were unable to sell
assets in order to continue funding their securitisation programmes. A vicious
cycle can easily arise in such circumstances: a bank which has engaged in substan-
tial maturity transformation encounters funding difficulty (inability to roll over
maturing debt) which it seeks to alleviate by selling assets which in turn depresses
asset prices which can undermine the solvency of the bank. This problem
becomes acute when all banks simultaneously attempt the same strategy of selling
assets to replenish liquidity: herein lies the fallacy of composition whereby what
may be rational for an individual bank acting alone ceases to be so when all banks
adopt the same strategy.
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In the case of Northern Rock (which developed securitisation as a central com-

ponent of its business strategy, (Llewellyn, 2008)), an initial shifting of credit risk
through securitisation exposed the bank to a liquidity risk that it (or its securitis-
ing Special Purpose Vehicle) would not be able to ‘roll-over’ in the wholesale
markets its maturing short-term borrowings that were used to fund the acquisi-
tion of long-term mortgages. This liquidity risk in turn was quickly transformed
into a structural funding risk (as alternative sources of funding became unavaila-
ble) which was ultimately transformed into a solvency risk. The Bank of England
has described the sequence in chart 1.
The financial crisis revealed two major implications of credit risk-shifting instru-
ments: (1) in many cases credit risk was not in practice shifted as much as banks
thought would be the case, and (2) even when risk was shifted this was sometimes
at the cost of increasing market, liquidity, funding and ultimately solvency risk.
In effect, credit risk that was initially shifted may involuntarily come back on to
the balance sheet of the originating bank. There were several reasons for this.
Firstly, some banks’ SIVs were unable to continue issuing asset-backed commer-
cial paper to finance the purchase of loans from initiating banks. Secondly, loans
that were planned to be securitised proved to be ‘non-securitisable’ because of
funding constraints. Thirdly, originating banks were called upon to honour
agreed lines of credit to SIVs. Fourthly, a bank might be induced to take back
securitised assets in order to alleviate a potential reputation risk.
Chart 1. Risk Transformation
CREDIT RISK
MARKETS
LIQUIDITY RISK
CENTRAL BANK
FUNDING RISK
RESOLTION
TAX-PAYER
The use of credit-risk-shifting instruments exposed banks to low-probability-

high-impact risks in that the reliance on short-term wholesale market funding to
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finance long-term mortgages meant that some banks became structurally depend-
ent on a limited number of wholesale markets for their funding. It was always
judged that the simultaneous drying up of all these markets would be extremely
unlikely as it had seldom, if ever, happened before. Equally, however, it would be
very serious if it were to occur. In the event, this is precisely what did happen.
Banks ignored the low-probability-high-impact risk of liquidity drying up in all
markets simultaneously. Such risks equally applied to institutions and investors
who issued short-term commercial paper in order to acquire asset-backed securi-
ties of various kinds.
Chart 2. Major UK banks’ customer funding gap (a)
Sources: Dealogic, published accounts and Bank calculations.

(a) Data exclude Nationwide.
(b) Customer funding gap less securitised debt. Where not available, stocks of securitisations are estimated from
issuance data.
Problems were compounded in the case of many derivative instruments by the

fact that they became difficult to price not the least because the risk characteristics
were opaque and complex. When secondary markets dried up in these instru-
ments after the summer of 2007, prices became unavailable. This forced holders
(banks) to attempt to value their holdings of derivative instruments on the basis
of models which were found to be fundamentally flawed in two respects: they
were based on an insufficiently long observation period from which to calculate
probabilities, and they did not take into sufficient account the tail-risk that the
risks attached to many of the assets within CDOs were themselves highly corre-
lated. Thus what were thought to be diversified instruments turned out to be
highly concentrated.
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In essence, therefore, financial innovation (most especially credit-risk shifting

instruments) had both risk-shifting and risk-changing properties.
6.3.2. Incentive Structures

Linked to new business models were internal incentive structures and reward
structures which can be regarded as part of a bank’s business model. Kashyap
et al. (2008) give particular emphasis to the potentially perverse incentive struc-
tures in securitisation models.
Several dimensions to bank incentive structures were relevant in the crisis: the
extent to which reward structures were based on the volume of business under-
taken; the extent to which the risk characteristics of decisions were incorporated
(or not so) into management reward structures; the nature of internal control
systems within banks; internal monitoring of the decision-making of loan offic-
ers; the nature of profit-sharing schemes, and whether or not decision-makers
also shared in losses. In many cases rewards were asymmetric as substantial
bonuses were paid in the event of high short-term profitability, while losses were
not equally reflected in reward structures. Reward systems based on short-term
profits and front-loaded payoffs proved to be hazardous as they induced manag-
ers to pay less attention to the longer-term risk characteristics of their decisions.
High staff turnover, and the speed with which officers moved within the bank,
also created incentives for excessive risk-taking. A similar effect could arise
through the herd-behaviour that is common in banking. The incentive structures
favouring ‘short-termism’ is epitomised in the now infamous statement of the
Chairman of Citi (Chuck Prince): “As long as the music is playing, you’ve got to
get up and dance. We’re still dancing”.
Overall, the evidence suggests that reward structures within banks (which often
focus on short-term profitability) produced a bias to excessive risk taking. In par-
ticular, UBS (2008) identified systemic deficiencies in its compensation policy as
a contributory factor in the substantial write-downs it suffered at the height of
the crisis. It emerged that at UBS triple-A rated mortgage-backed securities were
charged a very low internal cost of capital. Traders holding such securities were
allowed to count any spread in excess of this low hurdle rate as income which in
turn determined their bonuses. If the internal cost of capital is under-priced, and
bonuses are paid on any excess return over this low cost of capital, there is an
inevitable tendency for traders to take excessive risk.
6.3.3. Excess Financialisation

