Financial Institutions, Markets and Regulation: A Survey

Thorsten Beck, Elena Carletti and Itay Goldstein1

1. Introduction
The recent crisis has given impetus not only to an intensive regulatory reform debate, but to a deeper discussion
on the role of financial systems in modern market economies and the role of financial innovation. While there
has been an array of regulatory reforms, most of these reforms are aimed at avoiding the past crisis and are
less forward looking than we would like them to be.
This paper takes stock of the existing literature on market failures in the financial system and the
consequent fragility risks, discusses possible policy responses and discusses new areas of research. It draws
on a very rich theoretical and empirical literature, partly motivated and informed by the recent crises. However,
the paper also takes a more principled stance on some of the challenges faced by policy makers and regulators.
While we discuss the main market failures in banking and how the recent regulatory reform address them, we
also note that financial innovation, the changing border between regulated and non-regulated institutions and
increasing complexity makes the optimal regulatory framework a moving target.
We conclude with a few main messages on regulatory reforms. While trying to flesh them out with
some detail, we purposefully keep them on a more general level. Specifically, based on the discussion
throughout the paper, we conclude that (i) a mix of complex and simple regulatory tools is needed, where the
former reflects and influences market players’ risk-taking decisions, while the latter are less likely to be
circumvented; (ii) macro-prudential has to complement micro-prudential regulation, as the stability of
individual financial institutions does not add up to systemic stability; (iii) a stronger focus on effective
resolution is necessary, not just to minimize the risk of contagion and reduce the impact of fragility on the real
economy but also to set desirable incentives ex-ante for all the agents operating in the financial systems
(institutions, investors and policy makers); and (iv) a dynamic approach to regulation is critical, especially
when it comes to defining the regulatory perimeter.
The remainder of the paper is structured as follows. The next section discusses market failures in the
financial system that lead to fragility. Section 3 discusses regulatory responses to these market failures, while
section 4 presents recent regulatory reforms in the wake of the Global Financial Crisis. Section 5 focuses on

1
Beck: Cass Business School, City University London and CEPR; Carletti: Bocconi University, CEPR and IGIER:
Goldstein: University of Pennsylvania. We would like to thank Andrea Amato Marco Forletta for excellent research
assistance.
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the role of financial innovation both in deepening and completing financial markets but also creating financial
fragility. Section 6 is concerned with the regulatory perimeter. Section 7 draws policy conclusions from our
analysis, while section 8 concludes and looks forward to new research challenges.

2. Purpose of financial regulation – what market failures does it try to address?

The financial services industry is the most regulated sector in practically all economies. In almost all countries
around the world there are numerous institutions in charge of regulating and supervising the banking industry
as well as the financial industry more at large. Yet, we have recently experienced one of the most dramatic and
widespread crises of the financial sector in history and we have seen how pervasive its effects can be also for
the real economy. What happened? Why did things get so out of control? Why did this crisis come as such a
surprise to regulators? How should we design regulation going forward.
Financial regulation presents a complex set of issues. At a very basic level, there are different market
failures that regulation is trying to address, and there is no strong agreement on which one is more important
and what the optimal tradeoff in designing financial regulation is. The current structure of banking regulation
is more a series of answers to crises in the past rather than the implementation of a clear regulatory design.
Starting after the Great Depression, many countries adopted a whole range of regulatory measures. Others,
like France or Italy, went even further and nationalized their financial institutions. This regulation and
government ownership was successful in terms of stopping crises. From 1945 until the early 1970’s, there were
almost no financial crises.
However, stopping financial institutions from taking risks is also not efficient as it often entails
inefficient credit provision and little innovation. It is well understood that the financial sector plays a key role
in the economy and that for it to play this role we need to have some risk and fragility. Hence, minimizing
fragility is not necessarily the goal. The goal is perhaps to find the optimal balance between fragility and the
provision of credit and risk sharing by the financial sector. That is why, starting in the 1970s, financial
liberalization took place in many countries. This led to a revival of crises around the world (see, e.g., Boyd,
De Nicolo, and Loukoianova (2009)), which culminated in the 2007 global financial crisis. This has led to the
new wave of stricter regulatory measures. It seems that there is overall a learning process, whereby regulatory
views and tools are constantly revised I response to past events. Regulation becomes stricter following periods
of instability and looser following periods of stability.
This historical evolution has led to a set of regulations designed to stop specific problems as they
emerged rather than a well thought out way of reversing market failures in the financial system. However, the
problems inherent in financial regulation go beyond the understanding of the market failures in the financial
industry. First, setting regulation involves a political process and, as well known in political economy, “pure”
political factors may prevent regulation – in any sector - from being at the optimal level. Second, there is no
consensus on how much regulation is optimal. Some believe that very little is optimal and that the financial
system should be as free as possible to operate under market mechanisms and logics. According to this view
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which starts already in the late 80s (e.g., White, 1984, Dowd, 1989), rather than repressing the financial system
with complicated and restrictive regulation, the financial system should be left free to innovate and progress,
and financial crises should just be seen as a natural by-product of market forces.
Whereas there is some merit in this view, we do not support the “free banking” view in light of the
specialness of the financial industry and the substantial negative consequences that financial crises may entail
for economic growth and real activity. There are clearly externalities in the financial sector that are not fully
internalized by the various players, and so when left completely unregulated they will take actions that put the
system in a too great level of fragility or inefficiency. Yet, it is still an open question how much regulation is
needed and what the optimal mix is in addressing the various market failures involved.
Given this, the main scope of this survey is to analyze the various market failures affecting the financial
industry and then evaluate whether the existing regulation, and in particular the numerous regulatory reforms
adopted since the recent financial crisis, address them. Although our focus is mostly on the financial
institutions and in particular banks, we will also touch upon the market failures present in financial markets
and the regulatory reforms recently implemented in this area.
One theme we will emphasize is that financial regulation exists to preserve the stability of the financial
system, but not that of individual institutions, thus protecting the intermediary and allocative roles that financial
institutions and markets perform in the economy. In doing this, it should address the market failures in the
financial industry that lead to financial crises and to disruptive consequences for the real economy. Given the
wide scope of the survey, we restrict our attention to the main market failures as being:
1. Panics and runs, and the difference from fundamental crises.
2. Inefficient liquidity in interbank markets.
3. Bank interconnections, systemic risk, and contagion.
4. Bad incentives, bubbles, and crises.
We analyze each of them in turn, making use of the core academic insights on these topics.

2.1 Panics versus fundamental crises

Banking crises have been observed for many years in many countries. One typical feature of them is
the massive withdrawal of deposits by depositors, often referred to as bank run. In the academic literature,
there are two leading views on the origin of these runs, which are not mutually exclusive. One view is that runs
are driven by panics or self-fulfilling beliefs. The formal analysis goes back to Bryant (1980) and Diamond
and Dybvig (1983). In these models, agents have uncertain needs for consumption in an environment in which
long-term investments are costly to liquidate. Banks provide useful liquidity services to agents by offering
demand deposit contracts. But, these contracts lead to multiple equilibria. If depositors believe that other
depositors will withdraw, then all agents find it rational to redeem their claims and a panic occurs. Another
equilibrium exists where everybody believes no panic will occur and agents withdraw their funds according to
their consumption needs. In this case, their demand can be met without costly liquidation of assets.
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 While it explains how panics may occur, the theory is silent on which of the two equilibria will be
selected. Depositors’ beliefs are self-fulfilling and are coordinated by “sunspots.” Sunspots are convenient
pedagogically but they do not have much predictive power. Since there is no real account of what triggers a
crisis, it is difficult to use the theory for any policy analysis.
The second set of theories of banking crises is that they are a natural outgrowth of the business cycle.
An economic downturn will reduce the value of bank assets, raising the possibility that banks are unable to
meet their commitments. If depositors receive information about an impending downturn in the cycle, they
will anticipate financial difficulties in the banking sector and try to withdraw their funds, as in Jacklin and
Bhattacharya (1988). This attempt will precipitate the crisis. According to this interpretation, crises are not
random events but a response of depositors to the arrival of sufficiently negative information on the unfolding
economic circumstances.
The global-games literature offers a reconciliation of the two approaches. This literature goes back to
Carlsson and van Damme (1993), who show that the introduction of slightly noisy information to agents in a
model of strategic complementarities and self-fulfilling beliefs can generate a unique equilibrium, whereby the
fundamentals uniquely determine whether a crisis will occur or not. Goldstein and Pauzner (2005) extended
the global-games literature to a setting that matches payoffs in a bank-run problem and showed how the
fundamentals of the bank uniquely determine whether a crisis will occur or not. They also link the probability
of a crisis to the banking contract, showing that a crisis becomes more likely when the bank offers greater
liquidity. The bank then takes this into account, reducing the amount of liquidity offered, such that the cost of
runs is balanced against the benefit from liquidity and risk sharing.
This approach is thus consistent with the panic-based and fundamental-based views. Here, crises occur
because of self-fulfilling beliefs, that is, agents run just because they think that others are going to run. But,
the fundamentals uniquely determine agents’ expectations and thus the occurrence of a run. Thus, the approach
is consistent with empirical evidence pointing to the element of panic and to those pointing to the link to
fundamentals. In the first line of work, analyzing the period 1867-1960, Friedman and Schwartz (1963) argued
that the crises that occurred then were panic-based. In the second line of work, Gorton (1988) shows that in
the U.S. in the late nineteenth and early twentieth centuries, a leading economic indicator based on the
liabilities of failed businesses could accurately predict the occurrence of banking crises. Goldstein (2012)
provides a survey on the differences between the panic-based and fundamentals-based approaches and how to
test the hypotheses in the data.2
One strand of the business cycle explanation of crises stresses the role of information-induced runs as
a form of market discipline. In particular, Calomiris and Kahn (1991) and Diamond and Rajan (2001) suggest
that the threat of bank liquidation induced by depositors’ runs can discipline the banker not to divert resources

2
Other related surveys on the origins of financial crises are provided by Bhattacharya and Thakor (1993), Gorton and
Winton (2003), Allen and Gale (2007, Chapter 3), Freixas and Rochet (2008), Rochet (2008), Allen, Babus, and Carletti
(2009), and Degryse, Ongena and Kim (2009).
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for personal use or can ensure that loans are repaid. In this view, not only run crises can be efficient in that
they prevent the continuation of inefficient banks, but can also help provide bankers better incentives, thus
inducing better investment choices and better equilibrium allocations.
A final important remark is due here. Some people argue that modern banking systems have increased
in complexity over the last two decades and that as such the literature à la Diamond and Dybvig with its focus
on bank runs by retail depositors is no longer applicable to today’s financial institutions. We argue that this is
not the case. Despite running off-balance sheet vehicles or using various financial instruments to transfer credit
risk, banks remained equally sensitive to panics and runs as they were at the beginning of the previous century.
As Gorton (2008) points out, in the summer of 2007 holders of short-term liabilities refused to fund banks,
expecting losses on subprime and subprime-related securities. As in the classic panics of the 19th and early 20th
century, there were runs on banks. The difference is that modern runs typically involve the drying up of
liquidity in the short term capital markets (a wholesale run) instead of or in addition to depositor withdrawals.
This implies also a much stronger interplay between financial institutions and financial markets in modern
financial systems, as we shall stress later in the paper. In summary, problems of runs and panics, and how to
reduce their likelihood are important, as is the challenge of the regulatory perimeter, as funding and thus
sources of contagion can easily move outside the traditional banking system.

