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Banks and Governments, Happily Ever After October 7, 2011 Anna Gelpern American University Washington College of Law Overview Bank-Government Marriage I. A. Bailouts B. Financial Repression C. Regulatory Nexus D. Cross-Border Dimension

SLIDE 1

Banks and Governments, Happily Ever After

October 7, 2011

Anna Gelpern American University Washington College of Law

SLIDE 2

Overview

 I.

Bank-Government Marriage

A. Bailouts
B. Financial Repression
C. Regulatory Nexus
D. Cross-Border Dimension

 II. Pros and Cons  III. What Is to Be Done?

A. Divorce
B. Bankruptcy and Resolution
C. Tiering and Contingent Instruments

SLIDE 3

Overview

 I.

Bank-Government Marriage

A. Bailouts
B. Financial Repression
C. Regulatory Nexus
D. Cross-Border Dimension

 II. Pros and Cons  III. What Is to Be Done?

A. Divorce
B. Bankruptcy and Resolution
C. Tiering and Contingent Instruments

SLIDE 4

I.A. “Bailouts”: Bank DebtGovernment Problem (Ireland)

Sources: Financial Times, Baglioni & Cherubini (2010)

SLIDE 5

I.A. Bailouts: Problems

 Fiscal Cost (but see Rogoff & Reinhart 2009)  Moral Hazard, Distortion  Accountability

SLIDE 6

I.B. Financial Repression in Crisis: Government DebtBank Problem (Portugal)

5000 10000 15000 20000 25000 30000 Q1 2009Q2 2009Q3 2009Q4 2009Q1 2010Q2 2010Q3 2010Q4 2010Q1 2011 ECB Purchases?

Source: Banco de Portugal

SLIDE 7

I.B. Financial Repression

(Shaw 1973, McKinnon 1973 … Reinhart et al. 2011a, b, c) Methods Problems

 Capital Controls  Reserve Requirements and

Prudential Regulation

 Interest Rate Ceilings  Directed Lending

 … to Government

 Taxation  Inflation  Low Growth  Moral Hazard, Distortion  Transparency/

Accountability

SLIDE 8

I.B. Financial Repression as State of Being

Source: Financial Times and Japanese MoF

SLIDE 9

I.A+B. Bailouts+Repression = Marriage

 Banks save governments (Portugal, Japan)  Banks sink governments (Ireland, Iceland)  Governments save banks … then sink them (Ireland)  Governments sink banks … then save them (Argentina)

Secular? … Cyclical? … Structural? (Cf. Alessandri & Haldane 2009, Reinhart et al. 2011)

SLIDE 10

I.C. Bank-Government Regulatory Nexus

 LOLR  Deposit Insurance  Ex-post Guarantees  Recapitalization  Solvency Regulation (Capital)  Other Prudential Regulation (eg, Concentration Limits,

Affiliate Transactions)

 Liquidity and Collateral Eligibility  Business Conduct Regulation  Reserve Requirements

Dodd-Frank Act, Sec. 619 (Volcker Rule):

Notwithstanding the restrictions under subsection (a), … the following activities … are permitted: (A) The purchase, sale, acquisition, or disposition of obligations

f the United States or any agency thereof …

SLIDE 11

I.D. Regulatory Nexus: Cross-Border Dimension

Assets Liabilities and Capital

Cash 5 Own Gov’t Bonds 10 Loans, Private Sector 100 TOTAL: 115 Deposits 82 Commercial Paper 25 Common Stock 8 TOTAL: 115

SLIDE 12

I.D. Cross-Border Implications: Greek Government Debt in EU Banks

Source: EBA 2011

SLIDE 13

I.D. Cross-Border Dimension:

Third World Debt (1982)

Source: William R. Cline (1995)

130.1%

SLIDE 14

II. Marriage Pros and Cons

Pros Cons

 Risk-Free, Information-

Insensitive Asset

 Mutual Safety Net  Financial Stability (if

liquidity)

 Distortion

 … Moral Hazard

 Delay (if solvency)

 More Losses

 Transparency

 Accountability  Distribution

SLIDE 15

III. What Is to be Done?

 Divorce: Separate Banks from Governments, No-Bailout

Promises

 Ex Post: Financial Resolution and Sovereign Bankruptcy  Ex Ante: Tiering and Contingent Instruments

SLIDE 16

III. Tiering and Contingent Instruments

 Purposes:

 Transparency

 Reflect true bank-government relationship

 Mitigate distortion

 Force recapitalization/debt restructuring  Limit moral hazard

 Risk/loss distribution

 Domestic  Cross-border (home-host fighting)

 Preserve stabilizing function

SLIDE 17

III. Tiering and Contingent Instruments

 Asset side

 Formal priority/hierarchy of reserve assets  …limited collateral eligibility  …limited risk-free treatment for CAR purposes

 International Reserve Asset?  Liability side

 “Dormant CoCo” – automatic regulatory recapitalization  “College” capital – pre-committed recap pool for

internationally active banks

 Based on assets + deposit liabilities (Home + host

commitment)  Objections: … credibility?

SLIDE 18

Banks and Governments, Happily Ever After

… or “George and Martha—sad, sad, sad…”

Source: Warner Bros