Periodic Reporting for period 4 - TBTF (Addressing Too Big to Fail: Resolution, Organizational Structure, and Funding of Global Banks)
Berichtszeitraum: 2021-06-01 bis 2022-05-31
The research undertaken as part of TBTF has developed new theoretical frameworks to answer these questions, offering concrete guidance to researchers and policymakers. From a methodological perspective, this research has advanced the state of the art in financial intermediation theory by explicitly modeling the failure and resolution of global banks, emphasizing elements that are absent from leading theories: the design of mechanisms that allow for an orderly resolution of struggling global financial institutions, the incentives of national authorities in the regulation and resolution of global banks, the role of the corporate and organizational structure of global banks, the complexity of their regulation, and the determinants of their debt structure. The research has also generated significant insights into how investors can induce banks and firms to behave more responsibly and has investigated the ability of bank regulators to address climate-related financial risks and carbon externalities.
The objective of TBTF is to generate novel research insights that are directly relevant to regulators and policymakers, such as the EU’s Single Resolution Board and the European Central Bank.
Project research then turned to other ways financial regulators and market participants can address externalities generated by firms and financial institutions. One key finding in the article “A Theory of Socially Responsible Investment” (currently R&R at Review of Economics Studies) is that investors can indeed induce banks or firms to behave more responsibly. However, doing so requires that socially responsible investors who engage with a company are willing to make a financial sacrifice. This article also develops an investment criterion, the Social Profitability Index, to help guide the allocation of socially responsible capital. The article “Green Capital Requirements” turns to whether bank regulators can address risks and externalities resulting from climate change. The key finding of this research is that capital regulation can help the banking sector withstand financial risks resulting from climate change, such as extreme weather events, but is much less effective at addressing carbon emissions. Finally, the article “The Tragedy of Complexity” turns to the complexity of financial regulation (and other market outcomes). The setting reflects a typical situation for global banks: they deal with multiple regulators for different parts of their business (e.g. a bank capital regulator, a derivative markets regulator, etc.). This research shows that equilibrium regulation can become overly complex if each regulator considers only outcomes for its specific regulatory mandate. A more holistic view of the regulatory landscape could prevent this outcome.
The project’s research findings were disseminated via several channels, including seminar and conference presentations at academic institutions and presentations to policymakers (ECB, ESRB, Single Resolution Board, Bundesbank, Banque de France, Nederlandsche Bank, Federal Reserve, Office for Financial Research, etc.). To reach a broader audience, key research findings were also disseminated via several non-technical summaries (both written and video), some of which were geared towards interdisciplinary audiences (e.g. the Harvard Law School Forum). Some of the project’s research findings were presented to the ESRB General Board and summarized in an ESRB ASC Insight policy paper, reflecting that, as intended, the project’s research findings have already influenced policy. Finally, two project conferences were held at LSE to facilitate the dissemination and exchange of research findings and ideas.
For example, the research on bank resolution draws on the model of financing under asymmetric information proposed by Bolton and Freixas (2000) and extends this framework to capture the balance sheet of a systemic global bank. The model then adds relevant constraints, such as that national regulatory authorities are subject to domestic political economy constraints. Together, these ingredients allowed us to perform one of the first theoretical analyses of competing bank resolution frameworks and provide guidance for policymakers. The research on socially responsible investing innovates by extending a canonical corporate finance model (Holmström and Tirole, 1997) to include production externalities, such as systemic externalities caused by large financial institutions or carbon-emission externalities by industrial firms. The combination of these ingredients yields novel insights regarding the conditions under which investors can induce firms to “do good.”