2.2 Inefficient liquidity in the interbank markets.

Interbank markets play a key role in financial systems. Their main purpose is to redistribute liquidity
in the financial system from the banks that have cash in excess to the ones that have a shortage. Their smooth
functioning is essential for maintaining financial stability. The problem is that there are externalities in the
provision of liquidity by banks, and so the equilibrium will typically not feature the optimal amount of liquidity
provision. There are market breakdowns and market freezes that lead to insufficient liquidity provision due to
the externalities among banks.
The main reason for the existence of the interbank market is formalized by Bhattacharya and Gale
(1987). In their framework, which shares numerous characteristics with the subsequent works, individual banks
face privately observed liquidity shocks due to a random proportion of depositors wishing to make early
withdrawals. Since the liquidity shocks are imperfectly correlated across intermediaries, banks co-insure each
other through an interbank market by lending to each other after the liquidity shocks are realized.
In the absence of aggregate uncertainty and of frictions concerning the structure of the interbank
market or the observability of banks’ portfolio choices, the co-insurance provided by the interbank market is
able to achieve the first best. By contrast, as soon as a friction is present, the interbank market does no longer
achieve full efficiency. For example, given that liquid assets have lower returns than illiquid ones, banks have
incentives to under-invest in liquid assets and free-ride on the common pool of liquidity.
Similarly, interbank markets appear to be inefficient also when they do not work competitively.
Acharya, Gromb and Yorulmazer (2011), for example, analyse the situation when interbank markets are
5
characterized by monopoly power in times of crisis in addition to moral hazard. They show that a bank with
surplus liquidity has bargaining power vis-à-vis deficit banks which need liquidity to keep funding projects.
Surplus banks may strategically provide insufficient lending in the interbank market in order to induce
inefficient sales of bank-specific assets by the needy banks, which results in an inefficient allocation of
resources.
Full efficiency is not achieved by interbank markets also when banks are subject to aggregate
uncertainty concerning their liquidity needs. The reason is that banks set their portfolio choice before the
realization of the liquidity shocks. When the shocks realize, banks can obtain additional liquidity from other
banks or from selling their long term assets. As long as the liquidity shocks are idiosyncratic and independent
across banks, the market works well in relocating liquidity from banks in excess to banks in shortage of
liquidity. When the uncertainty concerning liquidity shocks is aggregate, the internal mechanism of liquidity
exchange among banks fails. When the system as a whole faces a liquidity shortage, banks are forced to satisfy
their liquidity demands by selling their long term assets. This leads to fire sales, excessive price volatility and,
possibly to runs by investors, when asset prices are so low that banks are unable to repay the promised returns
to their depositors.
The mal-functioning of interbank markets provides a justification for the existence of a central bank.
For example, in contexts of asymmetric information, the central bank can perform an important role in (even
imperfectly) monitoring banks’ asset choices, thus ameliorating the free riding problem among banks in the
portfolio allocation choice between liquid and illiquid assets. When surplus banks have bargaining power over
deficit banks, the role of the central bank is to provide an outside option to the deficit bank for acquiring the
needed liquidity. In contexts of aggregate liquidity risk, the central bank can help alleviate the problem of
excessive price volatility when there is a lack of opportunities for banks to hedge aggregate and idiosyncratic
liquidity shocks. By using open market operations to fix the short-term interest rate, a central bank can prevent
fire sales and price volatility and implement the constrained efficient solution (Allen, Carletti and Gale, 2009).
Thus, the central bank effectively completes the market, a result in line with the argument of Goodfriend and
King (1988) that open market operations are sufficient to address pure liquidity risk on the interbank markets.
Motivated by the current financial crisis, several papers seek to explain market freezes. Diamond and
Rajan (2009) relate the seizing up of term credit with the overhang of illiquid securities. When banks have a
significant quantity of assets with a limited set of potential buyers as in times of crises, shocks in future liquidity
demands may trigger sales at fire sale prices. The prospect of a future fire sale of the bank’s assets depresses
their current value. In these conditions, banks prefer holding on to the illiquid assets and risking a fire sale and
insolvency rather than selling the asset and ensuring its own stability in the future, since the states in which
the depressed asset value recovers are precisely the states in which the bank survives. In turn, this creates high
expected returns to holding cash or liquid securities across the financial system, an aversion to locking up
money in term loans and the possibility of market freezes as banks do keep their assets rather than trading
them.
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 Other works relate the possibility of market freezes to problems of information revelation or, more
generally, problems of asymmetric information. For example, Acharya, Gale and Yorulmazer (2009) analyse
how asymmetric information revelation about the quality of banks’ assets may induce freezes in markets for
rollover debt. In situations where there is a constant probability that “bad news" is revealed each period, the
absence of bad news in one period increases the value of the assets. By contrast, when there is a constant
probability that “good news" is revealed each period, the absence of good news in one period induces investors
to reduce their valuation of the bank’s assets even below their fundamental values. This reduces in turn banks’
debt capacity, that is banks’ ability to roll over their debt against the value of their assets. This leads to a spiral
in which asset values and banks’ debt capacity falls further. In the limit, when the frequency of rollovers
becomes unbounded, the debt capacity goes to zero even for an arbitrarily small default risk and the market
freezes.
More general problems of asymmetric information can generate freezes on the interbank market, if
they are severe enough. For example, Heider, Hoerova and Holthausen (2009) shows that interbank market
freezes are possible in extreme situations when banks invest in risky long-term investments and there is
asymmetric information on the prospects of these investments. This is because the existence of counterparty
risk increases interbank market spreads and, in extreme situations, it leads to non-viable spreads. A similar
mechanism but based on banks’ desire to avoid fire sales is present in Bolton, Santos and Scheinkman (2008).
The idea is that they may prefer to keep assets on whose value they have private information in their portfolios
rather than placing them on the market in order to avoid to have to sell them at a discount. The problem,
however, is that by keeping the assets on their portfolios, banks run the risk of having to sell them at even a
lower price at a later stage if the crisis does not cease before they are forced to do so. This so-called “delayed
trading equilibrium” in which intermediaries try to ride out the crisis and only sell if they are forced leads to a
freeze of the market for banks’ assets but may be Pareto superior.
A different mechanism for market crashes is proposed by Huang and Wang (2009, 2010). Instead of
relying on the presence of information asymmetry among investors about the fundamentals, they show that
purely idiosyncratic and non-fundamental shocks can cause market crashes if capital flow is costly. Agents
trade to smooth out idiosyncratic shocks to their wealth. Since there is no aggregate uncertainty, their trades
will be perfectly synchronized and matched, and there will be no need for liquidity if market presence is
costless. In this case, the market-clearing price always reflects the fundamental value of the asset, and
idiosyncratic shocks generate trading but have no impact on prices. In contrast, when market presence is costly,
the need for liquidity arises endogenously and idiosyncratic shocks can affect prices via two channels: first
trading becomes infrequent which makes traders more risk averse, and second the gains from trading for
potential sellers are always larger than the gains from trading for potential buyers. The asymmetry in their
appetite to trade leads to order imbalances in the form of excess supply, and the price has to decrease in
response.

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 A freeze will also arise when there are strategic complementarities among banks in the decision to
provide credit. This has been analysed by Bebchuk and Goldstein (2011). Suppose that the success of banks’
projects depends on how many banks invest in these projects. This can occur due to network externalities in
the real economy, for example. Then, the expectation that other banks are not going to invest will make it
optimal for an individual bank not to invest, and so making this a self-fulfilling belief. Bebchuk and Goldstein
use this framework to compare various types of government policy aimed towards assisting the financial sector
and analyse which one is more effective under what circumstances.

2.3 Bank interconnections, systemic risk, and contagion.

The prevalence of financial crises has led many to conclude that the financial sector is unusually
susceptible to shocks. What is striking is the fact that many crises are systemic, that is, they affect several
banks and not just individual intermediaries. The breadth of the recent financial crisis has made it clear that
the financial industry presents important externalities that have to be well understood and tackled with
appropriate regulation and interventions. In fact, a typical justification for intervention by central banks and
governments to prevent the bankruptcy of systemic financial institutions is the fear that their failure will lead
to a chain of failures in other institutions. This was for example the argument used by the Federal Reserve for
intervening to ensure Bear Stearns did not go bankrupt in March 2008, for example (see Bernanke (2008a))
but in many other cases as well.
The so-called “systemic risk” can originate from aggregate adverse shocks that lead to simultaneous
failures of several intermediaries or from contagion, that is from the propagation of one bank's failure to other
banks in a sequential fashion. The most common form of aggregate shock is the bursting of asset price bubbles
(as we will discuss more in the next subsection) and in particular real estate bubbles (Reinhart and Rogoff,
2009). Other possible sources of systemic risk are panics and multiple equilibria, liquidity trading and cash-
in-the-market pricing, that is the sale of assets at fire sale prices below fundamental values, and sovereign risk,
especially in the Euro area. By contrast, contagion requires an idiosyncratic shock affecting one individual or
a group of intermediaries and a propagation mechanism that transmits failures from the initially affected
institutions to others in the system. Various forms of propagation mechanisms have been analyzed ranging
from information spillovers (Chen, 1999), and interbank connections via interbank deposits (Allen and Gale,
2000) or payment systems (Freixas and Parigi, 1998; Freixas et al. 2000), to portfolio diversification and
common exposures (Goldstein and Pauzner, 2004; Wagner, 2011), common assets and funding risk (Allen et
al. 2012), transmission of fire sales prices through interdependency of banks' portfolios (Allen and Carletti,
2006) or the use of mark-to-market accounting standards (e.g., Allen and Carletti, 2008).
The academic literature on contagion is vast and, for reason of brevity, it is not possible to describe it
all here. Rather, we will limit ourselves to explain only a few key mechanisms of contagion in some more
details. Interested readers can refer to more comprehensive surveys such as Allen et al. (2009).

