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Banking System Stability and Bank Regulation

Final Report Summary - BANSYSREG (Banking System Stability and Bank Regulation)

This project tried to understand the relationship between bank competition and stability, between ownership structure and stability and the optimal regulatory framework in a global financial system and based on experiences from the recent crisis.

The project has produced several papers, two of which have been already published in academic journals, has helped start new work in the area of bank stability and supported the compilation of a database.

The main results of the project can be described as follows:

In the paper “Bank Ownership and Stability: Evidence from Germany” (joint with Heiko Hesse, Thomas Kick and Natalja von Westernhagen), we find consistent evidence that privately-owned banks are less stable than government-owned savings banks and cooperative banks. We also find evidence for the Too-Big-To-Fail phenomenon, as larger privately-owned banks hold less risk-weighted capital than their smaller peers, thus moving closer to insolvency, but face lower distress probability. Cooperative or savings banks, on the other hand, are more stable if larger. This paper could not be published due to a veto imposed by the Bundesbank, on whose data we relied for the analysis.

In the paper “Bank Competition and Stability: Cross-country Heterogeneity” (joint with Olivier de Jonghe and Glenn Schepens), we documents large cross-country variation in the relationship
between bank competition and bank stability and show that an increase in competition will have a larger impact on banks’ fragility in countries with stricter activity restrictions, lower systemic fragility, better developed stock exchanges, more generous deposit insurance and more effective systems of credit information sharing. The effects are economically large and thus have important repercussions for the current regulatory reform debate, as changes in regulations might affect the relationship between competition and stability. This paper has been published in the Journal of Financial Intermediation

In “Bank Failure Resolution: A Conceptual Framework” I present a conceptual framework to discuss the trade-off in bank resolution between (i) minimizing the external costs of bank failure and (ii) imposing market discipline. I show how resolution can be influenced both by the legal, regulatory and institutional frameworks as by agency problems between different stakeholders of the financial safety net, most prominently banks, regulators and tax payers. Critically, I discuss how failure resolution tools and preferences vary across banks of different size and importance and between idiosyncratic and systemic bank failures. This paper has been published in a book; Panagiotis Delimatsis and Nils Herger (Eds.): Financial Regulation at the Crossroads: Implications for Supervision, Institutional Design and Trade.

In “Supervising Cross-Border Banks: Theory, Evidence and Policy” (joint with Radomir Todorov and Wolf Wagner) we analyze the distortions that banks' cross-border activities, such as foreign assets, deposits and equity, can introduce into regulatory interventions. We find that while each individual dimension of cross-border activities distorts the incentives of a domestic regulator, a balanced amount of cross-border activities does not necessarily cause inefficiencies, as the various distortions can offset each other. Empirical analysis using bank-level data from the recent crisis provides support to our theoretical findings. Specifically, banks with a higher share of foreign deposits and assets and a lower foreign equity share were intervened at a more fragile state, reflecting the distorted incentives of national regulators. We discuss several implications for the supervision of cross-border banks in Europe. This paper has been published in Economic Policy.

In “Supranational Supervision: How Much and for Whom?”(joint with Wolf Wagner) we argue that the extent to which supervision of banks takes place on the supra-national level should be guided by two factors: cross-border externalities from bank failures and heterogeneity in bank failure costs. Based on a simple model we show that supranational supervision is more likely to be welfare enhancing when externalities are high and country heterogeneity is low. This suggests that different sets of countries (or regions) should differ in their supranational orientation. We apply the insights of our model to discuss optimal supervisory arrangements for different regions of the world and contrast them with existing arrangements and current policy initiatives. This paper has been published as working paper

The project has also supported the start of new research, including a research project on the effect of portfolio specialization/diversification on bank stability (joint with Olivier de Jonghe). It is expected that this research will lead to a paper within a few months.

The project has also supported the compilation of a database on bank resolution across countries, by compiling data on how failed banks were resolved across countries over the past 20 years, i.e. by liquidation, restructuring, merger and acquisition etc., and how long it took. This database will serve as input for future research.