Bank failures and regulation: a critical review
| Published date | 15 February 2013 |
| Date | 15 February 2013 |
| Pages | 16-38 |
| DOI | https://doi.org/10.1108/13581981311297803 |
| Author | Mikael Petitjean |
| Subject Matter | Accounting & finance |
Bank failures and regulation:
a critical review
Mikael Petitjean
CORE, Louvain School of Management,
Universite
´Catholique de Louvain, Mons, Belgium
Abstract
Purpose – The purpose of this paper is to define the key components of an effective regulatory
regime.
Design/methodology/approach – The paper takes the form of a critical analysis.
Findings – Regulatory arbitrage has been one of the major factors contributing to the severity of the
crisis. Given the ever more complex set of future regulatory constraints, it may keep generating costly
negative spillover effects on the whole economy. Moreover, rules-based regulation, however carefully
constructed, will unfortunately never prevent bank failures. Neither should it attempt to do so. An
effective overall regulatory regime must be sufficiently comprehensive and well-balanced. It must not
put too much emphasis on lowering the probability of individual bank failure. The key components of
an effective regulatory regime must be: Basel-type rules robust to off-balance-sheet arbitrage; little
forbearance in monitoring and supervision by regulatory agencies, with a focus on systemic risk
control; automatic and quick intervention as well as resolution mechanisms. While all components are
necessary, none is sufficient; and without strong international coordination, none will be effective.
Practical implications – Enhanced supervision of banks.
Social implications – Less costly bank failures.
Originality/value – The paper presents a critical review of current financial reforms in the banking
sector.
Keywords Banks, Regulation,Bank failures, Basel
Paper type Research paper
1. Introduction
There is common agreement among both academics and responsible practitioners that
the upcoming regulatory environment must force financial institutions to internalize the
negative externalities that they generate from time to time on the whole economy.
Regulatory reform must in particular address the socially unacceptable mechanism that
lets banks privatize their profits when the sky is blue and socialize their risks when the
hurricane is unstoppable[1].
Regrettably, the massive support extended by governments and central banks to
the financial sector during the crisis has created the biggest moral hazard in history
and reinforces the perversity of such a mechanism. As pointed out by Acharya (2011),
the irony of the situation is that:
[...] letting Lehman fail in an attempt to draw a line in the sand and limit moral hazard was
also a miserable failure. In retrospect, it had precisely the opposite effect. Unless and until a
robust, time-tested resolution mechanism to deal with multiple, large financial firm failures is
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1358-1988.htm
JEL classification – G18, G28
The author would like to thank an anonymous referee for his comments, as well as
David Llewellyn for his encouragement and his suggestions for future research.
JFRC
21,1
16
Journal of Financial Regulation and
Compliance
Vol. 21 No. 1, 2013
pp. 16-38
qEmerald Group Publishing Limited
1358-1988
DOI 10.1108/13581981311297803
put in place, it is now clearer than ever that no government will accept to be on the brink of
collapse again by letting any other large complex financial institution fail. Given the current
regulatory environment, moral hazard has therefore been strengthened, not weakened.
Regulatory arbitrage is also likely to keep generating costly negative spillover effects
on the whole economy because of the ever more complex set of future regulatory
constraints. On the one hand, a regulation-free banking system is certainly not an
option. On the other hand, whilst preventive measures such as the micro-prudential
rules aimed at lowering the probability of bank failure are probably unavoidable as
part of an overall regulatory regime, they face strong limitations as a large part of
banks’ business is devoted to exploiting arbitrage opportunities and loopholes created
by regulatory innovations. In this respect, over-regulation does not necessarily slow
down financial innovation. It may even accelerate it because financial innovation is
then aimed at circumventing regulation and not so much at creating new added-value
products or markets. Excessive risk taking by banks is endogenous to the regulatory
process. The very regulation designed to reduce it is often unsuccessful or even
counterproductive. By circumventing existing rules, financial institutions take more
risk and increase the probability of bank failure.
To respond to this endogeneity issue, the top priority in the regulator’ agenda in the
years ahead must be to minimize the social costs of bank failures by focusing on
remedial measures. In the revised Basel Accord, too much emphasis is still given on
preventing bank failures by lowering the probability of individual bank failure.
As such, the economy-wide costs of bank failures are still likely to be huge when they
occur. Not only regulators must force financial firms to deal explicitly with systemic
risk but they must also hit the long and winding road towards better bank crisis
management.
The paper is structured as follows. In Section 2, we show how preventive measures
such as the Basel I and II micro-prudential rules have been made ineffective by
regulatory arbitrage. In Section 3, we review the key (proposed) changes under
Basel III. In Section 4, we discuss the “ring-fencing” regulation that is argued to help
better prevent bank failures. In Sections 5 and 6, we argue that more weight needs to be
given in the Basel Accord to intervention and resolution arrangements, as well as to the
control of systemic risk. In Section 7, we show that coordination and implementation at
the international level are strictly required. In Section 8, we conclude briefly.
2. Basel I and II micro-prudential measures
The price of risk is most of the time poorly set when regulators rely too much on a
rules-based, Basel II-type, micro-prudential approach. Regulatory attempts to prevent
bank failures by defining the amount of capital required for covering risk are
regrettably but constantly arbitraged by financial institutions. In this respect, the
current strategy of increasing the discretionary price of risk through higher capital
requirements (irrespective of the level of systemic risk) is theoretically desirable but
falls into many practical pitfalls.
In theory, the price of risk for some well-defined assets can be exogenously increased,
thereby requiring financial intermediaries to set more capital aside or simply reducing
the willingness of some of them to take the risk. In reality, market circumstances change
so frequently that such an exogenous price setting will often lead to a situation where the
price of risk in some markets will be understated or overstated. Such a risk mispricing
Bank failures
and regulation
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