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 In looking for contagious effects via direct linkages, early research by Allen and Gale (2000b) studies
how the banking system responds to liquidity shocks when banks exchange interbank deposits. The first
important result is that the connections created by swapping deposits allows banks to insure each other against
idiosyncratic liquidity shocks but, at the same time, they expose the system to contagion as soon as some
frictions such as a small aggregate liquidity shock emerge. The second important result is that the resiliency
of the system depends on the network structure of the interbank deposits. In particular, incomplete networks,
that is networks where all banks are connected but each bank exchanges deposits only with a group of other
banks, turn out to be more prone to contagion than complete structures. The intuition is that better connected
networks are more resilient since the proportion of the losses in one bank's portfolio is transferred to more
banks through interbank agreements. Similar results concerning the resiliency of more complete networks are
present also in Freixas, Parigi and Rochet (2000) and more recently in Acemoglou et al. (2015), where the
resiliency of different networks is analyzed also as a function of the size of shocks.
A related question within the literature analyzing banks’ direct exposures as sources of contagion is
the extent to which contagion can be due to coordination problems among depositors when they receive private
information about banks’ future fundamentals (Dasgupta, 2004) or to the complementarities among investors’
decisions to undertake the same investment projects (Leitner, 2005).
Another related question concerns the issue of network formation, that is how banks choose to connect
when they anticipate contagion risk. Based on the intuition as in Allen and Gale (2000b) that better connected
networks are more resilient to contagion, Babus (2014) predicts that banks form links with each other up to a
certain connectivity threshold above which contagion does not occur. In other words, banks choose the network
that prevents the risk of contagion, but, given that forming links is costly, they do not wish to go beyond such
a connectivity threshold.
Another channel of contagion based on direct linkages among banks is financial innovation and/or
financial markets. The idea is that financial products like for example credit risk transfer allow banks to insure
each other against certain risks but at the same time, when certain conditions realize, they may expose banks
to failures and contagion. For example, credit risk transfers are beneficial as a way to insure different
intermediaries or different sectors that are subject to independently distributed liquidity shocks. However,
when some intermediaries are forced to sell the assets for example for idiosyncratic liquidity reasons and there
is price volatility and fire sales in some states of the world, then the presence of credit risk transfers can be
detrimental as they can generate contagion across intermediaries or sectors (Allen and Carletti, 2006). Similar
results on the benefits but also the risks of financial innovations are obtained by Parlour and Winton (2008)
and Shin (2009), among others.
The second approach to modeling contagion focuses on indirect balance-sheet linkages. One possible
contagion mechanism works through portfolio readjustments (Lagunoff and Schreft, 2001; de Vries, 2005;
Cifuentes, Ferrucci, and Shin, 2005). The basic idea is that the return of a bank’s portfolio depends on the
portfolio allocations of other banks. This implies that the decision of some banks to readjust their portfolios in
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response to the realization of some shocks produces negative externalities in that it reduces the returns of other
banks’ portfolios. This may induce other banks to abandon the investments as well either gradually as losses
propagate through the system or more rapidly in an attempt to avoid contagion of losses in the future.
Portfolio readjustments can also generate contagion if they happen at the level of investors holding
claims on different banks. Such mechanisms have been analyzed by Kodres and Pritsker (2002), Goldstein and
Pauzner (2004) and others. In Goldstein and Pauzner (2004), for example, investors hold deposits in two
different banks. The realization of a crisis in one bank reduces their wealth, and so makes them more risk
averse (under the common assumption of a decreasing absolute risk aversion utility function). Then, they are
more likely to run in the other bank, generating the contagion between the two banks.
Besides the theoretical investigations, there has been a substantial interest in looking for evidence of
contagion. Most studies focus on contagion from direct linkages among banks. Typically, they estimate
bilateral credit relationships for different banking systems and then test the stability of the system, mostly
focusing on the interbank market, by simulating the breakdown of a single bank. Studies in this category
include Upper and Worms (2004) on the German banking system, Cocco, Gomes, and Martins (2009) on
Portugal, Furfine (2003) on the US, Boss, Elsinger, Thurner, and Summer (2004) on Austria, and Degryse and
Nguyen (2007) on Belgium. These papers find that the banking systems demonstrate high resilience, even to
large shocks. For instance, simulations of the worst case scenarios for German system show the failure of a
single bank could lead to the breakdown of up to 15% of the banking sector based on assets. Since these results
depend heavily on how the linkages between banks are estimated and they abstract from any type of behavioral
feedback (Upper 2006), it is likely that they provide downward bias estimator of contagious outcomes.
Other studies like Mistrulli (2011) or Iyer and Peydró-Alcalde (2011) base their analyses on actual
data. For example, the former analyzes the possibility of contagion within the Italian interbank market using
banks’ actual bilateral exposures, while the latter finds that following the failure of a large Indian bank, banks
with higher interbank exposure to the failed bank experience higher deposit withdrawals.
Turning to the empirical investigation of contagion through indirect connections between financial
institutions, Adrian and Brunnermeier (2011) propose a new measure for systemic risk, the so-called covar,
that is conditional on an institution (or the whole financial sector) being under distress. As example of this type
of contagion is found in Jorion and Zhang (2009), who find evidence of credit contagion via counterparty
effects. The discussion in this and the previous sub-section underline that a proper risk analysis in finance has
to look beyond the stability of individual institutions towards systemic risk. While so far we have discussed
primarily the cross-sectional dimension of systemic risk, we now turn to the time-series dimensions of this
phenomenon.

2.4 Bad incentives, bubbles and crises

Banking crises often follow collapses in asset prices after what appears to have been a ‘bubble’. This
is in contrast to standard neoclassical theory and the efficient markets hypothesis which precludes the existence
10
of bubbles. The global crisis that started in 2007 provides a stark example. In numerous countries, including
the US, Ireland, UK and Spain, real estate prices rose substantially up to 2007 and the financial crisis was
triggered precisely when they collapsed.
Asset price bubbles can arise for many reasons. One important factor is the ease of credit, that is the
amount of liquidity provided by the central bank as money or credit. This may induce “speculative manias” as
argued already by Kindleberger (1978) and lead to optimism and increased prices. Numerous crises can be
read as being induced, or at least facilitated, by excessive credit availability. For example, the recent crisis can
be seen as being induced by the substantial credit availability deriving from apparently loose monetary policies
of central banks particularly the U.S. Federal Reserve and the presence of global imbalances resulting from
the Asian crisis of the end of 2000s. This fueled into asset price and real estate bubbles in many countries.
When the bubbles burst, asset prices declined rapidly below fundamental values causing problems to financial
market, financial institutions and finally the real economy.
Numerous other crises show a similar pattern of events. As documented, among others, by Kaminsky
and Reinhart (1999) and Reinhart and Rogoff (2011), a common precursor to most of crises is financial
liberalization and significant credit expansion. These are followed by an average rise in the price of stocks of
about 40 percent per year above that occurring in normal times. The prices of real estate and other assets also
increase significantly. At some point the bubble bursts and the stock and real estate markets collapse. Given
banks and other intermediaries tend to be overexposed to the equity and real estate markets, typically a banking
crisis starts about one year after the bubble burst. This is often accompanied by an exchange rate crisis as
governments choose between lowering interest rates to ease the banking crisis or raising interest rates to defend
the currency. Finally, a significant fall in output occurs and the recession lasts for an average of about a year
and a half.
There are a number of theories that can explain how bubbles can arise (see, e.g., Tirole (1982, 1985),
Allen and Gorton (1993), Allen, Morris and Postlewaite (1993), Abreu and Brunnermeier (2003), Scheinkman
and Xiong (2003), Brunnermeier and Nagel (2004), Hong, Scheinkman and Xiong (2008), and Brunnermeier
(2001) for an overview). Here we focus on theories that are explicitly related to financial crises, where bubbles
can occur because of agency problems, financial accelerator theories and amplification effects on the role of
collateral.
One mechanism for the creation of bubbles in the presence of agency problems is analyzed in Allen
and Gale (2000c). The idea is that many investors in real estate and stock markets obtain their investment funds
from external sources but the ultimate providers of funds are unable to observe the characteristics of the
investment. This leads to a classic asset-substitution problem, which increases the return to investment in risky
assets and causes investors to bid up prices above their fundamental values. A crucial determinant of asset
prices is thus the amount of credit provided by the financial system. Financial liberalization, by expanding the
volume of credit and creating uncertainty about the future path of credit expansion, can interact with the agency

11
problem and lead to a bubble in asset prices. When the bubble bursts, either because returns are low or because
the central bank tightens credit, there is a financial crisis.
There has been a substantial literature attempting to understand how shocks, and in particular negative
shocks, are amplified through the system and generate negative bubbles. Some theories rely on the so-called
financial accelerator (Bernanke and Gertler, 1989; Bernanke, Gertler and Gilchrist (1996). The idea is that
negative shocks to borrowers’ wealth are amplified because of the presence of asymmetric information and of
an agency problem between borrowers and lenders. In a similar spirit but focusing on the role of collateral,
Kiyotaki and Moore (1997) suggest that a shock that lower asset prices can lead to a crisis. The reason is that
by lowering the value of collateral, lower asset prices imply less borrowing and thus further reduction in asset
prices and borrowing capacity, and so on in a downward spiral. Geanakoplos (1997, 2003, 2009) and Fostel
and Geanakoplos (2008) push the analyses further by investigating the effect of asset prices on collateral value
and borrowing capacity in more general equilibrium settings.

3. Financial regulation: typology

The main goals of financial regulation are to maintain financial stability and consumers’ (or
depositors’) protection. The former includes preventing systemic risk and maintaining the role of financial
intermediaries in credit markets. The latter includes the protection of essential needs and wealth of ordinary
people. Despite these announced goals, as we will claim again further below, till the 2007 financial crisis the
focus of financial regulation has been mostly centered around the concept of microprudential regulation. What
this means is that despite systemic risk has always been one of announced goals of financial regulation, the
design of the regulatory tools has always been mostly centered on guaranteeing the stability of the individual
financial institutions rather of the system overall. The reason for that was the belief that guaranteeing the
stability of individual institutions would imply systemic stability. However, the 2007 financial crisis has clearly
shown that microprudential approach to financial regulation does not suffice in guaranteeing financial stability
because of what some scholars have defined “fallacy of composition” (Brunnermeier et al., 2011), that is the
impossibility of making the system as a whole safe by making sure that individual banks are safe. The reasons
are multiple. First, as explained in the previous section, there are risks such as those due to the interconnections
among banks which go beyond the preservation of individual stability. Second, going one step further, it may
happen that in trying to make themselves safer, banks can behave in a way that collectively undermines the
system. Asset sales and fire sale prices are an example of this. Banks start selling assets when they need to
deal with idiosyncratic shocks. But doing so, they disregard the effect that their sale will have on asset prices
and thus on the stability of the other institutions. Similarly for diversification. Banks choose their
diversification strategies taking account of their own individual risk sharing and hedging motives, disregarding
the effects of increasingly more correlated portfolios on systemic risk. These are just two forms of the more
general and well-known problem of individual agents not being able to internalize externalities.