The collective action of banks adopting new business models produced what
might be termed ‘excess financialisation’ of economies. This was seen in various
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dimensions: the increasing role of banks in the financial intermediation process;

a sharp rise in the assets of the banking system relative to GDP; the rapid growth
and overall size of the financial system in the economy; the burgeoning leverage
of banks (as measured by their gearing ratios), the sharp rise in overall debt-GDP
ratios in the economy; the degree of intra-sector leverage (the extent to which
leverage increased within the financial sector as financial institutions became
increasingly exposed to other financial institutions); the frenetic pace of financial
innovation; the sharp rise in trading volumes of banks; the market capitalisation
of banks relative to overall market capitalisation of stock market companies (Van
Weseveen, 2008), and the share of total profits in the economy accounted for by
banks.
In the UK, banking sector assets as a proportion of GDP rose from 40 percent in
1960 to 220 percent in 1990 and to 540 percent in 2008. Although this ratio
tends to rise in all countries as national income rises, our theme is that these
measures of ‘financialisation’ became excessive and unsustainable. Similarly, for
the ten largest US banks, total assets doubled in the period mid-2004 to mid-2007
while the sum of risk-weighted assets (against which capital needed to be held)
rose by only 20 percent. Furthermore, the loan-to-assets ratio of these banks
declined from 52 percent in 1997 to less than 40 percent, while the investment-
to-asset ratio rose from 32 percent in 1998 to 54 percent by 2008. At the same
time, the deposit-to-asset ratio declined from 45 percent in 1998 to 36 percent in
2008.
The unsustainable ‘excess financialisation’ that emerged from new bank business
models that occurred in the decade before the onset of the crisis was largely asso-
ciated with underlying factors which were themselves unsustainable (Llewellyn,
2010). The growth of securitisation, structured investment vehicles (SIVs), and
the use of credit risk-shifting instruments, had the effect of inducing an “over
expansion” of banking business and unrealistic perceptions of risk. Combined,
these created conditions for banking activity to become excessive which the
supervisory process did little to constrain even though supervisory agencies in
several countries (in various Financial Stability Reports) expressed public concern
about many of the trends that culminated in the crisis.
Several factors lay behind the increasing role of banking and ‘excess financialisa-
tion’ in the years leading up to the crisis:
• Excess gearing, and an under-capitalisation, meant that banks could expand
at a faster rate, and to a higher level, compared with the position had they
maintained a level of capital commensurate with their risks. Overall, banks
became highly leveraged with a rise in assets on the balance sheet relative to
total capital, (Alessandri and Haldane, 2009, and Wehinger, 2008).
Although banks appeared to be well-capitalised, this was largely because
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they were under-estimating risks and holding assets off balance sheet with-
out capital backing even though there was often a contingent liability
attached.
• The macro-economic environment, and the collective euphoria of the pre-
crisis years, meant that risks were systematically under-estimated and also
under-priced. This increased both the demand for loans and the willingness
of banks to meet that demand. The sharp rise in the size of bank balance
sheets was compounded by a persistent under-estimation and under-pricing
of risk. Several supervisory agencies and others (including the Bank of Eng-
land (2006 and 2007), IMF and the Bank for International Settlements) gave
frequent warnings that risks were being systematically under-priced.
• The collective euphoria, and the high profitability of banks at the time,
meant that the cost of capital was artificially low because it did not reflect
the true risks that banks were incurring. This amounted to an effective sub-
sidy to banks.
• The perceived safety-net for banks (government support, etc) also had the
effect of lowering the cost of funding for banks.
• For various reasons, including the nature of the competitive environment at
the time, banks adopted more short-termist strategies to maximise the rate
of return on equity. In truth, profitability was enhanced not by superior
banking performance, but by banks raising their risk threshold and moving
up the risk ladder. As already noted, internal reward and bonus structures
created a bias towards short-termism and also to excess risk taking.
• The universal optimism generated by the dominant economic ideology of
the time (the rational expectations and efficient-markets hypotheses), meant
that rating agencies, central banks, governments, supervisors and many
other agents, were not inclined to challenge the strategies and business oper-
ations of banks.
Each of these factors, both individually but most especially when combined, cre-
ated sufficient conditions for an over-expansion of banking activity, and an arti-
ficially enhanced role of banks. As might have been put by Sherlock Holmes: “It
is elementary Dear Watson: if any industry is ‘subsidised’ or under-prices its pro-
duct, it will grow too fast and become too big and to a level that becomes unsus-
tainable without the subsidy!”
Our general theme is that new business models generated an increased ‘financial-
isation’ of the economy. The argument is that this became excessive and unsus-
tainable because it was based on factors that were themselves ‘artificial’ and
unsustainable. In particular, the banking sector became excessively large and
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based on various forms of internal and external ‘subsidies’ that could not be sus-
tained in the long run. In this regard, banks expanded beyond their marginal
economic and social value. Although banking seemed to be extremely profitable
in the years prior to the crisis, this was misleading as such seemingly excess
returns were based on various unsustainable ‘subsidies’ and an under-estimation
and under-pricing of risk.
6.3.4. Diversity of Business Models1

Although new business models emerged that focused largely, though not entirely,
on credit risk-shifting instruments and short-term wholesale funding, business
models were not homogenous between banks and diversity remained. A recent
CEPS report (Ayadi et al., 2011) offers an empirical study of business models and
their implications for risk characteristics, business performance, and efficiency. A
sample of 26 European banks (representing around 55 percent of EU bank assets)
was analysed covering the period 2006-09. A cluster analysis sorted the banks
into three categories: what were termed Retail Banks (engaging in retail banking
activities with limited investment exposures), Wholesale Banks (extensive trading
and derivatives transactions), and Investment Banks (active in wholesale and
interbank markets). The general conclusions are summarised as follows:
• Retail banks tended to be less risky (high Z scores), held more liquidity and
made less use of credit risk-shifting instruments.
• Investment banks were the most highly leveraged with heavy trading activ-
ity.
• Market-based measures of risk in the period before the crisis (e.g. CDS
spreads) seemed not to reflect differences in risk.
• A positive relationship emerged between the use of derivatives and low
RWA suggesting that they were used to reduce the capital charge without
lowering risk. RWA was found not to be a good measure of riskiness.
• Wholesale banks were the most risky (mainly German Landesbanks).
The findings show that those banks that kept their focus predominantly on retail
business proved more resilient to the crisis, thanks to relatively lower leverage
and higher loss-absorbency capital, and maintained their levels of lending to the
real economy. Most importantly they were less likely to receive government sup-
port. Banks that relied excessively on leverage and other short-term funding, and
engaged in risk-shifting activities without retaining a portion of the risks on their
books, were the worst performers during the crisis and the most likely to need
1
This sub-section draws heavily on a draft by Rym Ayadi based on Ayadi et al. (2011).
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government support. The study singled out this latter group of banks in the cat-
egory of the ‘wholesale banking’ model. The analysis also emphasised the ‘invest-
ment banking’ category, in which the banks were also highly leveraged and heav-
ily engaged in trading and repos markets as being badly hit by the crisis. These
investment and wholesale banks were more likely to use derivatives to lower their
risk-weighted assets, a key concept in measuring the Basel II regulatory capital. A
more acute concern, which was highlighted in the research, arises from the shift-
ing from one business model to another. ABN Amro, for example, switched from
being a predominantly retail bank to an investment bank and then to a wholesale
bank in less than three years.
The results provide some justification to the recent popularised view that the
retail banking model is safer than others. Despite their commercial orientation
and their size, these banks were safer than their peers and performed relatively
well before, during and after the crisis. The findings also point to some weak-
nesses in the institutions in the investment banking model, which tend to rely on
less stable funding sources, engage heavily in trading activities and maintain a
very low share of loss-absorbing capital (i.e. common tangible capital) compared
to the other two models despite comparable Tier-1 ratios. In turn, the wholesale
banking group appears to be the most risky, possibly arising from a lower share
of liquid assets and a greater use of more volatile interbank funding. In this sense,
capital requirements that focus on more loss-absorbing capital, especially in the
definition of leverage ratios, and on the use of more traditional forms of funding
and liquidity management (such as the net stable funding ratio) could be useful
in reducing inherent risks in banking.
The fact that most of the banks in the sample, including nearly half of the retail
banks, have received government support in one form or another is likely to invite
moral hazard problems. Indeed, although various measures point to differing
underlying risks, the market’s pricing of default probabilities (via CDS spreads)
were virtually identical on average for the three business models. This implies that
market participants saw no reason to distinguish between the inherent risks of
different business models, possibly in anticipation of the eventual government
support that the sampled banks would receive. These findings call for a serious
investigation into the use of additional capital charges for ‘systemically important
financial institutions’ or SIFIs. Implementing a Financial Stability Contribution
(FSC), as proposed by the IMF (2010) and partly supported by the European
Commission (COM(2010) 254), to internalise the cost of crises and facilitate cri-
sis management in the EU may also address the risks arising from ‘too-big-to-fail’
institutions. Above all, greater focus needs to be given to various measures in
Resolution arrangements to lower the cost of bank failures so that banks can
more readily be allowed to fail.
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A heavy reliance on risk-adjusted capital requirements may be misguided since

