Unit 8 Economic dynamics: Financial and environmental crises

8.10 Addressing instability of the financial system

Figure 8.22 brings together channels and feedback processes that amplify a fall in house prices. As discussed in Sections 8.3–8.9, these include the behaviour of both banks and households. The global financial crisis originated in the US housing market and although all high-income countries were affected by the financial crisis that followed, not all of them had experienced a house price boom and collapse.

In some countries, the financial accelerator amplified the housing booms and busts. In other countries, like Germany, for example, it is not possible to turn an increase in the value of your house into purchasing power enabling you to spend more on goods and services or housing (without selling the house). This is an example of how regulations, which vary across countries, can help stabilize the economy. We will discuss how new regulations followed the financial crisis.

The too big (or interconnected) to fail problem for policymakers

external effect, externality

An external effect occurs when a person’s action confers a benefit or imposes a cost on others and this cost or benefit is not taken into account by the individual taking the action. External effects are also called externalities.

When banks make loans and choose their financial structure, including their leverage, these actions impose external effects elsewhere in the economy.

Governments sometimes rescue banks that are considered too interconnected or too large to be allowed to fail but on other occasions—as in the case of Lehman Brothers—the government does not bail it out. The chaos created by the failure of Lehman illustrates the costs to the economy arising from the external effects of the decisions of banks. Banks know that a government bailout is possible and this leads them to take riskier decisions than they otherwise would. Although these riskier decisions increase the expected profitability of the bank, they increase the systemic risk to the banking system as a whole, and therefore, to the economy. As such, government bailouts of banks amount to providing them with an implicit subsidy, which is paid for by the taxpayer.

Riskier banks should face higher costs of funding their activities but this dampening mechanism is blunted because perceptions are widespread in financial markets that failing banks will be bailed out.

Figure 8.23 sets out the logic of bank–government interactions that reinforces excessive risk-taking by banks.

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https://www.core-econ.org/macroeconomics/08-financial-environmental-crises-10-instability-of-financial-system.html#figure-8-23

Figure 8.23 Bank–government interaction can produce excessive risk-taking by banks.

Figure 8.24 shows that greater confidence in bailouts reinforces the perception in financial markets of the implicit funding subsidy, which feeds into the choice of funding structure and hence into bank riskiness, which increases the probability of bank failure.

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https://www.core-econ.org/macroeconomics/08-financial-environmental-crises-10-instability-of-financial-system.html#figure-8-24

Figure 8.24 The external effect of the implicit funding subsidy to banks.

Regulation to mitigate the effects of ‘too big to fail’

The more successful governments are at dealing with failing banks without bailing them out, the lower the implicit subsidies are that they receive and the lower their incentive to take excessive risks. By reducing the external effects of bank behaviour on the rest of the economy, the interests of the owners of banks are brought into closer alignment with those of taxpayers.

The following policies to improve the regulation of banks follow from the logic of Figure 8.24 and have guided reforms that were implemented following the global financial crisis.

1. Raise the capital requirements for banks (reduce their leverage)

The business model of banks is to make risky loans, so all banks manage the risk that some loans are not repaid (default risk). But in the absence of regulation, they do not manage the risks that they impose on others (the external effect of their choices). They may take on too much risk, knowing that if it goes wrong, others will pay the price.

Taxpayers and depositors therefore delegate power to regulate and supervise banks to government authorities, whose job it is to make sure that banks do not take on excessive risks. Capital adequacy requirements⁠ are an important regulatory instrument for banks. They incentivize banks to properly manage risks by requiring shareholders, that is, the owners of the bank, to absorb losses. A higher capital requirement means the bank is less highly leveraged. This means that the fall in the value of its assets can be greater without the bank becoming insolvent (and taxpayers bearing the burden of a bailout). Its equity is squeezed (because the shareholders own the now less valuable equity), which is the same thing as saying that the shareholders bear the cost. Knowing this, the bank takes fewer risks.

2. Resolution regimes (dealing with failing banks)

Bank regulation is not intended to prevent banks from taking risks, and it is inevitable that some banks will fail. Indeed, just as in other markets, entry and exit are desirable to stimulate innovation. What is important is that the failure of a bank can be managed in an orderly fashion so that its critical functions are preserved and losses to the economy are minimized.

As the case of Lehman illustrates so dramatically, a mechanism is needed when a systemically important (large/highly connected) bank is in danger of failing.

resolution

The process of closing or restructuring a bank without interrupting its critical economic functions. Bank shareholders and some or all of the bank’s creditors bear the losses, instead of taxpayers. One approach to resolution is bail-in. See also: bail-in.

bail-in

A bail-in resolution is a way of allocating losses to a bank’s shareholders and potentially to some of its creditors. The bail-in procedure follows a legal order of priorities in terms of liability. The first step is to ‘write down’ the bank’s equity capital to reflect the losses incurred: that is, to reduce the value of the shareholders’ equity. If these funds are insufficient, other liabilities, such as bonds, are written down or converted into equity.

This mechanism is called a resolution regime for banking. It is a regulatory structure through which a failing bank is closed or restructured in such a way that its critical economic functions are not disrupted. Banks can be resolved in a number of ways, but in all approaches, losses are imposed not on taxpayers or bank customers but on bank shareholders and on some or all creditors such as the financial institutions who lent to the bank by buying its bonds.

To ensure this, the resolution regime will require that a bank is better able to absorb losses as discussed in (1) above. The second element is to use the mechanism of ‘bail-in’ to ensure that the owners of bank bonds bear losses before any are borne by the taxpayer. ‘bail-in’ means that bond holders are treated—in the case of bank failure—like owners and they will not be repaid (at all or in full). This contrasts with a bail out, where taxpayers rather than bondholders can end up paying the price of the failure of the bank.

To explore these issues further with specific examples, watch economist and bank regulator, Claudia Buch, describe the lessons from more than a decade of financial sector reforms following the financial crisis.

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Watch this video of Claudia Maria Buch, one of the authors of the Insight ‘Too big to fail: lessons from a decade of financial sector reforms’.

To summarize our discussion of the housing and banking crises, falling house prices in the US were amplified through the banking and broader financial system to affect the functioning of the macroeconomy, plunging the world into the global financial crisis. In many countries, the economy moved past the tipping point with widespread bankruptcy of construction firms, repossession of homes, failures of banks, and the need for drastic government and central bank action, which left a legacy in high levels of government debt and vulnerability to the next crisis—the 2020–2022 COVID-19 pandemic.

Climate scientists warn of processes very similar to house price crashes with catastrophic tipping points in the global climate, to which we now turn.