12
 With this in mind, we now review the main regulatory tools. Our focus is on capital requirements, as
they have been the core of financial regulation, also in the aftermath of the financial crisis. To complement
this, we will discuss, albeit briefly, liquidity requirements and safety nets, that is central bank liquidity
provision and deposit insurance in the broader form of government guarantees and bailouts. In reviewing the
academic literature below, we maintain the view that banking regulation should be structured so to solve the
market failures in the financial system, which we described in the previous section. This means, for example,
that capital regulation should be designed to minimize the risk of banks’ failures and contagion, while liquidity
requirements should be set so to reduce the risk of panics and forced asset sales with consequent fire sales on
financial markets.
3.1 Capital regulation
In general, capital solves various roles. First, it absorbs unanticipated losses and thus reduces the risk
of insolvency and contagion. The idea is capital ratios represent a cushion to absorb losses, thus reducing the
likelihood of failure Second, capital protects uninsured depositors and hence maintains confidence in the
financial system. Third, capital protects bondholders and creditors in the event of insolvency and liquidation.
It protects deposit insurance and taxpayers. Finally, it provides incentives to bank managers and shareholders.
Despite these numerous roles, the academic literature has mostly focused on capital as a way to reduce
the problem of limited liability and excessive risk taking due to high leverage and the (implicit or explicit)
support of financial institutions through widespread deposit insurance and bailouts. The main idea behind
capital regulation is then that larger capital ratios reduce bank risk taking. The intuition is simple: With more
stake at risk, bankers should have fewer incentives to take on risk.
The effects of capital on banks’ risk taking have been discussed in the literature since the 1970s. Earlier
papers (e.g., Kareken and Wallace, 1978; Kahane, 1977, but also, more recently, Boot and Boot and
Greenbaum, 1993, and Hellman, Murdock and Stiglitz, 2000) were quite negative on the benefits of capital
requirements showing that they were either ineffective in preventive in risk taking or even counter-productive
inducing bankers to choose riskier assets.
Other, more recent works, instead, support a more positive capital for capital, justifying capital
regulation as needed to offset moral hazard from deposit insurance. The general idea is that because banks
have access to low cost funds guaranteed by the government, they have an incentive to take significant risks.
If the risks pay off they receive the upside, while if they do not the losses are born by the government. Capital
regulation that ensures shareholders will lose significantly if losses are incurred is needed to offset this
incentive for banks to take risks. One way of capturing this is to model the effects of capital on banks’
monitoring incentives (Holmstrom and Tirole, 1997). Using this framework, Dell’Ariccia and Marquez (2006)
and Allen, Carletti and Marquez (2010) analyze how the relationship between capital and banks’ incentives to
monitor changes depending on the presence and design of deposit insurance, credit market competition etc.
Overall, this literature supports a positive role of capital and thus of capital regulation in ameliorating banks’
incentives to monitor borrowers and thus reducing the credit risk of individual banks.
13
 As mentioned above, another rationale for capital regulation is the prevention of contagion and
systemic risk. Contagion is the market failure that central banks often use to justify intervention, as, for
example, in the case of the arranged takeover of Bear Stearns in March 2008, as it was publicly stressed
(Bernanke, 2008). Yet, the theory of capital as a way to reduce systemic risk is still in its infancy, given the
focus till recently on the microprudential role of capital regulation. Going forward, it is essential to develop
new theories of capital regulation based on preventing contagion and systemic risk. In general, as we argue
also further below, there is the need of a deeper analysis of the appropriate design of macroprudential
regulation. Attempts in this direction can be found in Acharya (2009) and Rochet (2004), but much more work
is needed in this area.
One of the major problems in designing capital regulation is in modeling the costs of equity finance
for financial institutions. The literature assumes typically that equity is more costly than other forms of finance
(see, for example, Gorton and Winton, 2003). This also justifies the need for capital regulation as in its absence,
banks would simply minimize their capital holdings and hold more debt. However, it is not at all clear what
this higher cost is due to. One simple answer is that it is privately more costly because in many countries debt
interest is tax deductible at the corporate level but dividends are not. One important shortcoming of this
explanation though is that it does not explain the difference in capital holdings across industries. Simple
evidence shows indeed that non-financial firms hold around 30-40% of their liabilities in the form of capital
whereas the financial firms operate with approx. 10% of capital on average in normal times (Flannery and
Rangan, 2008).
Given this, another, more plausible, explanation is that debt is implicitly subsidized in the financial
industry through government guarantees and bailouts (see also Admati et al., 2010). If this is the case, the
removal of the public guarantees and the design of clear resolution schemes would enhance financial stability
substantially as it would improve banks’ incentives to take risks and induce higher capital holdings. A more
recent explanation for the higher cost of equity capital in banks is based on the market segmentation between
deposits and capital and the positive role of capital as a way to reduce the bankruptcy costs of deposit taking
institutions (Allen et al., 2015).
Another important issue in current capital regulation is that it is based on accounting book values rather
than market values. The recent crisis has clearly showed that book values have important shortcomings, in
particular as they may prevent to discover insolvency risks at an early stage, thus preventing early intervention
at troublesome banks. Theoretically, it is unclear as to whether capital regulation should be based entirely on
accounting book values and not at all on market values. A related literature is the one on the use of mark-to-
market accounting for financial institutions (e.g., O’Hara, 1993; Allen and Carletti, 2008; Plantin, Sapra, and
Shin, 2008, Heaton, Lucas and McDonald, 2010). This literature highlights the trade-off involved. Valuing
banks’ assets at market prices has the advantage of reflecting the true value of their balance sheets. However,
if markets are flawed it may also lead to important inefficiencies in terms of increased price volatility and

14
contagion, suboptimal real decisions and reduced liquidity creation. Such inefficiencies should be taken into
account in investigating the extent to which capital regulation should be based on market capital.
3.2 Liquidity requirements
Whereas the literature on capital regulation, albeit focused on the microprudential role of capital, is
abundant, the one on liquidity requirements has just started. One explanation is perhaps the absence of liquidity
requirements as regulatory tool till the recent new Basel III accord.
Although the role of liquidity requirements still need to be investigated in detail, liquidity ratios should
aim at reducing the occurrence of panics and the occurrence of fire sales and mispricing of assets. To this end,
works on the role of liquidity regulation should focus on analyzing its effects on banks' incentives to take
risk/excessive maturity transformation, premature sale of long term assets and asset prices and depositors'
incentives to withdrawals.
One way of thinking of these effects is going back to the frameworks described above where banks
operate as providers of liquidity insurance and expose themselves to maturity transformation by choosing the
appropriate mix of long and short term assets they want to invest in. (Diamond and Dybvig, 1983; Goldstein
and Pauszner, 2005; etc.). Introducing liquidity requirements in these frameworks forces banks to increase the
investment in the short term asset relative to what they would choose in the absence of regulation, thus inducing
a reduction in the maturity transformation they operate. This will also possibly lead them to reduce strategic
complementarities and collective moral hazard, thus reducing also the need for public intervention ex post
(Fahri and Tirole, 2012). In terms of the premature sale of long term assets and asset prices, the introduction
of liquidity requirements should allow banks to better deal with liquidity shocks, thus leading to fewer assets
on sale and a lower likelihood of fire sales. This in turn should benefit the banking system as a whole as it
would lead to fewer bank failures and thus lower propagation of losses through the system.
What seems to be more unclear is the effect of liquidity requirements on the behavior of banks’
depositors and thus on the probability of occurrence of panic and fundamental driven crises. The reason is as
follows. On the one hand, as already mentioned, liquidity requirements reduce the premature liquidation (or
sale) of the long term assets, thus reducing depositors’ incentives to run out of coordination problems and
panics. However, by forcing banks to invest more in shorter term assets, which are typically less profitable
than longer term assets, liquidity requirements also reduce banks’ profitability in the longer run. This in turn
may lead depositors and investors more generally to run at the bank out of worries of inadequate resources of
the bank in the long run,that is out of fundamental driven reasons. Given these two contrasting effects, the
overall implications of liquidity regulation on bank stability is unclear. Much more work is needed in this
direction in the upcoming years, also looking at the interaction between capital and liquidity requirements.

3.3 Safety nets: central bank intervention and deposit insurance

Besides being a rationale for financial regulation, the fears of systemic risk and contagion have also
been used as reasons to justify public interventions and widespread support in the financial industry. This
15
support is provided through what is typically called “safety nets arrangements, namely a lender of last resort
facility and deposit insurance, or more generally, government guarantees. Although both the two instruments
represent a form of insurance for the banking system, they differ in their task, scope, time of application and
contractual arrangement.
The lender of last resort (LOLR) facility is assigned the task of preventing the emergence of systemic
crises by supplying liquidity to individual banks in distress. The exact scope and form of central bank
intervention are highly controversial in the academic literature. The main controversy centers on the trade-off
between the benefits (prevention of contagion) and the costs (distortion of incentives-moral hazard problem)
of bailing out distressed banks. According to Bagehot (1873), central banks have a role in lending freely at
time of crises in order to avert panics. Loans should be made at a penalty rate and only against good collateral,
so to be extended to illiquid but solvent banks. LOLR rules should be well defined and publicly announced.
This should discourage banks from using central bank facilities to finance current operations and should
prevent an indiscriminate rescue of all institutions. The need of the LOLR is due to the market’s inability to
deal with bank liquidity shocks because of the presence of asymmetric information about bank solvency. This
causes intermediaries not to be able to transmit credible information on the true asset value during a crisis.
This view has been highly criticized by Goodhart (1987), among others, on the ground that it is
virtually impossible, even for the central bank, to distinguish illiquidity from insolvency at the time the LOLR
should act. This implies that the Bagehot view of lending only to illiquid institutions is not practicable. Given
this, what matters for central bank intervention is not whether the bank is illiquid or insolvent but rather
whether its failures would propagate to the system. According to an even more extreme view (Goodfriend and
King, 1988), there is no need of LOLR to individual banks. Rather, open market operations are sufficient to
address pure liquidity risk on the interbank market.
Which view of LOLR is correct very much depends on the market failure LOLR wants to address. If
the goal is to prevent contagion and widespread failures, then individual liquidity assistance to banks in
difficulty may be needed, also because solvent banks may be unable to obtain liquidity from the market (Rochet
and Vives, 2004). By contrast, if the role of LOLR is only to provide hedging against liquidity risk, then open
market operations are sufficient to eliminate price volatility and fix prices so to allows banks to reallocate
liquidity from those with low (idiosyncratic) shocks to those with high shocks (Allen, Carletti and Gale, 2009).
Differently from the LOLR; deposit insurance has both the tasks of consumer protection and of
prevention of systemic crises. The main justification for the latter role is the model of Diamond and Dybvig
(1983), where the introduction of deposit insurance eliminates the bad panic equilibrium, thus leaving the good
equilibrium where banks optimal the first best allocation in the economy as the unique equilibrium. In other
words, deposit insurance is a way to eliminate depositors’ coordination problems and guarantee financial
stability when banks are subject to panic runs only.
Deposit insurance has been among the most common policy tools against financial fragility since the
financial crisis leading to the great depression. In the United States, that crisis has led to the understanding that
16
banks are inherently fragile due to a coordination failure among depositors, and that a way to stabilize them is
to provide deposit insurance by the government, such that depositors know that their money is safe even if
others rush to demand early withdrawal. This led to the establishment of the Federal Deposit Insurance
Corporation, which since then has had significant success in reducing the likelihood of runs. Other countries
have also adopted similar policies.
In the basic Diamond and Dybvig (1983) model, deposit insurance achieves perfect outcomes without
any downside. In it, the mere fact that the government guarantees the deposits acts to prevent runs, and so the
deposit insurance does not even have to be paid in equilibrium. Essentially, the whole effect of the deposit
insurance is achieved off the equilibrium path.
However, in reality things are clearly much more complicated than this. First, banking crises occur not
only due to panic but sometimes also due to bad fundamentals of the bank as we surveyed before. Hence, if
the government designs a system of guarantees it will likely need to pay depositors in some cases when
deteriorating fundamentals have led to a crisis. Then, the cost of paying the insurance has to be weighed against
the benefit in terms of reduced crisis likelihood. Second, the presence of guarantees is likely to affect banks’
choices of investments and liabilities. It is often argued that the bank will end up taking more risk when the
government provides deposit insurance, and so this is another cost of providing deposit insurance that has to
be considered against the benefit.
Overall, the question of optimal deposit insurance policy is still an open question that deserves more
research. Allen, Carletti, Goldstein, and Leonello (2014) provide recent theoretical analysis utilizing the
global-games methodology described above. The strength of this methodology is the ability to endogenously
pin down the probability of a crisis and how it is affected by the parameters of the model and also by the
guarantee scheme and by the resulting bank choices. This enables us to assess the benefits and costs of the
guarantees scheme. Allen, Carletti, Goldstein, and Leonello (2014) then provide analysis of the optimal design
of a guarantee scheme as well as the optimal size of guarantees under a particular scheme.

4. Regulatory reforms – what has been done?

European countries have undertaken a large number of regulatory reforms or are in the process of
doing so, ranging from higher capital and liquidity requirements for banks and a banking union for
the Eurozone to new regulatory frameworks for the insurance and investment fund sectors. We focus
on the main regulatory reform programmes and proposals over the past five years and concentrate
our discussion on the regulatory reforms in banking. The reforms involving banks range from
restrictions on business activities, and organisational structures to new regulatory tools and new
supervisory structures. The reforms involving non-bank financial institutions range from the mutual
fund and insurance sectors to transaction taxes and OTC markets.

17
 Our focus is on the initiatives affecting the European regulatory framework, although some
of these reforms such as the new capital rules, are transpositions at the European levels of more
international guidelines and accords.