the risk-weights appear to be unrelated, and even inversely linked, to underlying
risks. Although the results of the study have to be interpreted with care, there is
concern that certain banks may use their specialisation in trading activities to
offload some of the riskier portions of their assets from their balance sheets with-
out actually reducing their inherent risks. This gives additional justification for
the use of simple rules, such as the proposed leverage ratio as called for under the
Basel III framework2.
6.4. Post-crisis Pressures on European Banking

This and the next section consider business model scenarios in the post-crisis era
in a short- and medium-term perspective. The starting point is that European
banks face an unprecedented combination of pressures in four key dimensions:
(1) Balance sheet pressures focussed on capital, liquidity and funding. Across
the euro area, banks face massive re-financing requirements this year at a
time when conditions in the inter-bank and wholesale markets have been
difficult. However, immediate funding pressures have been eased substan-
tially by the ECB’s innovative large-scale programme of three-year loans
(and the easing of collateral requirements) designed to avoid a further seri-
ous credit crunch in the euro zone. In December 2011 and February 2012,
the ECB made low interest rate and long-maturity loans to euro zone banks
of over € 1 trillion. These loans are at a lower interest rate, in larger
amounts, and for longer maturities than are available in the market. The
point, however, is that welcome as the ECB’s initiative is, it remains a palli-
ative, and cannot become a permanent feature of European banking models.
(2) The macro economy in many euro area countries remains weak and the
forecast for the short-term outlook is at best anaemic. Herein lies the poten-
tial for a serious negative-feed-back-loop (NFBL): weak bank lending
impeding the possibility of economic revival, and weakness in the economy
impairing the balance sheet position of banks through higher loan-loss expe-
rience. As a point of perspective, the December 2011 euro area Bank Lend-
ing Survey reported that 35 percent of banks reported a tightening in their
lending conditions and lending interest rates rose in 2011(4).
(3) Market pressures with a combination of uncertainty about the position and
even durability of the euro, substantial bank exposure to sovereign debt
(most especially with respect to Greece, Spain, and Portugal), weakness in
2
An alternative would be to oblige banks to hold much more capital than is currently required. Indeed, a recent
study has found that the socially ‘optimal’ capital requirement would be around 20% of the RWA (Miles et al.,
2011).
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the supply of new equity to banks, and a rise in the cost of capital with
suppliers of capital factoring in higher risk premia. Although banks across
Europe are under capital pressure, few have been able to issue new equity
capital on any significant scale.
(4) Regulatory pressures in the context of one of the greatest-ever intensifica-
tions of the regulatory regime focussed on capital and liquidity require-
ments. These could prove to be massively pro-cyclical and weaken the tra-
ditional financial intermediation role of banks at a time when European
economies most need it.
Each one of these pressures could be formidable and present banks and their
regulators with formidable challenges. The point, however, is that it is the com-
bination of pressures that potentially creates a precarious position both for banks
and the economies of Europe.
6.4.1. Ominous Parallels: End 2011

A further perspective is that at the end of 2011 close and ominous parallels
emerged between market conditions and those that emerged in 2008 most espe-
cially with regard to price, maturity, and availability conditions in the inter-bank
market. Important suppliers of dollar funds in the European market (US Money
Market Funds) reduced exposure to European banks to their lowest level since
2008. As in 2008, banks were heavily reliant on wholesale and short-term fund-
ing markets with difficult availability in the 3-12 month maturity range. Again as
in 2008, and partly because of enhanced counter-party risk, banks were hoarding
liquidity rather than making it readily available in the inter-bank market. Similar-
ities also emerged in several market prices: OIS spreads paid by banks, CDS
prices, tiering of inter-bank interest rates, a wide range of bond market spreads,
and increased volatility of bank bond prices. Financial market liquidity indicators
also deteriorated. These can be seen in various charts in the December issue of the
ECB’s Financial Stability Review.
There was also a parallel in the stock market valuation of banks between end-
2011 conditions and those in 2008. In particular, bank equity prices were weak
with a wide differential between the market and book values of banks. This nor-
mally suggests market doubts about the true value of bank assets, scepticism
about future earnings prospects, and a higher uncertainty discount as investors
find it difficult to assess the true value of banks in current conditions. In line with
this uncertainty, stock market prices of bank shares became volatile both abso-
lutely and in relation to the market generally.
Whilst there were many parallels with the position in 2008, in some respects the
combination was yet more hazardous: the general macro economic outlook was
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weaker, fiscal positions had weakened considerably in part due to government

bail-out and support operations for banks, and the combination of the euro and
sovereign debt crises had become more stark.
At the end of 2011 banks across the euro area were finding it increasingly difficult
(if possible at all) to raise unsecured funds in the bond markets and the cost of
funding had risen to 2008 levels. Faced with enormous re-financing requirements
in prospect in the first quarter of 2012, banks might have been required to sell
assets on a substantial scale which, had such sales had a large impact on asset
prices, could have transformed a financing into a solvency crisis for some banks.
6.4.2. ECB Intervention

