The Regulation of Systemically Relevant Banks: How Governments Should Manage Their Exposure to Banking System Risk

181 Pages·2018·11.946 MB·English

by  Sebastian C. Moenninghoff

Finanzwirtschaft, Banken und Bankmanagement I
Finance, Banks and Bank Management
Sebastian C. Moenninghoff
The Regulation
of Systemically
Relevant Banks
How Governments Should Manage
Their Exposure to Banking System Risk
Finanzwirtschaft, Banken
und Bankmanagement |
Finance, Banks and Bank Management
Reihe herausgegeben von
A. Wieandt, Königstein, Deutschland
S. C. Moenninghoff, Vallendar, Deutschland
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Sebastian C. Moenninghoff
The Regulation
of Systemically
Relevant Banks
How Governments Should Manage
Their Exposure to Banking System Risk
With a foreword by Hon.-Prof. Dr. Axel Wieandt
Sebastian C. Moenninghoff
Vallendar, Germany
Dissertation WHU – Otto Beisheim School of Management, Vallendar, Germany, 2017
ISSN 2524-6429 ISSN 2524-6437 (electronic)
Finanzwirtschaft, Banken und Bankmanagement | Finance, Banks and Bank Management
ISBN 978-3-658-23810-0 ISBN 978-3-658-23811-7 (eBook)
https://doi.org/10.1007/978-3-658-23811-7
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Foreword
Sebastian Moenninghoff´s thesis is dedicated to the perennial challenge that Too-Big-to-Fail
(TBTF) in banking poses for financial, economic and political stability – a field of research
that has received significant and increasing attention by both academics and regulators
since the financial crisis. TBTF implicit guarantees became explicit in the great financial
crisis of 2007-2009, with governments in the U.S. and Europe coming to the rescue of the
respective banking systems with extensive guarantees, comprehensive bad-bank schemes
and asset purchase programs, as well as significant recapitalizations of banks in trouble. In
response to the crisis and under pressure from taxpayers and voters, politicians declared
their intentions to abolish TBTF in banking. Since then, the competent regulatory bodies
have developed and the respective legislative bodies have enacted a specific regulation
targeted at systemically relevant banks and other financial institutions.
The thesis consists of three significant contributions to the research on TBTF and the
regulation of systemically relevant banks,
• a review of the empirical literature on TBTF in chapter 2,
• a conceptual/theoretical piece that allows for the discussion of regulatory policy
options in the context of an overall sovereign portfolio perspective in chapter 3,
• and an empirical event-study examining the impact of the new regulation of sys-
temically relevant banks on stock returns in chapter 4.
The conclusions drawn are clear and compelling:
• TBTF is a wide-spread phenomenon which creates significant (increasing in times
of asset price volatility) sovereign (and therefore tax-payer) exposure and concur-
rent wealth distribution effects, can lead to competitive distortions in banking
markets, and, might also impact bank behavior, notably risk taking behavior.
• There is no first-best regulatory solution to TBTF and the optimal policy design
depends critically on the (ex ante) risk appetite of any given society and needs to
take into account the implications for economic growth.
• Any kind of regulation that is specifically targeted at the largest, most systemical-
ly relevant institutions has to take into account potentially perverse incentives cre-
ated by an official designation as systemically relevant institution.
Chapter 2, “Consequences of Government Guarantees for Banks – A Survey of the TBTF
Doctrine”, provides a comprehensive literature review including the most recent contribu-
tions to the field. Starting point of the literature review is the concept of explicit or implicit
VI Foreword
government guarantees for banks. The discussion is organized according to a comprehen-
sive framework that distinguishes between the primary and secondary consequences of
government guarantees. Primary consequences are the resulting government exposure to the
banking sector and related wealth transfer / subsidies. Secondary consequences are compet-
itive distortions and the influence on bank risk-taking, i.e. moral hazard. This comprehensive
framework is new and original, and highlights the importance to distinguish between con-
sequences and related different methodological approaches when interpreting findings on
TBTF. This is an important contribution considering the extensive research body in this
field and the variance of results between different publications. The framework forms the
basis for a more granular discussion of how to measure the impact of TBTF on sovereigns
and banks, and how to regulate systemically relevant banks going forward. The significant
size of government exposure levels and competitive distortions revealed by several studies
during times of heightened market volatility is also presented graphically. Measurement
challenges are discussed in depth. A key conclusion from this chapter is that governments
need to measure (and potentially) report their exposure to the banking system and adjust
regulation accordingly. The chapter also identifies challenges in measuring the link be-
tween TBTF guarantees and bank (risk-taking) behavior. In summary, this chapter provides
a state-of the art review of the existing literature in the rapidly evolving field of TBTF,
provides a fundamental framework to discuss and categorize the extensive research body on
TBTF going forward, and sets the agenda for future research in the field.
Chapter 3, “Government Guarantees and Banking System Risk – A Regulatory
Framework from an Exposure Perspective” develops a government exposure perspective on
banking system risk and bank regulation. This perspective allows for a comprehensive
evaluation of the full range of regulatory banking options. The approach to combine stand-
ard credit risk theory and portfolio theory in a single framework for bank regulation is nov-
el and highly innovative and allows for a concise conceptual discussion and quantitative
comparison of a broad range of regulatory options, ranging from free and narrow banking
regimes (implying zero government exposure) over regulations such as minimum capital
and liquidity requirements, taxes, bail-in regimes, etc. (implying limited exposure) to a fully
nationalized banking system (implying full government exposure). The chapter first develops
the fundamentals of credit risk exposure in bank regulation. Building on a macro-financial
contingent claims approach of Bodie and Brière it then derives a stylized simulation model
to highlight and discuss the major trade-offs in regulating (systemically) relevant banks.
The optimal solution depends on the governments´ and henceforth societies´ risk prefer-
ences. The recent introduction of bank resolution regimes can be interpreted as a shift in
focus of regulation from reducing the probability of default to also reducing the exposure at
default in case of a banking crisis. All in all, this chapter elevates the discussion of bank
regulation to the next level, from a mere “call for more regulation” to a more nuanced dis-
cussion of risk preferences and tradeoffs. It is important to highlight that the discussion in
this chapter also includes a sub-chapter on limitations and avenues for future research.
Foreword
VII
Chapter 4, “Empirical Evidence from the New International Regulation Dealing with
Global Systemically Important Banks” builds on the paper “The perennial challenge to
counter Too-Big-to-Fail in banking: Empirical evidence from the new international regula-
tion dealing with Globally Systemically Important Banks” co-authored with Steven
Ongena, and myself, which has been published in the Journal of Banking and Finance. This
paper estimates how the designation of specific banks as Globally Systemically Important
Banks (G-SIBs) and announcements about the supervision and regulation of G-SIBs affect-
ed the relative stock returns of those banking organizations. The paper finds that, in general,
announcements about new regulations depressed G-SIB returns relative to returns of other
banks, but that announcements identifying specific banks as G-SIBs (or likely G-SIBs)
caused the returns of those banks to increase relative to those of other banks. According to
the paper, the empirical evidence indicates that any tendency of heightened supervision and
regulation to reduce funding advantages for G-SIBs was at least partly offset by announce-
ments that identify G-SIBs by name because those announcements reduced or eliminated
any doubts about which banks regulators view as TBTF. The paper has been widely quoted
in current research and policy papers, clearly demonstrating the uniqueness of the contribu-
tion, both in terms of the rigor of the empirical event study as well as the relevance of the
policy conclusions.
It has been a great privilege and a tremendous pleasure to supervise Sebastian Moen-
ninghoff´s thesis on the regulation of systemically relevant banks. I am looking forward to
having many more fruitful exchanges and discussions with him.