4.1.Capital and liquidity requirements

The main regulatory reforms introduced after the 2007 financial crisis are contained in the new Basel
III regulatory standards. The new accord introduces a stricter definition of capital, a high quality and
quantity of capital, two dynamic capital buffers, a minimum leverage ratio, and two minimum
liquidity ratios.
The Basel III accord is implemented in Europe through the Capital Requirement Directive IV
(CRD IV), whose objective is to create a level playing field across countries. The package contains a
directive and a regulation. Key aspects of the Basel III accord such as the new definition of capital
and the liquidity requirements are included in the regulation and will thus be directly applicable in
the Member States. Others such as capital buffers, enhanced governance and other rules governing
access to deposit-taking activities are included in the directive and will therefore need to be transposed
into national laws with the usual discretion left to the national regulators to implement more stringent
rules (DFID, 2013).
As in the Basel III standards, the CRD IV leaves the minimum capital requirements unchanged
at 8 per cent of risk-weighted assets (to which the capital buffers have to be added) but, as in the
international accord, it requires banks to increase Common Equity Tier 1 (CET 1) from the current 2
per cent to 4.5 per cent of risk-weighted assets. The regulation defines CET 1 instruments using 14
criteria similar to those in Basel III and mandates the European Banking Authority to monitor the
capital instruments issued by the financial institutions. Banks are also required to maintain a non-
risk-based leverage ratio that includes off-balance sheet exposures as a way to contain the risk-based
capital requirement as well as the build-up of leverage.
To address the problems related to systemic risk and interconnectedness, the CRD IV
introduces also size restrictions in line with the prescriptions of the Basel Committee and the Financial
Stability Board. In particular, it prescribes mandatory capital buffers for global systemically
important institutions (G-SIIs) and voluntary buffers for other EU or domestic systemically important
institutions. G-SIIs will be divided in five sub-categories, depending on their systemic importance. A
progressive additional CET 1 capital requirement, ranging from 1 per cent to 2.5 per cent, will be
applied to the first four groups, while a buffer of 3.5 per cent will be applied to the highest sub-
category. Each Member State will maintain flexibility concerning the stricter requirements to impose
18
on domestic systemically important institutions (D-SIIs). This means that the supplementary capital
requirements larger institutions will be left to the discretion of the reciprocal supervisors, with
potential distortions in terms of level playing field.
Further, the CRD IV package contains a capital conservation buffer in the form of additional
common equity for 2.5 per cent of risk-weighted assets, as well as of a countercyclical buffer requiring
a further range of 0-2.5 per cent of common equity when authorities judge credit growth may lead to
an excessive build-up of systemic risk. Banks that do not maintain the conservation buffer will face
restrictions on dividend payouts, share buybacks and bonuses.
Member States have some flexibility in relation to the above mentioned capital buffers and
also relative to other some macro-prudential tools such as the level of own funds, liquidity and large
exposure requirements, the capital conservation buffer, public disclosure requirements, risk weights
for targeting asset bubbles in property bubbles, etc. For these tools Member States have the
possibility, for up to two years (extendable), to impose stricter macro-prudential requirements for
domestic institutions that pose increased risk to financial stability. The Council can however reject,
by qualified majority, stricter national measures proposed by a Member State.
In addition to changes in the capital requirements, the CRD IV package also introduces global
liquidity standards. Following again the Basel accords, two ratios are envisaged: a Liquidity Coverage
Ratio (LCR) to withstand a stressed funding scenario and a Net Stable Funding Ratio (NSFR) to
address liquidity mismatches. The LCR is a measure of an institution’s ability to withstand a severe
liquidity freeze that lasts at least 30 days. By contrast, the NSFR is designed to reveal risks that arise
from significant maturity mismatches between assets and liabilities. Special indications are provided
to the methods to be used to calculate these two ratios in terms of how to classify assets and liabilities,
maturity mismatches, etc.
Note also that the CRD IV leaves the possibility for European banks to zero risk-weight all
sovereign debt issued in domestic currency (Hay, 2013), while it assigns capital requirements
depending on the risk of the sovereign for non-euro denominated bonds. This is the same situation as
in the US currently, where Basel I, under which the sovereign debt of developed countries enjoys
zero-risk weighting, still holds. Discussions are ongoing at the moment as to whether to change the
favourable prudential treatment of European sovereign bonds following, in particular, the recent
ESRB report (ESRB, 2014).
In summary, the tighter capital requirements aim both for higher quantity and higher quality
of capital. However, they also complement the originally purely micro-prudential approach with a
macro-prudential approach, both related to the cross-sectional dimension (SIFIs) and to the time-
19
series dimension (capital buffers) of systemic risk. The new measures of liquidity requirements
recognize the close interaction of capital strength and funding ease.

4.2.Banking union, resolution frameworks, and bail-in instruments

One major financial reform in Europe concerns the creation of a banking union. This
comprises a single supervisory mechanism (SSM), a Single Resolution Mechanism, a Single
Rulebook and a harmonized (but, importantly, still decentralized) deposit insurance scheme. The
rationales for a banking union are various: 1) break the adverse feedback loop between sovereigns
and the financial system; 2) act as a pre-condition for bank recapitalisation through the European
Stability Mechanism (ESM); 3) create more distance between banks and regulators, thus preventing
forbearance and regulatory capture; 4) improve the effectiveness of supervision through the
implementation of a “single rulebook”.
The SSM, which is hosted by the European Central Bank (ECB), started its functioning on
November 4, 2014. In brief, the SSM is now the supervisor of all banks operating in the Euro area. It
supervises directly the largest 133 banks, accounting for approx. 85% of the assets of the banks
operating in the Euro-area, and, indirectly, all the other remaining banks. Banks in other European
Member States may voluntarily decide to be supervised by the SSM. Moreover, the SSM should
conclude Memorandums of Understanding with national authorities of non-participating Member
States to set the general terms of cooperation.
The SSM operates as any other normal supervisor in that it is empowered with the supervisory
tasks that can ensure the coherent and effective implementation of the prudential supervision of credit
institutions, in particular concerning the application of the single rulebook for financial services. For
example, the ECB has the power: to grant and withdraw banks’ licence authorisations, although in
compliance with national laws and subject to specific arrangements reflecting the role of national
authorities; assess the suitability of the purchase of significant stakes in credit institutions; monitor
and enforce compliance with capital regulation rules, limits to the size of exposures to individual
counterparties and disclosure requirements on a credit institution’s financial situation; require credit
institutions to dispose of sufficient liquid assets to withstand situations of market stress; and limit
leverage.
Other measures like additional capital buffers, including a capital conservation buffer, a
countercyclical capital buffer and global and other systemic institution buffers and other measures
aimed at addressing systemic or macro-prudential risk remain under the control of national
authorities. The SSM can request stricter requirements and more stringent measures than the ones
20
proposed by the national authorities. These rules apply only for the Macroprudential tools for which
there is a legal basis, which implies that at the moment all the instruments that are not included in the
CRD IV package such as loan-to-value ratios, i.e. the ratio of a loan to the value of an asset purchased,
remain with the national authorities, without the ECB having any possibility to intervene. This can
turn out to be an important shortcoming which we will discuss later in more detail.
The SSM retains powers to ensure that credit institutions have proper internal governance
arrangements, and if necessary, impose specific additional own funds, liquidity and disclosure
requirements to guarantee adequate internal capital. Moreover, the SSM has the tasks and the power
to intervene at an early stage in troubled credit institutions in order to preserve financial stability. This
should, however, not include resolution powers. Other tasks like consumer protection or supervision
of payments services remain with national authorities.
Specific governance structures have been put in place to maintain full separation and avoid
conflicts of interest between the exercise of monetary policy and supervisory tasks within the ECB.
In particular, the SSM’s Supervisory Board plans and carries out the SSM’s supervisory tasks and
proposes draft decisions for adoption by the ECB’s Governing Council. Decisions are deemed
adopted if the Governing Council does not object within a defined period of time that may not exceed
ten working days. The Governing Council may adopt or object to draft decisions but cannot change
them. A Mediation Panel to resolve differences of views expressed by the NCAs concerned regarding
an objection by the Governing Council to a draft decision of the Supervisory Board has been created.
The second pillar of the banking union concerns the Single Resolution Mechanism (SRM).
The objective is to manage resolution efficiently with minimal costs to taxpayers and the real
economy. As for the SSM, the SRM applies to all banks in the Euro Area and other Member States
that opt to participate Within the SRM, the Single Resolution Board (SRB) and of the Single
Resolution Fund (SRF) are established. The former, which started to operate on 1 January 2015 but
will be fully operational from January 2016, is the European resolution authority for the Banking
Union. It works in close cooperation with the national resolution authorities of participating Member
States in order to ensure an orderly resolution of failing banks according to the rules contained in the
Bank Recovery and Resolution Directive (BRRD). These include harmonized rules concerning
acquisitions by the private sector, creation of a bridge bank, separation of clean and toxic assets and
bail-in creditors.3

3
There has been an intense debate on the coordination between the provisions concerning bail-in in the BRRD directive
and those contained in the new state aid regulation. On this matter, see Kerle (2014) and Micossi, Bruzzone and
Cassella (2014).
21
 The SRB is in charge of the SRF, a pool of money constituted from contributions from all
banks in the participating Member States. The SRF has a target level of €55 billion (approx. 1% of
all banks’ assets of participating Member States) but has the possibility to borrow from the markets
if decided by the Board. It will reach the target level over 8 years.
The resolution process is quite complicated and includes various institutions. The decision to
resolve a bank will in most cases start with the ECB notifying that a bank is failing to the Board, the
Commission, and the relevant national resolution authorities. The Board will then adopt a resolution
scheme including the relevant resolution tools and any use of the Fund. Before the Board adopts its
decision, the Commission has to assess its compliance with State aid rules and can endorse or object
to the resolution scheme. In case of disagreement between the Commission and the SRB, the Council
will also be called to intervene. The approved resolution scheme will then be implemented by the
national resolution authorities, in accordance with national law including relevant provisions
transposing the Bank Recovery and Resolution Directive.

4.3.Activity restrictions
Another important set of reforms or proposal for reforms include activity, size and bonuses
restrictions. For sake of brevity, we describe them very briefly here and refer to Allen, Beck and
Carletti (2014) for a more detailed discussion.
The proposals on activity restrictions in Europe are contained in two reports, the Vickers
report in the UK and the Liikanen report in Europe. Both the Vickers proposal and the Liikanen
proposal aim at making the banking groups safer and less connected to trading activities so as to
reduce the burden on taxpayers. However, the two approaches present significant differences. The
Vickers approach suggests ring-fencing essential banking activities that may need government
support in the event of a crisis. In contrast, the Liikanen approach suggests isolating in a separate
subsidiary those activities that will not receive government support in the event of a crisis but that
will rather be bailed-in. Moreover, the two proposals differ in terms of what activities have to be
separated/ring-fenced. For example, deposits from and loans to large corporations have to be given
permission not to be ring-fenced according to the Vickers approach while they do not have to be
separated according to the Liikanen approach. Also, trading activities need to be separated under the
Liikanen approach only if they amount to a significant share of a bank’s business, while they are
never permitted within the ring-fence in the Vickers approach. 4

4
Table 1 compares in more detail the Vickers and the Liikanen reports, also with the Volcker rule in the US.
22
 To date, no structural reforms have been formally introduced in Europe. Following the
Liikanen report, in January 2014 the Commission has put forth a proposal for a regulation on
structural reforms but this has not yet been approved. Some individual countries, on the hand, have
been moving ahead with their national approaches, including the UK.

5. The traditional financial system in Europe – where do European financial systems stand six
years after the Global Financial Crisis

While not synchronized or similarly pronounced across all European countries, large parts of the
European Union and the Eurozone went through a credit bubble in the first decade of the 21st century,
followed by a bust in the wake of the Global Financial Crisis. Unlike the U.S., most European
countries have been very slowly in recognizing losses incurred during the crisis and forcing or
supporting banks in their recapitalization. The sluggish credit recovery over the past years has been
the backdrop on which the ECB has moved towards quantitative easing, though much later than other
leading economies, including the U.S, UK and even Japan, a delay partly explained by political
considerations.
There is an ongoing debate to which extent the current credit crisis reflects supply or demand
side constraints. Giovannini et al. (2015) report that there is no evidence for a shortage of long-term
finance in Europe, though there is large cross-country variation. Also, recent increases in long-term
funding have been more on the debt side, in the form of bank lending and corporate bonds. On the
other hand, initial public offerings (IPO) have declined in recent years, while secondary public
offerings (SPO) have increased. The recent crises have resulted in both supply constraints as well as
demand reduction in the bank lending market. In spite of recapitalization by governments and through
private markets and investors, Europe’s banking system continues in a rather weak position, at least
compared to the U.S. banking system.