It was at this stage that the ECB intervened on a massive scale with its new financ-
ing facility (LTRO). The balance sheet of the ECB expanded sharply. The inter-
vention eased the immediate funding pressure on banks, removed the immediate
need for substantial asset sales, bought time for banks to adjust and for countries
to adopt structural reforms, and also allowed banks to meet margin calls on
derivatives trading if, and when, required to do so.
All this represented a new business model not only for banks (relying on the cen-
tral bank for funding rather than the interbank market) but also for the ECB as
it was providing semi-permanent funding for commercial banks which is not the
traditional role of a central bank. In effect, it took over bank financing from the
interbank market. There are several implications and reservations attached to this
new business model for banks and the ECB:
• ECB intervention in itself has not changed the underlying position of banks
that existed at the end of 2011.
• Whilst it buys time (three years), the question arises as to whether funding
conditions will improve over this period and by the time that repayments
need to be made. There is, therefore, an exit problem to consider and whether
the interbank market will take over the funding operations of the ECB.
• It implies the ECB absorbing credit risk.
• Somewhat perversely, access to ECB funding might weaken banks’ access to
(and raise the cost of) private funding markets to the extent that the best
quality collateral has already been pledged to the ECB. Thus, whilst for pri-
vate investors the probability of default of banks may have decreased, the
loss-given-default has increased because of the lower availability of high-
quality collateral.
• Given the low cost of ECB funding (1 percent) there is an arbitrage incentive
for banks to buy peripheral sovereign debt. Whilst the ECB is not allowed
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to lend directly to governments, it is able to lend to banks that in turn pur-

chase sovereign debt.
• There is a danger than banks develop business models on the assumption of
ECB funding which, in time, might be difficult to extricate from.
In some respects (due largely to intervention by the ECB), there has been some
recent easing in the conditions faced by European banks: bank stock market
prices have risen; what could have been serious re-financing problems for banks
this year has been alleviated by a new loan facility offered by the ECB, and the
European Banking Authority (EBA) has indicated that most banks are on track
in raising their capital ratios. The problem, however, is that palliatives and res-
pites that buy time are not sustainable alternatives to structural adjustments to
underlying problems.
6.4.3. Strategic Options for Banks

Banks that are capital constrained (for instance, when required by regulators to
raise equity-asset ratios) have four broad strategic options within their business
models. The first obvious route is to inject more private equity capital either by
capital issues or through retained profits although the latter can be a slow process
when profitability is also under pressure. A second broad option is to make var-
ious balance sheet adjustments: limiting loans and credit, selling assets or parts of
the business, and technical balance sheet adjustments that have the effect of rais-
ing the equity ratio (such as buying back debt that is trading at a discount and,
where possible, re-calculating risk weights attached to some balance sheet items).
The first of these strategic option satisfies the requirement to raise the equity-asset
(E/A) ratio by raising the numerator while the second operates through lowering
the denominator. There is a crucial difference between the two as argued below.
A third possibility is through securitisation whereby banks generate loans though
do not hold them on the balance sheet (and hence avoid a full capital charge) but
sell loan packages to investors who fund the purchase through issues of securities.
In order to avoid some of the problems in securitisation that surfaced during the
crisis, it would need to be done in a different way, not the least through initiating
banks keeping some of the risk themselves. A fourth option (such as was the case
with RBS), is for governments to inject capital which amounts to a bail-out of
troubled banks. However, the problem is that in some countries with troubled
banks, governments are not in a position to do this because they themselves have
reached the limit of debt-issuing capacity.
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6.4.4. Conflict of Objectives

There are two immediate objectives: to sustain a stable banking system, and to
ensure that banks are able to support growth and a revival of the European econ-
omies through their lending most especially to the corporate sectors. A conflict
between the two objectives can arise when the former requires a rise in equity
capital ratios while the latter requires an expansion of bank lending. Of course,
this apparent conflict can be removed simply by banks injecting more equity cap-
ital. However, in current conditions this is both difficult (in some cases impossi-
ble) and expensive. In which case, banks are responding to the need to build up
equity ratios by de-leveraging which is precisely the opposite of what is needed if
banks are to support the economy. In fact, bank lending in many EU countries
has been falling for some time. A way out of this potentially serious NFBL needs
to be found. In extremis, this could be achieved through a temporary injection of
state capital coupled with strong conditionality provisions.
6.5. The Crisis as Transformational

Having considered business models prior to the crisis and the immediate after-
math, this section consider possible post-crisis scenarios in the medium term. The
central theme is that the crisis will prove to be transformational in several dimen-
sions and three in particular: (1) the size of the banking industry, (2) bank busi-
ness models, and (3) the cost of bank services.
Post-crisis business models are likely to be dominated by three pressures: the
unwinding of pre-crisis unsustainable business models and practices, the specific
lessons of the crisis, and a substantially more demanding regulatory environment.
6.5.1. Size and Cost of the Banking Industry

As many of the trends that supported the ‘excess financialisation’ and growth of
banks were unsustainable, their removal is likely to have the reverse impact
towards a more sustainable system and set of business models. As a result, banks
may become less significant in the financial intermediation business than in the
past. A member of the Bank of England’s Monetary Policy Committee takes a
similar view arguing that it is likely, and probably desirable, that “banks will
become less significant intermediaries in channelling savings from households to
companies and other households,” (Miles, 2009). In particular, there is likely to
be slower growth in bank balance sheets, bank business will decline as a share of
GDP, they are likely to be less profitable than in the period running up to the
crisis, and bank services are likely to become more expensive. The IMF has also
argued:
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“immediate, short-run policies and actions taken need to be consistent