Königstein i. Ts., March 2018

Axel Wieandt
Preface
This dissertation was written during my doctoral studies at WHU - Otto Beisheim School
of Management. I wish to thank Professor Markus Rudolf, Professor Lutz Johanning and
Professor Axel Wieandt for valuable comments and discussions. I am deeply indebted to
Professor Axel Wieandt for continuous helpful guidance, important advice and constant
encouragement and support during this work. I want to express my profound appreciation
to Professor Steven Ongena for valuable guidance on the empirical analysis in Chapter 4. I
would like to thank Professor Günter Franke, Professor Hans-Helmut Kotz and Professor
Jan Pieter Krahnen for fruitful discussions at the beginning of my doctoral studies, and
Professor Douglas Diamond and Professor Randy Kroszner for valuable discussions during
my time at the University of Chicago Booth School of Business.

I would like to thank my parents and my wife Annette for their support.

Sebastian C. Moenninghoff
Table of Contents
1. Introduction .................................................................................................................... 1
2. Consequences of Government Guarantees for Banks – A Survey of the TBTF
Doctrine ........................................................................................................................... 3
2.1 Introduction .............................................................................................................. 3
2.2 Surveys of Government Guarantees for Banks ........................................................ 5
2.3 TBTF as a Consequence of Government Guarantees ............................................... 6
2.3.1 Consequences of government guarantees ....................................................... 6
2.3.2 The logic of the TBTF doctrine ...................................................................... 8
2.3.3 Alternative theories in the context of government guarantees for banks ........ 8
2.3.4 Empirical approaches to measuring the prevalence of TBTF ....................... 10
2.4 Gove rnment Exposure and Subsidies ..................................................................... 11
2.4.1 Contingent claims approach and absolute subsidy estimates ........................ 11
2.4.2 Funding advantages based on contingent claims approach and
rating-implied spreads .................................................................................. 13
2.4.3 Costs of past rescue measures....................................................................... 15
2.4.4 Summary of empirical evidence of government exposure and subsidies ..... 16
2.5 Comp etitive Distortions from Government Guarantees ......................................... 17
2.5.1 Dimensions of competitive distortions ......................................................... 17
2.5.2 Empirical approaches to measure guarantee-return relationships ................. 19
2.5.3 Empirical evidence of competitive distortions ............................................. 21
2.5.3.1 Competitive distortions by individual institution systemic
relevance .......................................................................................... 21
2.5.3.2 Competitive distortions by scope of activities covered by
guarantees ......................................................................................... 30
2.5.3.3 Competitive distortions by geography ............................................. 31
2.5.4 Summary of empirical evidence of competitive distortions ......................... 33
2.6 Government Guarantees and Risk Taking .............................................................. 34
2.6.1 The concept of moral hazard in banking ...................................................... 34
2.6.2 Empirical approaches based on guarantee-risk relationships ....................... 36
2.6.3 Empirical findings based on guarantee-risk relationships ............................ 36
2.6.4 Summary of empirical evidence of bank risk taking based on
guarantee-risk relationships .......................................................................... 39
2.6.5 Empirical approaches based on risk-return relationships ............................. 41
2.6.6 Empirical findings based on risk-return relationships .................................. 42
2.6.7 Summary of empirical evidence of bank risk taking based on risk-return
relationships .................................................................................................. 44
2.7 Conc lusion ............................................................................................................. 45