Bank vs. markets? A new financial structure debate

Beyond concerns about the recovery of different components of the financial system across
Europe, the current discussion on the Capital Market Union has again raised the discussion on the
financial structure in Europe, not only within the Eurozone. While previous research has shown the
irrelevance (on average) for economic growth of the degree to which a financial system is bank- or
market-based, more recent research has shown that the relative strong reliance on Europe on bank
intermediation (both in absolute and relative terms) might explain the underperformance in growth
23
and the stronger impact of the recent crisis (e.g. Langfield and Pagano, 2015). This comes in addition
to the observation that certain segments of the financial system that are critical for the financing of
young and small enterprises are underdeveloped in most European countries, including the private
equity industry, venture capital and angel financing. These findings also serve as motivation for a
stronger focus on building sources of equity finance/capital markets in Europe, including the Capital
Market Union initiative.
The contrast between markets and banks, however, might be a wrong one. Most of finance
today is intermediated, even if it goes through public markets, such as public debt and equity
markets. Institutional investors, including insurance companies, pension and mutual funds pay a
critical role, which is also reflected, e.g., in the prominent role of institutional investors in the
ownership structure of publicly listed firms. On the other hand, there might be indications that there
are not sufficient sources of equity finance in the economy.
Financial intermediaries and markets also have other complementarities. Securitization is an
important connection between intermediaries and markets in the cross-section. IPOs of companies
financed by venture capitalists are an important connection over time, between financial
intermediaries and public markets.
The question, therefore, seems not necessarily in the contrast of two specific segments, but
rather in having a diversified if not complete financial system. And it is in this context that the focus
should be on specific segments of the financial system that play less of a role in Europe than other
developed regions of the world, including private equity funds, venture capital funds, and corporate
bond markets (Figure 1).
In this context, new players are emerging, including non-intermediated forms of bringing
savers and entrepreneurs together, such as peer-to-peer lending and crowd-funding platforms. These
platforms work with many borrowers and lenders, with an only limited role for the platform provider,
building on other social media models. Rather than on private information acquisition, these new
models of financial intermediation often rely on Big Data, collected on potential borrowers based on
social media. As we will discuss below, the emergence of new players is an important dimension of
financial innovation and contributes to the process of financial deepening. However, these new
players will eventually pose the question of the regulatory perimeter.

24
Figure 1: The Size of Venture Capital and Private Equity Industries in the US and European
Union
1.2

1.0

0.8

0.6

0.4

0.2

0.0
2012 2013 2014

VC EU %GDP VC USA %GDP

PE EU %GDP PE USA %GDP

Source: Figures for private equity are taken from the Zephyr Global Private Equity Annual Reports 2013-2014 published
by BvD. Venture capita data are from Dow Jones VentureSource Report 2014. GDP data are from OECD

Complexity and globalization

One striking phenomenon over the past decades has been a clear trend towards more complex
financial institutions, which results in serious challenges for regulators. Specifically, Cetorelli and
Goldberg (2014) report that while in 1990 only one U.S. bank holding company had more than 1,000
subsidiaries, in 2012 at least half a dozen had. Using data both for U.S. banks and non-U.S. banks
with branches in the U.S., they show that many of the leading banks have hundreds if not thousands
of subsidiaries, making it very hard for supervisors to properly monitor them (Figure 2). Complexity
can take on different forms, reflected not just in the number of subsidiaries, but also in the expansion
across different financial activities, including investment banking, insurance, mutual funds, and even
non-financial activities (Figure 3). In addition, banks have organized their increasing variety of
activities often in multi-tiered ownership relations, with up to ten levels of ownership links. Cetorelli
and Goldberg also show that while the number of affiliates and the share of non-bank activity are
positively correlated with the size of the parent bank, measures of business and geographic
complexity are not. Complexity is thus a bank characteristic, which is not completely correlated
25
with size; in addition to the challenge of too-big-to-fail, there is thus the challenge of too-complex-
to-resolve.

Figure 2: Number of subsidiaries for largest foreign banks in the US

Source: Cetorelli and Goldberg (2014)

Figure 3: Number of subsidiaries across different financial segments for largest foreign banks
in the US

Source: Cetorelli and Goldberg (2014)

Not just financial institutions, but also the regulatory framework has become more and more
complex over the past decade, with the Basel II capital regime being a watershed. Hakenes and
Schnabel (2014) use a theoretical model to show that it is in banks’ interest to push complex
regulation, in what they refer to as regulatory capture by sophistication. Specifically, in a world where
regulators are less well paid than bankers and with a variation in skills across regulators, regulators
might be swayed to rubber-stamp banks’ risk models in order to not have to admit that they do not
understand these risk models. This allows banks to hold less capital than required. This trend towards

26
sophistication and the resultant capture has been exacerbated by the Basel II regulatory framework,
which allowed the use of banks’ internal risk model to compute risk weights for different asset classes.
However, this phenomenon becomes more critical if the regulator has discretionary power, such as
under pillar II of Basel II. It is important to note that this type of regulatory capture by sophistication
is somewhat different from the regulatory capture due to conflict of interest, social connection
(rotating door), political interference or lobbying activity by banks.
Related with the trend towards complexity is the increasing globalization of banks, with the
leading global banks being active across a large number of regions and countries. In addition, over
the past decade there has been a trend towards regional banks, i.e. Latin American and African banks
reaching out across their respective regions. This poses additional challenges for supervisors in terms
of cooperation across borders. While this topic is somewhat outside the current survey, it is important
to be flagged.

6. Financial innovation – regulatory arbitrage, creation of fragility or contribution to financial

deepening?

Financial innovation is a very broad concept, but can be generally defined as new financial products
and services, new financial intermediaries or markets, and new delivery channels.5 Examples abound,
ranging from the introduction of the ATM/cash machine in the 1970s and mobile phone based
financial services in the 2000s, over the introduction of money market funds as alternative to bank
deposits, the emergence of venture capital fund to structured financial products. The above mentioned
intermediation platforms of peer-to-peer lending and crowdfunding also fall under the category of
financial innovation. Goetz and Rouwenhorst (2005) identify 19 major financial innovations,
grouped into innovations that (i) facilitate the transfer of value through time (e.g. savings accounts),
(ii) enhance the ability to contract on future values (e.g. venture capitalists) and (iii) increase the
negotiability of contracts (e.g.securitization).
The traditional innovation-growth view posits that financial innovations help reduce agency
costs, facilitate risk sharing, complete the market, and ultimately improve allocative efficiency and
economic growth, thus focusing on the bright side of financial innovation. Laeven, Levine and
Michalopoulos (2015) quote several historical examples where financial innovation has been critical

5
One can also refer to this as production, process and organizational innovation.
27
in allowing major technological innovation to be adopted on a broad scale. For example, specialized
investment banks emerged to facilitate the construction of vast railroad networks in the 19th and 20th
centuries across North America and Europe, screening and monitoring borrowers on behalf of
disperse and distant investors. In the second half of the 20th century, venture capital funds arose to
finance IT start-ups, characterized by limited if any tangible assets that could be used as collateral
and thus requiring patient investment capital and close screening and monitoring as well as technical
advice. And in recent decades, financial innovation has supported bio technology. Lerner and Tufano
(2011) undertake a counterfactual exercise, a “counterfactual historiography”, comparing real
development with hypothetical development in world without (i) venture capital and private equity,
(ii) mutual funds and exchange-traded funds and (iii) securitization. Their analysis points to overall
positive effects of these innovation that would not necessarily have been achieved with alternative
arrangements. There is also empirical evidence for the importance of both financial deepening for
innovation (Amore et al., 2013; Chava et al., 2013) as well as of financial innovation for economic
growth (Laeven et al., 2015). Beck et al. (2012) show that countries with higher innovative activity
in the banking system experience faster growth in industries with higher needs for external finance
and higher growth opportunities.
The innovation-fragility view, on the other hand, focuses on the “dark” side and has identified
financial innovations as the root cause of the recent Global Financial Crisis, by leading to an
unprecedented credit expansion that helped feed the boom and subsequent bust in housing prices
(Brunnermeier, 2009), by engineering securities perceived to be safe but exposed to neglected risks
(Gennaioli, Shleifer and Vishny, 2012), and by helping banks and investment banks design structured
products to exploit investors’ misunderstandings of financial markets (Henderson and Pearson, 2011).
Several authors have pointed to distortions introduced by financial innovations, such as securitization
and new derivative securities, and how they have contributed to aggressive risk taking, reduction in
lending standards and thus fragility (e.g., Keys et al., 2010; Dell’Ariccia, Igan and Laeven, 2008;
Rajan, 2006
Financial innovation has been often used for purposes of regulatory arbitrage or to get around
regulatory restrictions. For example, Euro-accounts were established in reaction to Regulation Q,
which prohibited payment of interest on sight accounts in the U.S. Another example is the use of
Special Purpose Vehicles (SPV), investment trusts to which bank off-loaded loan portfolios, in return
for securities issued by the SPV and often rated AAA. In total, banks set up conduits to securitize
assets worth $ 1.3 trillion, insuring the securitized assets with explicit guarantees (Acharya, Schnabl
and Suarez, 2011). The objective of such securitization operation was to save capital, as guarantees
28
were structured in a way to reduce regulatory capital requirements. Acharya, Schnabl and Suarez
(2011) show that the losses on these conduits had to be taken back on banks’ balance sheets during
the crisis as consequence of wholesale runs.
Taking a broader view, Freixas, Laeven and Peydro (2015) argue that financial innovation is
one of the key drivers of systemic risk. Financial innovation allowing for better risk management
and sharing might reduce idiosyncratic risk, i.e. the risk of individual financial institutions considered
on a stand-alone basis, while at the same time increase systemic risk as larger part of the financial
system are exposed to the same systematic or aggregate risk and/or increasing the appetite and
capacity to take on risk. This is confirmed by Wagner (2010) who shows theoretically that as banks
become more similar due to diversification of risks, systemic risk increases.
The use of financial innovation on the bank-level has provided somewhat contradictory
results. On the one side, Norden, Silva Buston and Wagner (2014) show that the use of credit
derivatives reduced corporate loan spreads in the U.S., suggesting that banks passed on benefits of
risk management benefits. The benefits were even stronger during the recent crisis, when banks with
higher holdings of such derivative positions cut lending by less. On the other hand, Nijskens and
Wagner (2011) show that even before the crisis the share price beta of banks trading credit default
swaps (CDS) or issuing collateralized loan obligations (CLOs) increased suggesting higher risk from
the use of these risk management tools. This effect is driven by higher correlation with the market
while volatility actually decreases, suggesting that while these risk management tools serve to reduce
idiosyncratic bank risk they actually increase systemic risk.
Financial innovation might also affect the incentives of financial intermediaries. Wagner
(2007 a, b) shows that financial innovation that reduces asymmetric information can actually increase
risk-taking due to agency problems between bank owners and managers, or because of lower costs of
fragility. Keys et al. (2011), for example, show how reduced incentives to screen borrowers in the
U.S. due to the possibility of being able to securitizing loans contributed to higher loan losses.
In summary, both theory and empirical work has shown that financial innovation can bring
benefits but also increased risks both by the design of products but also through changing incentives.
While financial innovation is thus critical for the development of the financial system, it also poses
significant challenges for regulators. Regulatory frameworks are designed in light of existing
products and providers. They are mostly rule-based (and intermediary-based), e.g. for liquidity
requirements only specific clearly defined assets are considered. Rule-based regulatory regimes have
the clear advantage of providing certainty, and reduce room for supervisory overreach. They also
guarantee a certain independence for supervisors, given the limited degree of freedom for
29
interpretation. On the other hand, rule-based regulatory systems are less adequate in reacting to new
products and markets as existing rules do not refer to them. A principle-based regime is more flexible
in this context, but might be more open to arbitrage possibilities.
While regulation might give rise to certain financial innovations, regulators in turn will try to
catch up with innovation, a process that Kane (1977) refers to regulatory dialectic. Compared to the
financial sector, regulators are at a disadvantage, as regulation (especially rule-based regulation)
refers to specific institutions, products and markets. Risk-based supervision would imply regulating
and supervising all financial intermediaries that offer the same products under the same regime. For
example, all institutions offering deposit services should be subject to the same prudential regulation.
We will discuss this issue in more detail in the next section.