with the long-run vision of a viable financial system… and that the viable
financial sector of the future will be less leveraged and therefore smaller
relative to the rest of the economy.” (IMF, 2009)
Several factors work in this direction. Banks are likely to become more realistic
about risks and their pricing and reverse the earlier under-pricing of risk. In addi-
tion, in the short run at least, they are likely to become more risk averse. The
requirement to operate with significantly higher capital ratios and lower gearing
will also limit the role of banks compared with the years prior to the onset of the
crisis. This is likely to be reinforced by banks facing a higher cost of equity capi-
tal. Regulatory costs more generally (including the requirement to hold more
liquidity on the balance sheet) will also rise. It is also likely that internal reward
and bonus structures will change to remove the bias towards excess risk-taking.
Furthermore, banks will receive less comfort from being ‘too-big-to-fail’ for two
reasons: under new intervention arrangements (such as, in the UK, the Special
Resolution Regime recently introduced as a result of the crisis) banks may be
closed before they become insolvent, and penalties (including tax) could be
imposed on banks with access to safety nets. The latter could take the form of
what amounts to ex ante insurance premia to be paid by banks to pay for rescues
that might be needed in the future and in order to minimise the potential burden
on the tax-payer. Hitherto, the tax-payer has effectively acted as an ‘insurer of last
resort’ but without extracting ex ante premiums.
For all these reasons, the cost of bank services is also likely to rise with the pros-
pect that intermediation margins (the difference between lending interest rates
and the rate of interest on deposits) widen. If anything, and because there will be
a strong demand for retail deposits as banks shift away from wholesale funding,
the widening of margins is likely to take place more in terms of lending rates than
deposit rates.
These trends are likely to produce two outcomes: less credit generation in total,
and some displacement of credit from banks to other routes: a process of disin-
termediation. If banks become more constrained in the post-crisis environment,
a key issue is who will provide the credit previously generated in the banking
sector. Displacement could occur, for instance, through a re-activation of securi-
tisation, non-finance companies such as supermarket banks, and the capital mar-
ket as bond financing displaces bank financing. Siemens has announced that it is
to establish its own bank in order to reduce reliance on bank financing and to give
it access to deposit facilities at the central bank.
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6.5.2. Future Business Models

Bank business models are also likely to change as a result of the trauma of the
banking crisis. This could involve a reversion to the more traditional model of
‘originate to hold’ implying originating loans, holding the assets on the balance
sheet, monitoring borrowers, and holding capital against the credit risk with
internal insurance displacing external insurance instruments such as CDSs.
The change in the nature of bank business models is also likely to include less
reliance on more volatile wholesale funding sources and greater reliance on tra-
ditional retail deposits. This will be accentuated by the withdrawal of official
exceptional funding and liquidity support. Holdings of liquid assets will also be
higher than in the immediate past.
Regulation (and the requirement to create ‘living wills’) is likely to induce banks
to create less complex business structures, and higher regulatory capital require-
ments on banks’ trading book may limit the extent of this business.
A key issue centres on the future role of securitisation in bank business models.
There is an economic imperative to resurrect the securitisation market. Citigroup
estimates that in 2008 securitisation supplied between 30 and 75 percent of credit
in different sectors. While a proportion of this total credit might have been exces-
sive, if securitisation were to remain dormant, a serious credit crunch could
emerge as, for reasons outlined, banks are unlikely to be able to hold the loans
shifted from the securitisation sector on their own balance sheets.
Notwithstanding the problems that emerged with securitisation, and the fact that
very little has been undertaken since the onset of the crisis, it remains a viable
model and needs to be a major technique in the financial system. This is most
especially the case if, as has been argued, banks will face more balance sheet
constraints than in the past. There are systemic advantages to securitisation. The
skill lies in developing the securitisation model while avoiding some of the pit-
falls. This could include, for instance, greater transparency, a requirement for
banks to keep some of the credit risk on their own balance sheets, and techniques
that are less complex than in the past.
6.6. Assessment
The European banking industry has reached something of a turning point where
major regulatory changes will impact the size, growth, future business models
and the structure of the financial system as a whole. The evolution of European
banking and its business models over the coming years is likely to be dominated
by the legacy of the crisis and the regulatory and supervisory responses to it.
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Two dimensions to bank business models were identified at the outset: the range
of business lines and the way the traditional financial intermediation role is con-
ducted. A key issue with respect to the latter is whether, and to what extent, banks
will revert to what has been termed the ‘traditional’ model. Two issues emerge
with respect to the former: the range of business lines adopted by banks, and the
extent to which different business lines are to be conducted within differentiated
business structures. A key dimension recommended by the Vickers report (Inde-
pendent Commission on Banking, 2011), and currently being studied by the EU
Commission, is the extent to which different business activities are to be ‘ring-
fenced’ and in particular whether core business is to be ring-fenced from other
activities such as investment banking and securities trading. Regulatory decisions
made in this area will have significant implications for future bank business
models.
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69
7. B ANKING B ANANA S KINS – B RIEF R EMARKS

David Lascelles
The latest Banking Banana Skins survey (February 2012) showed that the greatest
concern in the banking sector at the moment is the state of the global economy:
if it does not recover the effects could be severe: large loan losses, especially in the
sovereign risk sector (eurozone in particular, a global concern stretching from
New Zealand to Canada), and household debt (credit cards, mortgages). The
underlying fear is that there could still be bank failures – only this time govern-
ments will be less well placed to bail them out.
There are also institutional concerns: is bank management equipped to deal with
risk, will regulation be robust enough to prevent failure, is there enough capital/
liquidity to help banks through? These are concerns rather than predictions, of
course, but they help explain why banks are reluctant to lend, and why the recov-
ery may be slow.
The latest TOP TEN Banana Skins are:
Banking Banana Skins 2012 (2010 ranking in brackets)
1 Macro-economic risk (4)

