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A roadmap for banking regulation, by HEC Paris Prof. David Thesmar

24 March 2014

On 12th March in the pleasant setting of the new Exane BNP Paribas building, just off Oxford Circus, HEC UK alumni have had an opportunity to hear David Thesmar, Finance professor at HEC Paris discuss a big question: “Can we fix the banking system?”  An avid crowd of about seventy banking professionals gathered to hear where academic research at HEC Paris stands this crucial question.

A roadmap for banking regulation, by HEC Paris Prof. David Thesmar - HEC Paris 2014

More than five years into the crisis, Europe is still feeling the pain. The cost of the last credit crunch was 3 per cent of global GDP and government bailouts saw up to 30 per cent of GDP transferred from taxpayers to bank stakeholders. For public policy makers, who are tasked with making banking regulation fit to prevent future crises, resolving the problems still faced by troubled banks is a number one priority.

Vulnerable banks

 Mr Thesmar shared extracts from three of his latest research papers on the topic. “This is what we do at HEC when we don’t teach, which is most of the time,” he said, introducing the first theme of the evening which was about evaluating banks’ vulnerability to systemic risk.
Central banks have already started to implement some findings from this research – no least, the FED, the ECB and the Banque de France.

Recognising that banks are inherently instable institutions because of their role in money creation and the fact they are highly leveraged institutions is the premise of Mr Thesmar’s work. “It led to two problems: bank runs and excessive leverage. Which led to more risk taking, and the credit crunch,” he says, “Regulation, in the form of deposit guarantees and capital requirement rules, such as Basel I & II, has proved inefficient to prevent the crisis”.

In fact, it is banks’ interdependence which has been the key change in the financial system. That is, the potential for one banks’ asset movements to affect the whole system. “Banking interdependence is a key development because it has increased coordinated failures. And not just across borders.” Mr Thesmar says. This calls for a new framework of macro-prudential supervision and regulation, in addition to the micro approach.

Through a few examples, Mr Thesmar explained the mechanisms that provoke contagion, where asset stress spreads through the market as certain banks have to deleverage their balance sheets. His research models evaluates across 90 banks in the EU, the “systemicness” of each bank based on which assets it holds and how susceptible to stress these assets are. From there,  aggregate vulnerability, the systemicness of the whole system, can be derived. This gives policymakers a tool which permits to test different controlling measures and their impact on the level of risk in the financial system –  whether it is capping bank size, reducing leverage, going for direct recapitalizations, direct asset purchase, or other.

For the record, Spanish and Italian banks top these rankings, but as size matters in measuring systemicness, large European bank names such as BNP Paribas and Societe Generale also appear in the Top 10 of the systemicness ranking.
 Source: HEC Paris

The repo market

The second topic that was covered that evening was interbank refinancing through the Repo market. Banks usually refinance using sovereign bonds as collateral. Because of this practice, sovereign stress has a direct impact on the cost of funding for banks, which in turn can cause bank distress.

A study of whether Central Clearing Counterparties (CCPs) provide a good mitigant to this sovereign risk contagion effect highlights that the market tends to price an implicit probability of default of the CCP itself, which is correlated to banks default. So CCPs are not the panacea – “therefore, they too should be regulated” concluded Mr Thesmar.

A roadmap for banking regulation

Mr Thesmar also touched upon the findings of a third paper about the “shadow banking system”, i.e. the nexus of non-banking financial institutions which also perform the activity of money creation. This is an ever rising part of the financial industry, and one that deserves to be factored in when looking at systemic risk: shadow banks pose similar concerns than banks (debt overhang, excessive risk taking and failures), however they are not regulated.

So what is the roadmap for regulators to navigate through the troubled waters of interbank connections? How to monitor and prevent contagion to the whole system? Mr Thesmar strongly advises for a proper mapping of banks’ interdependences, looking at the impact of asset fire sales and sensitivities in the Repo market as indicators. Additionally, he calls for better regulation of CCPs and the shadow banking system, to prevent excessive leverage and unnecessary risk-taking.

“Perhaps one way out of all this is “limited purpose banking”, a world where banks do not perform maturity and liquidity transformation, but where deposits are shares of mutual funds that can be exchanged for cash on a secondary market. This would be a true revolution in banking” – some food for thought for our London financiers but even more so, their regulatory bodies.

References

- Vulnerable Banks , Robin Greenwood, Augustin Landier, David Thesmar, NBER Working Paper No. 18537, Issued in November 2012
- Going for broke: New Century Financial Corporation, 2004-2006, Landier, Augustin, Sraer, David and Thesmar, David (2010) Going for broke: New Century Financial Corporation, 2004-2006. TSE Working Paper n. 10-199, September.


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