7. Regulatory perimeter: Fragility in Banks vs. Markets

Much of the traditional regulation intended to improve the stability of the financial system is
concentrated in the traditional banking sector. This is based on historical experience, according to
which panics and runs were very pervasive in the banking sector and such failures tend to spread
across banks. Indeed, banks make themselves quite fragile with the way they structure their assets
and liabilities. They invest in long-term illiquid assets and finance themselves with demand deposits,
allowing people to come and demand their money back at any point in time. This causes banks to be
exposed to the risk of panic among depositors whereby they all demand liquidity at the same time
and the bank fails. Moreover, due to banks’ interconnections, such failures are likely to spread to
other banks.
The history of the banking sector in the US prior to the establishment of the Federal Deposit
Insurance Corporation (FDIC) and the Federal Reserve System is indeed plagued with many such
occurrences. The same is true for other countries, which are largely following and learning from the
US experience. Thus, financial stability regulation has focused to a large extent on stabilizing the
banking system. First, the FDIC provides deposit insurance, which guarantees deposits up to a certain
amount. This has proven quite powerful as a tool to tame panics, as depositors know that they do not
have to rush to the bank at the first sign of weakness, since their deposits are guaranteed and not
threatened by the withdrawal of others. Second, vast regulation on the amounts of capital, liquidity,
and other choices made by banks have been introduced to make banks safer and reduce the risk-taking
motive that might have been strengthened by the introduction of insurance. Many such regulations
are coordinated by the Basel committee.

30
 To a large extent, other financial entities operating in financial markets, such as mutual funds,
hedge funds, money-market funds, etc. have been left unattended by financial-stability regulation.
The idea was that they are different than banks, as they do not have the peculiar structure of demand
deposit contracts and they do not have the system of vast connections among institutions, and so they
do not put the system at a risk. A common theme is that prices should be allowed to fluctuate, people
should be allowed to take risk, and institutions should be allowed to fail as long as there is no severe
externality that they do not internalize which might threaten the system. This line of thinking,
however, has proven to be incomplete.
Over the years, other financial institutions have started taking on bank-like features. Perhaps
the most striking example is the Long Term Capital Management (LTCM) hedge fund which failed
in 1998. LTCM exposed itself to huge leverage in an attempt to enhance returns to shareholders.
Doing that, it also generated large risks, and indeed collapsed in 1998. Hence, the thinking that
deposit-type risk does not exist in such institutions was shown incorrect. Moreover, after the fact,
people have realized that LTCM was also at the heart of a system of vast connections to other
institutions, and so its failure put the system at the risk of systemic failure. Indeed, it took quite a bit
of effort from the side of US regulators to have all counterparties agree to a resolution that stabilized
the system. The failure of Lehmann Brothers in 2008, although different in many respects, carried
some similar lessons.
More generally, the fact that banks have been so heavily regulated has limited their ability to
provide credit and liquidity and led to the emergence of other institutions that had many features
similar to banks, but were not treated like banks or regulated like banks. The common name for such
institutions is “shadow banking”, for which the definition is somewhat unclear. It probably covers
everything that is not a traditional bank. Indeed, one of the key lessons from the last crisis is that
shadow banking has to be looked at and that the regulation of the financial system has to take an
integrative approach and consider the potential fragility of banks alongside shadow banks and not
just banks in isolation. The idea is that if you regulate only banks, other institutions will emerge to
replace them and take over their functions, and so it is important to prevent such a regulatory arbitrage
and regulate the system with a holistic view.
A case in point is the money-market mutual funds. These are funds that invest in bonds,
treasuries, and other such assets and have a liability structure that is very similar to banks.
Specifically, they promise investors the right to withdraw a fixed amount. This is known as a fixed
net asset value (NAV), whereby the net asset value promised to investors upon withdrawal is fixed.
Due to this feature, investors have been treating their claims in money-market funds as very safe and
31
used them like money for different transactions. This entity emerged to a large extent as a response
to regulation in the banking system: the limitations on the returns that banks can offer led investors
to demand this kind of vehicle that will offer a bank-like claim with a higher return. Regulation did
not treat money-market funds like banks and so they were free to do many of the things banks could
not do.
Over the years, money market funds did not experience many problems and the perception
that they are safe was validated in reality. But, during the years leading to the crisis, they started
investing in riskier securities, exposing themselves to the mismatch between very liquid liabilities
and less liquid assets, just like banks. This whole structure led to a crisis in the fall of 2008 when,
following the collapse of Lehmann Brothers, one money market fund could not honor its liabilities to
investors (this is known as ‘breaking the buck’). This almost unprecedented event has led to massive
runs in the industry across other money market funds. (For empirical evidence, see Schmidt,
Timmerman, and Wermers (2014) and for a discussion on regulatory implications Rosengreen
(2014)).
The events in the money-market funds led regulators in the US and other countries to realize
that regulation should not target just entities called banks, but more broadly other entities that look
like banks or offer services like banks. One of the conclusions has been that the fixed-NAV structure
is not sustainable and money market funds are thus moving into a structure of floating-NAV which
resembles the one used in other mutual funds. According to this structure, investors are not promised
a fixed amount when they withdraw, but rather the market value of their underlying assets as of the
day of redemption. This will surely decrease the extent to which money market funds look like banks
and the extent to which they should be regulated like banks.
However, the shift to a model of floating NAV does not prevent runs and panics. Recall that
runs are generated by the presence of a first mover advantage. Investors want to demand their money
when they think others will do so if the liability structure is such that the redemption by some investors
reduces the value to those who do not redeem. This is certainly the case with fixed deposits or money
market funds that have fixed NAV: Investors withdrawing early get the fixed amount and this reduces
whatever is left to pay to the remaining investors. But, Chen, Goldstein, and Jiang (2010) have
provided empirical evidence that such first-mover advantage exists also in floating-NAV funds.
The idea is that when investors take their money out of a mutual fund, they get the last updated
market value of the underlying assets. However, following large redemptions, the fund will have to
take actions and adjust the portfolio in the following days and this will hurt the value that remaining
investors can get. The problem is particularly severe in funds that hold illiquid assets. These are the
32
funds that provide the liquidity transformation (in the spirit of banks) and for them the costs of
portfolio adjustments following redemptions will be more pronounced. Indeed, Chen, Goldstein, and
Jiang (2010) have shown that there is a very different pattern in funds holding illiquid assets relative
to those holding liquid assets. The former exhibit much stronger sensitivity of outflow to negative
performance indicating that investors are more likely to take their money out fearing the redemptions
by others.
This force has shifted attention recently to bond funds. These are funds that invest in corporate,
government, and other types of bonds. They have grown tremendously in the US over the last few
years. This is again likely to be a response to the tightened regulation of banks. As banks find it more
difficult to lend, firms are issuing more bonds to address their financing needs, and mutual funds are
holding these bonds. The problem with bonds is that they are much more illiquid than equity, and so
the liquidity mismatch for funds that hold bonds is more severe. Goldstein, Jiang, and Ng (2015)
show in a recent paper that bond funds indeed exhibit different flow-performance sensitivity that
leads to more outflows upon bad performance and consistent with the fact that they lead to greater
first-mover advantage and fragility. They also show that this is amplified in times of aggregate
illiquidity.
If indeed bond funds create the trigger for panic, this can put pressure on the financial system
and the real economy in times of crisis. Vast evidence from the empirical literature on financial
markets has shown that outflows from mutual funds create persistent price pressure (e.g., Coval and
Stafford (2007) Manconi, Massa and Yasuda (2012), and Ellul, Jotikasthira and Lundblad (2012))
and that these price impacts can have real effects on firms’ activities (e.g., Edmans, Goldstein and
Jiang (2012) and Hau and Lai ( 2013)). Recently, Gilchrist and Zakrajcek (2012) show an effect of
market-driven credit spread on real economic outcomes.
In summary, financial regulation should view the system as a whole and consider the fact that
regulating parts of the system will likely shift activity to other parts and put them at the risk of
fragility. An integrative approach, which is now attempted by the Financial Stability Oversight
council (FSOC) in the US, is welcome and more of this approach should be implemented worldwide.
Fragility should be measured based on the activity that is being pursued and not based on the entity
pursuing it.

33
7. Looking beyond the feedback loop – creating arbitrage-safe regulatory frameworks

Our analysis suggests some high-level conclusions for an incentive-compatible regulatory framework
that ensures a thriving financial system that supports the real economy, while at the same time
minimizing the risk and the repercussions of bank fragility. We first point to some very general policy
lessons, with examples, before providing some concrete recommendations in the case of European
financial systems.

1. Complexity vs. simplicity: We need the right balance of (i) regulatory tools fine-tuned to the risk
decisions of financial intermediaries and market participants and (ii) simple tools that cannot be easily
circumvented. Both are meant to force banks to internalize the externalities from their possible failure,
but having both types of tools reflects the trade-off between the goal of perfect risk pricing and the
cost of market players searching for arbitrage options. Just to give two examples, one related to capital
buffers and the other to activities of banks. Risk-weighted capital-asset ratios try to force banks to
hold capital buffers appropriate for their level of risk-taking, while the leverage ratio is a back-stop
that prevents banks from excessively reducing capital through outsmarting the risk weight
system. Similarly, forcing banks to hold additional capital or impose higher risk-weights for specific
activities that expose the bank to higher risks and/or are not considered central to financial service
provision is a pricing-based tool, whereas outright prohibition of certain activities (e.g. trading on
own account) is a simpler tool to achieve the same. While a pricing-based tool might be better to
balance social benefits and costs, complete prohibition might be better in case of uncertainty about
(the distribution of) costs and benefits.
What does this imply for Europe? While the CRR and CRD IV translated the Basel III
agreement into European rules, the lessons from the recent crises have only partly been incorporated.
On the one hand, government bonds still attract a zero risk weight, thus not reflecting the riskiness of
sovereign credit even in many European countries. Maybe more worrisome (and maybe more
relevant), there are no concentration limits on government bond holdings by banks, unlike for other
asset classes. To our understanding, this issue is currently being discussed among supervisors. On
the other hand, the leverage ratio has been set rather low at 3%, while other jurisdictions aim for
higher ratios (4 or 5%). Critically, in the recent Comprehensive Assessment, the participating banks
were not subjected to and evaluated under stress tests with the leverage ratio as benchmark, but rather
only with risk-weighted capital-asset ratios as benchmark. This might also explain why market-based
assessment of capital shortfalls provide different bank rankings and calculations of total shortfall than
34
accounting-based calculations such as done under the Comprehensive Assessment (Acharya and
Steffen, 2015).