2 Credit risk (2)
3 Liquidity (5)
4 Capital availability (6)
5 Political interference (1)
6 Regulation (3)
7 Profitability (-)
8 Derivatives (7)
9 Corporate governance (12)
10 Quality of risk management (8)
Source: Banking Banana Skins 2012 CSFI.
Also interesting is the latest Banana Skins Index which measures the level of anx-
iety in the markets (see p. 70).
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Banana Skins Index
Source: Banking Banana Skins 2012 CSFI.
The bottom line plots the average score given to all risks each year. It shows
anxiety rising in the late 1990s in the run-up to the dotcom crisis of the early
2000s, followed by an easing as the world moved into the ‘good times’ of the mid-
naughties. Interesting is the sharp uptick in 2006, reflecting, we now believe, the
early signs of concern about asset quality which exploded with the sub-prime
crisis of 2007, followed by Lehman 2008. I believe this is a useful leading indica-
tor of market sentiment that no one else measures. If it is correct, it tells us that
anxiety is currently at its highest level since we started the series in 1998.
However the Banana Skins series also tells us that there is persistent concern
about the harmful effects of excessive regulation, even among non-banking
respondents (e.g. consultants, analysts, professional observers). Even though
public opinion and political expediency are currently demanding a regulatory
crackdown, we should be aware that any regulatory reaction to a particular situ-
ation contains the seeds of the next banking crisis. This is to say that new regula-
tions will encourage banks to find ways round the new rules and to take on new
risks to sustain return on capital. One of the best quotes in the survey was, I think:
“The risk of increasing capital to a level which stops banks paying an
adequate return to equity investors is huge and avoidable. When the his-
tory of the 2020 banking crisis is written, Basel 3 capital requirements
will be seen as the main cause.”
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71
8. C ONCLUDING O BSERVATIONS
Thorsten Beck
I would like to make short remarks in four areas that were mentioned during
today’s excellent conference. Specifically, I would like to comment on the rela-
tionship between finance and growth and how the profession’s view on this has
developed over the past years. Then, I will turn my attention to bank failure and
the reform of the resolution framework that has become urgent after the 2007/8
crisis and in light of the current bank fragility in Europe. Next, I will comment
on the relationship between bank competition, regulation and stability. Finally, I
will speak on the issue of cross-border banking in Europe.
First, let me talk briefly about the area of finance and growth. In my opinion, we
have to rethink what the proper role of the financial sector in the economy is and
how we gauge its contribution. Academics have traditionally focused on the facil-
itating role of the financial sector, which consists of mobilizing funds for invest-
ment and contributing to an efficient allocation of capital in general. In doing so
the financial sector supports capital formation and productivity growth, and ulti-
mately economic growth. Policy makers – especially before the crisis and more in
some European countries than others – have often focused on financial services
as a growth sector in itself. This view towards the financial sector sees it more or
less as an export sector, i.e. one that seeks to build a – often – nationally centered
financial center stronghold by building on relative comparative advantages, such
as skill base, favorable regulatory policies, subsidies, etc. While there is strong
evidence for the facilitating role of finance, there is less evidence for growth ben-
efits from building a financial center1. But the recent crisis has certainly taught us
the risks of such a financial center approach, which brings with it high contingent
taxpayer liabilities that in a crisis turn into real taxpayer costs and that turn a
banking crisis more easily into a deep recession and potentially into a sovereign
debt crisis.
Refocusing our attention on the facilitating role of finance might be therefore
useful. Cross-country comparisons have shown that countries with higher levels
of Private Credit to GDP grow faster, but the same line of research has shown that
there is a non-linearity in this positive relationship and that it might even turn
negative at very high levels, consistent with other evidence that finds that rapid
1
Some of these thoughts were first spelled out in joint work with Arnoud Boot and Hans Degryse. See Beck,
Degryse and Kneer (2012) for some initial evidence.
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credit growth is a good crisis predictor2. Why is the relationship non-linear? Why
does the marginal contribution of financial deepening decrease at high levels?
One answer might lie in who gets credit. In recent work with several co-authors,
I have shown that the relationship between financial intermediation and real eco-
nomic growth goes through lending to enterprises, but not necessarily through
lending to households3. This does not imply that lending to households should be
considered a social bad, rather that we cannot expect financial deepening based
on extending loans to households (mostly mortgages) leading to higher growth
rates.
Second, I would like to make some remarks on bank resolution. We do not really
care about failing banks per se, but we care about the external costs that they
impose on the rest of financial system and the economy at large. These external
costs arise from the (i) domino effect, i.e. close interlinkages between banks so
that the failure of one institution can easily result in the failure of other institu-
tions in spite of sound fundamentals in these other banks, (ii) contagion effects
through the spread of retail and wholesale runs and contagion through fire-sales
on asset markets, and (iii) effects on the real economy through the loss of lending
relationships. In countries with larger banking sectors, these external costs also
tend to be higher. These costs are external to the banks as they are not taken into
account by risk decision takers in financial institutions. The challenge is therefore
not to reduce the risk of bank failure to zero, but rather to minimize the external
costs that arise from bank failure. This would involve a bank resolution frame-
work that minimizes these external costs while still imposing losses on some of
the failing banks’ stakeholders according to their seniority. Purchase and assump-
tion models, bridge bank models or tailored solutions, such as through living
wills that identify the parts of the banks critical to the rest of the financial system
and the real economy, can achieve these two objectives to a large extent and can
significantly improve on the ad-hoc interventions undertaken in the previous cri-
sis, which involved either bail-out or liquidation.
By constructing a bank resolution framework that forces risk decision takers to
internalize these external costs to a larger extent, we also reduce the safety net
subsidy that can partly explain why the financial system has grown so large in
spite of decreasing if not negative marginal social returns to further financial
deepening as discussed above.
2
For a summary of the finance and growth literature see Levine (2005) and Beck (2012). For more recent
evidence a possibly negative impact of finance on growth at very high levels of Private Credit to GDP, see
Arcand, Berkes and Panizza (2011).
3
See Beck et al. (2012).
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CONCLUDING OBSERVATIONS 73
Third, I would like to comment on the relationships between bank competition,

stability and regulation. First of all, on the question whether regulation impedes
or fosters competition. I seriously think this is the wrong question and should be
rephrased as: what kind of regulation impedes or fosters competition? Regulation
aiming at more transparency vis-à-vis clients can foster competition as can regu-
lation forcing financial institutions to share credit information through a credit
registry. Regulation introducing interest rate ceilings or floors or preventing new
entrants into the financial system rather undermines competition. In this context
it is also important to not confuse the costs of regulatory burden for the banks
with the social costs of such regulations. To link to the previous topic of bank
resolution, living wills certainly impose a high regulatory burden on banks, but
these private costs might be more than outweighed by the social benefit of lower
external costs of bank failures.
Let me in this context also comment on the relationship between bank competi-
tion and stability, a debate which the literature has not really settled yet. This
ambiguity might be related to the different measures of competition and stability
that researchers have focused on or, as two co-authors and I show in recent work,
to cross-country differences in regulation and market structure4. Specifically, we
document a large cross-country heterogeneity in the relationship between bank
competition and stability, ranging from positive to negative and with different
degrees of intensity. We show that an increase in competition will have a larger
impact on banks’ risk taking incentives and thus fragility in countries with stricter
activity restrictions, more herding in revenue structure, more generous deposit
insurance schemes and more effective systems of credit information sharing. Pol-
icy makers thus have to take into account the regulatory framework and market
structure that banks operate in when assessing the impact of competition on fra-
gility. Even more importantly, the regulatory framework and the risk-taking
incentives it sets for banks might be more important for the objective of reducing
fragility than attempts at ‘fine-tuning’ competition or market structure.
Finally, I would like to comment on cross-border banking. Large cross-border