2. Complement micro- with macro-prudential regulation. As argued above, stability of individual

financial institutions does not imply systemic stability, so that a focus on systemic risk and thus
regulatory tools focusing on the whole financial system are important to complement micro-
prudential tools focusing on individual financial institutions. This has to happen both on the time-
series dimension, having disposable tools to reduce fluctuations and volatility in the credit cycle, and
in the cross-section, having disposable tools to address the interconnectedness of financial
institutions. Recent reforms have partly addressed these two dimensions, with counter-cyclical capital
buffers and additional capital buffers for systemically financial institutions (SIFIs). Most of the
toolbox, however, is focused on the supply side rather than on the user side, which might be an
important additional area of policy focus, as tools to smoothen the credit cycle on the user side
(especially in boom periods) have less space to be evaded if complemented with the necessary
financial conduct regulatory framework. Specifically, loan-to-value caps for individual loans can be
more easily circumvented than loan-value caps for borrowers.
This discussion is especially relevant for the European Union and even more so for the newly
established banking union. While the SSM can use macro-prudential tool covered under the CRR and
CRD IV, it cannot use other macro-prudential tools, which will remain exclusively under national
authority (Sapir, 2014). Given that not only micro- but also macro-prudential decisions have
externalities beyond national borders, this seems an important gap in the regulatory framework
constructed under the banking union. The ESRB, which does not have any formal powers beyond
issuing warnings and recommendations, cannot completely fill this gap. Finally, the CRD IV foresees
some flexibility in relation to some macro-prudential powers. In particular, member states have the
possibility, for up to two years (extendable), to impose stricter macro-prudential requirements for
domestic institutions that pose increased risk to financial stability. The requirements concern the level
of own funds, liquidity and large exposure requirements, the capital conservation buffer, public
disclosure requirements, risk weights for targeting asset bubbles in property bubbles, etc. The Council
can however reject, by qualified majority, stricter national measures proposed by a member state. A
more effective macro-prudential framework would pool the responsibility of all macro-prudential
tools, even if in a two-level structure. Different options can be considered, such as (i) leaving primary

35
decision power on the national level, with ECB and/or SSM having the right to impose stricter rules
or (ii) the SSM being the primary and only decision taker with input from national authorities.

3. Focus on resolution: given the externalities from bank failure, it is critical to have frameworks in
place to resolve financial intermediaries in a way that minimizes disruptions for the rest of the
financial system and the real economy, while allocating losses according to creditor ranking. An
incentive-compatible resolution framework has therefore not only important effects ex-post, i.e. in
the case of failure, but also important ex-ante incentive effects for risk-decision takers. Knowing what
happens in case of distress can provide the necessary incentives during normal times, i.e. risk decision
takers will adjust their decision if they know that returns in case of distress will reflect the creditor
ranking. To put it bluntly: Knowing that you will lose your shirt in case of failure can reduce
incentives to take aggressive risks. Providing feasible options for resolution of banks that minimizes
the externalities for the rest of financial system and the real economy also reduces the gap for financial
safety net managers between ex-ante optimal and ex-post optimal reactions to bank distress. One
important component of incentive-compatible resolution frameworks are living wills for large banks
that often have the status of too-big or too-complex-to-fail. These living wills spell out what would
happen in the case of failure – which parts of the bank will be wound down, which will be maintained
at any price as they constitute a public utility and which parts might be sold off. The critical advantage
of such tailored living wills is not just to prepare regulators for the worst-case-scenario, but can also
be used by regulators to force certain restructuring of financial institutions to make them “resolvable”.
This challenge is especially important in the light of the incomplete banking union for the
Eurozone. On the one hand, there has been substantial progress in strengthening (often non-existing)
resolution frameworks on both national and European levels. Many countries have introduced bank
resolution framework that take into account the special characteristics of banks and the need for swift
resolution, while maintaining the creditor ranking. The BRRD has introduced bail-in rules for
debtholders that aim to minimize the risk that taxpayers will have to be liable for bank losses. On the
supranational level, the Eurozone has made enormous progress in moving towards a supra-national
financial safety net, establishing both the single supervisory and the single resolution mechanisms.
On the other hand, however, the banking union, as it currently stands is not complete. The SRM seems
to be a rather complicated coordination mechanism, which involves several players. In addition, the
fact that the UK is outside the SRM will critically hamper its effectiveness, given the importance of
London as international financial center and many European banks having substantial parts of their
operation in London.
36
 Critically, a proper funding mechanism, including a public back-stop is missing. The target
size of the single resolution fund of €55bn would not cover any major bank failure, which leaves the
problem of too-big-to-fail unresolved in Europe. Even in the presence of much more rigorous bail-
in rules introduced under the BRDD, interim funding might be necessary as large banks are unlikely
to be resolved over a weekend. Finally and even more important than the limited self-funding, there
is no public back-stop funding mechanism in place, which reduces the effectiveness of the resolution
framework. Ultimately, this leaves again the failure of any large financial institution outside the
formal financial safety net and subject to political ad-hoc weekend negotiations. Even in a world
with high confidence in the competence, independence and integrity of the supervisory institution
and process, the shortcomings of these other two pillars will affect the SSM. How credible can a
supervisor be in threatening to close a bank if there is no water-tight resolution process in place?

4. Dynamic approach to regulation. As the financial system develops and financial innovation
creates new products and new providers, regulation and supervision have to adjust. This concerns
primarily and foremost the regulatory and supervisory perimeter. This would imply functional rather
than institutional regulation (“if it looks like frog and it quacks like a frog….”). This would also
imply that the regulatory perimeter has to be adjusted over time and that the focus of prudential
regulation (both micro- and macro-prudential) might have to shift over time as new sources of
systemic risks arise. One (negative) example was the sudden realization of the systemic importance
of AIG in the CDS market (and therefore in the global financial system) in autumn 2008, not having
been supervised thoroughly by prudential supervisors.
The question of the regulatory perimeter will arise for the SSM as much as for other bank
regulators and thus the challenge of potentially expanding regulation and supervision towards non-
bank segments of the financial system closely inter-connected with banks. It remains to be seen how
easy it will be for the SSM legally and politically to redefine its regulatory perimeter if it identifies
new sources of systemic risk, be they linked to the banking system or completely outside the banking
system.

8. Looking forward: What do we know, what do we not know yet and what should we know
The years since the crisis have seen an enormous increase in theoretical and empirical explorations
in both (idiosyncratic and systemic) risk measurement and micro- and macro-prudential regulation.
The overhaul of the regulatory frameworks across the globe was not only the result of lessons learned
from the recent crises but was also accompanied by extensive academic work. We have become
37
better at measuring risk and designing regulatory tools to reduce build-up of systemic risk and manage
it more effectively. Having said this, much of the discussion has been dominated by the last crisis –
as always: regulatory reforms after a crisis are designed to prevent the last but not the next crisis. We
have thus become better in analysing the known unknowns; this, however, leaves us with the
unknown unknowns, including financial innovation leading to new business models and new
structures in the financial system and thus new and future sources of financial fragility. As the
financial system develops, research and analysis (both academic and within central banks and
regulatory authorities) has to adopt to the dynamic nature of the financial system.

The four policy lessons discussed above, however, imply some important venues of further research.

1. Complexity vs. simplicity: several studies have addressed the issue of usefulness of risk-weighted
capital-asset ratios vs. leverage ratios in predicting bank-level fragility (e.g., Haldane, 2012;
Demirguc-Kunt, Detragiache and Merrouche, 2013). One important caveat, however, has been the
Goodhart critique – as a specific metric (such as the leverage ratio) becomes a policy tools, it might
become less effective. Comparing different measures of capital strength across banks and across
countries with different capital framework and regulatory frameworks with market-based measures
of fragility (where available) and possibly internal supervisory measures of fragility might provide
insights into the relevance and adequacy of different capital requirements. Using market-based
measures of tail risk will be important input into the analysis, as actual failures will most likely
continue to be rare. As much as more sophisticated measures of systemic risk contributions of
individual banks and covariance between different banks are necessary, the development of simple
rule-based measures of systemic risk will be important, especially in less transparent environment
where few banks are publicly listed and issue publicly traded securities so that little market-based
information can be used. Fine-tuning stress test tools based on detailed supervisory information will
be even more important in these environments.

2. Complement micro- with macro-prudential regulation: there have been few studies so far on
the effectiveness of macro-prudential regulation, both on the extensive (which tools) and intensive
(how much) margin (though see for example, Vandenbussche et al., 2015 and Claessens et al., 2014).
Similar to the assessment of the risk-taking channel of monetary policy on bank fragility, however,
loan-level data are necessary to gauge the effectiveness of macro-prudential tools on banks’ risk-
taking and fragility. Jimenez et al. (2014) is one of the few papers taking up this challenge; using the
38
Spanish credit registry data they assess both the introduction of dynamic provisioning in Spain in the
early 2000s and the relaxation during the crisis in 2008. Their conclusion is that the tool was effective
though not sufficient to prevent either credit boom or the credit collapse. The use of credit registry
data across different countries (and therefore different financial structures, different macro-prudential
tools and different economic structures) will be critical in getting a better assessment of what works
best in macro-prudential regulation.

3. Focus on resolution: As countries adopt bank resolution frameworks, an assessment of different

structures and designs (both in terms of tools and institutions) will be feasible in terms of impact on
banks’ risk taking, risk profile and fragility. Establishing causality will be difficult, but a combination
of market data (where available) and supervisory data will be one route forward.

4. Dynamic approach to regulation: one important area for future research will be to explore
different sources of systemic risk across the financial system, including in the shadow financial
system. Recent work by Koijen and Yogo (2014) has shown significant additional risks in the life
insurance sector stemming from life insurers moving liabilities off their balance sheets through
unrated shadow reinsurers in less regulated jurisdictions.

TO BE COMPLETED!

39
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 Table 1: Comparing the Structural Reform Proposals
Liikanen group report UK Vickers report US Volcker rule

Holding company with Permitted Permitted Not permitted

banking and trading
subsidiaries

Deposit-taking institution Not permitted (but other Not permitted (but other Not permitted
dealing as principal in group companies may do group companies may do
securities and derivatives so) so)
1/

Deposit-taking institution Not permitted (but other Not permitted (but other Not permitted
investing in hedge funds group companies may do group companies may do
and private equity so) so)

Deposit-taking institution Not permitted (but other Not permitted (but other Permitted
providing market making group companies may do group companies may do
services so) so)

Deposit-taking Unrestricted Restricted Unrestricted

institution’s non-trading
exposures to other
financial intermediaries

Higher loss absorbency Yes, via leverage ratio for Yes, as add-on to the For SIBs with substantial
rule 2/ trading business that conservation buffer for US footprint
exceeds size threshold UK ring-fenced bank

Size threshold for Yes; applies to all banks Yes; applies to all banks No
application with trading books larger and building societies with
than EUR 100bn, or deposits greater than
trading assets more than EUR 25bn
15-25 per cent of balance-
sheet

Enacted into law No Scheduled for completion Yes

by 2015

Implementing regulations No No No
finalised?
Notes:

1/ US federal government and agency securities, debt and securities issued by US state and municipal governments
and government-sponsored enterprises, and derivatives of these securities are exempt from proprietary trading
restrictions of the Volcker rule.

2/ The Dodd-Frank Act subjects US banks with assets in excess of USD 50bn to more stringent prudential
requirements. Similar requirements have been proposed, under the recent Intermediate Holding Company proposal,
for non-US banks with more than USD 50bn in global assets that have a systemically important presence in the US.

Source: Table 1 on p. 15 of Viñals et al. (2013)

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