banks have been the face of the recent crisis (e.g. RBS in the UK, ABN-AMRO-
Fortis in the Netherlands). Beyond the argument that they were not necessarily
the cause of the crisis, but rather part of a larger transformation of financial sys-
tems across Europe and the developed and emerging world in the early 2000s,
there are clear benefits of cross-border banking for the real economy5. The main
stability benefits stem from diversification gains; take the example of Spain; in
spite of its Spanish housing crisis, Spain’s large banks remain relatively solid,
given the profitability of their Latin American subsidiaries. Similarly, foreign
4
See Beck, de Jonghe and Schepens (2011).
5
For the following, see Allen et al. (2011).
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banks can help reduce funding risks for domestic firms if domestic banks run into
problems. However, the costs might outweigh the diversification benefits if out-
ward or inward bank investment is too concentrated. Several Central and Eastern
European countries are highly dependent on a few West European banks and the
Nordic and Baltic region are relatively interwoven without much diversification6.
Critically, cross-border banking raises regulatory concerns. National regulators
are biased when deciding whether or not to intervene in a bank with activities
outside its regulatory perimeter. This could also be seen in the recent crisis, where
banks with higher share of cross-border assets and deposits were intervened rel-
atively late, while banks with higher foreign equity shares were intervened rela-
tively early (Beck, Todorov and Wagner, 2012). A move towards supra-national
regulation of cross-border banks is therefore called for to internalize these distor-
tions in national supervisors’ incentives. This can also be seen in the broader
context of a trilemma of financial integration (Schoenmaker, 2011) that states
that financial integration, financial stability and national sovereignty in bank reg-
ulation cannot be achieved simultaneously and one of the three has to give. Pre-
suming that one wants to maintain financial stability, the options are hence either
a move towards national banking systems, with stand-alone, fire-walled subsidi-
aries or a move towards supra-national supervision. This would call for a pan-
European bank regulator for large cross-border banks only, with the necessary
supervisory, intervention and resolution powers and the necessary firing powers,
provided either through a deposit insurance scheme and/or back-stop funding
from the European Union. As second-best solution, but also complementary to
the above suggested solution, living wills with ex-ante burden sharing agreements
between countries can be a step into the direction of overcoming national biases
in supervision of cross-border banking.
As you can see, the four topics I touched upon are all linked. Financial interme-
diation is important for real sector growth and competition in the financial sector
can increase these growth benefits. Competition with the ‘wrong’ regulatory
framework and in the ‘wrong’ market structure, however, can increase fragility.
One important way to harness financial institutions and markets is through a
proper bank resolution framework that forces risk decision takers in banks to
internalize the external costs coming from their potential failure. This is even
more important in the case of cross-border banks. Safeguarding the Single Euro-
pean Banking Market with a strong and resourceful bank resolution framework
for large cross-border banks is also critical to reap the benefits from financial
integration.
6
See Schoenmaker and Wagner (2011) for a discussion and evidence.
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CONCLUDING OBSERVATIONS 75
References
ARCAND, J.-L., BERKES, E. and PANIZZA, U. (2011), Too Much Finance?, Mimeo.
ALLEN, F., BECK, Th., CARLETTI, E., LANE, Ph., SCHOENMAKER, D. and WAGNER,
W. (2011), Cross-border banking in Europe: implications for financial sta-
bility and macroeconomic policies, London, CEPR.
BECK, Th. (2012), “The Role of Finance in Economic Development – Benefits,
Risks, and Politics” in D. MÜLLER (ed.), Oxford Handbook of Capitalism.
BECK, Th., BUYUKKARABACAK, B., RIOJA, F. and VALEV, N. (2012), “Who Gets
the Credit? And Does it Matter? Household vs. Firm Lending Across Coun-
tries”, B.E. Journal of Macroeconomics 12.
BECK, Th., DEGRYSE, H. and KNEER, Ch. (2012), Is more finance better? Disen-
tangling intermediation and size effects of financial systems, Tilburg Univer-
sity mimeo.
BECK, Th., O. DE JONGHE and G. SCHEPENS (2011), Bank Competition and Sta-
bility: Cross-country Heterogeneity, Tilburg University CentER Discussion
paper 2011-080.
BECK, Th., TODOROV, R. and WAGNER, W. (2011), Supervising Cross-Border
Banks: Theory, Evidence and Policy, Tilburg University Mimeo.
LEVINE, R. (2005), “Finance and Growth: Theory and Evidence” in Ph. AGHION
and S.N. DURLAUF, Handbook of Economic Growth, 865-934, Amsterdam,
Elsevier.
SCHOENMAKER, D. (2011), “The Financial Trilemma”, Economics Letters 111,
57-59.
SCHOENMAKER, D. and WAGNER, W. (2011), The Impact of Cross-Border Bank-
ing on Financial Stability, Duisenberg School of Finance, Tinbergen Institute
Discussion Paper, TI 11-054/DSF 18.
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77
I NTERNATIONAL C ENTRE FOR F INANCIAL

R EGULATION (ICFR)
Launched in 2009 as a public – private venture the ICFR is the only independent,
non-partisan organisation to be exclusively focused on best practice in all aspects
of financial regulation internationally.
Operating in developed and emerging markets, we deliver our work through
research, events and training, that seeks to be practical and focussed on out-
comes.
We believe in the promotion of efficient, orderly and fair markets which offer
appropriate protection for investors and retail consumers alike. Financial centres
of the future should be based upon sound principles of regulation, with supervi-
sors, regulators and participants who act in the interest of all stakeholders.
The ICFR is not a lobby organisation but seeks to influence policy and practice
in many jurisdictions through its work.
ICFR P ROGRAMME OF A CTIVITIES

For full details of the ICFR Programme please visit the ICFR website at
www.icffr.org. Below are some highlights:
Research
ICFR Publication: The Optimal Relationship between the Regulator and the Reg-
ulated. September 2012.
ICFR Regulatory Briefings bring together diverse perspectives, drawn from regu-
lators, industry, academia and economics, to give an overview of competing view-
points on often contentious regulatory issues.
ICFR – Financial Times Research Prize. Launched in partnership with the Finan-
cial Times in 2009 the annual Research Prize seeks to develop new thinking on
financial regulation. The papers delivered are of a consistently high standard and
can be downloaded from the website. The theme of the 2012 Prize will be
announced in October.
ICFR PhD Network on Financial Regulation supports and encourages innovative
research on financial regulation through a collaborative network of PhD stu-
dents, linking them to practitioners, policy makers and senior academics. Visit
our website for details on how to join the Network
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78
Training
ICFR-Intuition Regulatory Portal combines the ICFR’s depth of knowledge and
insight on financial regulation with Intuition’s widely acclaimed online tutorials.
The Portal contains news items, research papers and essential eLearning tutorials.
Events
The ICFR holds its Annual International Regulatory Summit in the autumn and
the 2012 event will in held in London on 25-26 September.
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79
SUERF – S OCIÉTÉ U NIVERSITAIRE E UROPÉENNE DE

R ECHERCHES F INANCIÈRES
SUERF is incorporated in France as a non-profit-making Association. It was

founded in 1963 as a European-wide forum with the aim of bringing together
professionals from both the practitioner and academic sides of finance who have
an interest in the working of financial markets, institutions and systems, and the
conduct of monetary and regulatory policy. SUERF is a network association of
central bankers, bankers and other practitioners in the financial sector, and aca-
demics with the purpose of analysing and understanding European financial mar-
kets, institutions and systems, and the conduct of regulation and monetary policy.
It organises regular Colloquia, lectures and seminars and each year publishes sev-
eral analytical studies in the form of SUERF Studies.
SUERF has its full-time permanent Executive Office and Secretariat located at
the Austrian National Bank in Vienna. It is financed by annual corporate, per-
sonal and academic institution membership fees. Corporate membership cur-
rently includes major European financial institutions and Central Banks. SUERF
is strongly supported by Central Banks in Europe and its membership comprises
most of Europe’s Central Banks (including the Bank for International Settle-
ments and the European Central Bank), banks, other financial institutions and
academics.
SUERF S TUDIES
1997-2010
For details of SUERF Studies published prior to 2011 (Nos. 1 to 22 and 2003/1-
2010/5) please consult the SUERF website at www.suerf.org.
2011
2011/1 The Future of Banking in CESEE after the Financial Crisis, edited
by Attilla Csajbók and Ernest Gnan, Vienna 2011, ISBN 978-3-
902109-56-9
2011/2 Regulation and Banking after the Crisis, edited by Frank Browne,
David T. Llewellyn and Philip Molyneux, Vienna 2011, ISBN 978-
3-902109-57-6
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80
2011/3 Monetary Policy after the Crisis, edited by Ernest Gnan, Ryszard
Kokoszczynski, Tomasz Łyziak and Robert McCauley, Vienna
2011, ISBN 978-3-902109-58-3
2011/4 Divergence of Risk Indicators and the Conditions for Market Disci-
pline in Banking, Vienna 2011, ISBN 978-3-902109-59-0
2011/5 Roles, Missions and Business Models of Public Financial Institu-
tions in Europe, Vienna 2011, ISBN 978-3-902109-60-6
2012
2012/1 New Paradigms in Monetary Theory and Policy?, edited by Morten
Balling and David T. Llewellyn, Vienna 2012, ISBN 978-3-9021-
0961-3
2012/2 New Paradigms in Banking, Financial Markets and Regulations?,
edited by Morten Balling, Frank Lierman, Freddy Van den Spiegel,
Rym Ayadi and David T. Llewellyn, Vienna 2012, ISBN 978-3-
9021-62-0
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Basel III and Shadow Banking

Patricia Doreen Jackson

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SUERF – The European Money and Finance Forum

SUERF Study 2012/3

Future Risks and Fragilities for Financial Stability

Editors: David T. Llewellyn and Richard Reid

Keywords: Financial Stability, Incentive Structures, Market Discipline, Bank Disclosure

JEL Codes: G1, G20, G21, G28, G38

Vienna: SUERF (SUERF Studies: 2012/3) – June 2012

© 2012 SUERF, Vienna

3. Supporting Market Discipline: The Case of a Bank Disclosure

4. Basel III and Shadow Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29

5. Regulation and Competition in the Financial System. . . . . . . . . . . . 41

5.3. Is there a Trade-off between Financial Stability and

6. The Evolution of Bank Business Models: Pre- and Post-crisis . . . . . 45

7. Banking Banana Skins – Brief Remarks. . . . . . . . . . . . . . . . . . . . . . 69

International Centre for Financial Regulation (ICFR) . . . . . . . . . . . . . . . 77

SUERF – Société Universitaire Européenne de Recherches Financières . . 79

ing new regulatory systems (such as the incoming macro-prudential framework)

2.1. Which Incentives Have Worked?

2.2. What Has Not Worked?

2.3. Missing Incentives

2.4. Creating New Perverse Incentives

2.5. Lessons for Future Risks and Fragilities

3. S UPPORTING M ARKET D ISCIPLINE :

3.1. The Role of Accounting

First most obviously it arises in connection with bank accounting statements. A

Haldane places these issues in a broader historical and regulatory context. As he

3.2. Two Interpretations of the Crisis: Inadequate

3.3. The Way Forward

recording of their positions with appropriate identifications, allowing and any

ment purposes; the establishment of a private sector Bank Disclosure Council,

4. B ASEL III AND S HADOW B ANKING

• The minimum common equity levels are to be increased from 2% to 4.5%

Phase-in arrangements (shading indicates transition periods)

4.2. Costs of Regulatory Change

markedly depending on the profile of individual borrowers, types of collateral

4.3. Changes in Banking Models

4.4. Shadow Banking

if shadow banking seems to be becoming systemic. Currently non-bank lenders

4.5. Way Forward

SHARPE, W. F. (1966), “Mutual Fund Performance”, Journal of Business,

5. R EGULATION AND C OMPETITION IN THE F INANCIAL

The UK is implementing a set of reforms to UK financial services industries,

5.1. Competition as a Policy Objective

Other procedural changes reinforced this. For example, competition features in

5.2. Will Regulation Increase Competition in the UK

tion is what happens if the combination of changes to supervisory regulation and

5.3. Is there a Trade-off between Financial Stability and

6. T HE E VOLUTION OF B ANK B USINESS M ODELS :

6.1. The Context of Business Models

6.1.1. Bank Business Models

undertaken (e.g. bank-assurance, securitisation and derivatives trading, etc.),

6.1.2. Context of Structural Change

(Tett, 2008). In effect, a shadow banking system emerged. As argued in

6.2. The Traditional Model

Table 1. Alternative Bank Models