The current crisis and its high social cost have shattered the confidence of economic agents in the banking system and questioned the capacity of financial markets to channel resources to their best use. While it is essential for the well functioning of economic activity that financial institutions do take risk, the decisions taken by financial intermediaries have proven ex post to be excessively risky. So, what was wrong with financial regulation? How were overoptimistic expectations, short termism and inaccurate risk models implicitly encouraged? This book is devoted to exploring the general issue of the origins of excessive risk-taking in the banking industry. The four years since the start of the crisis, covering the period from the first turmoil in the interbank market to the fully fledged sovereign crises of 2011, gives us sufficient perspective to make a better assessment of some of the main issues and challenges it has raised. We focus here on the four main issues that provide the incentives for excessive risk-taking. Because it is the board of directors that is ultimately accountable for the level of risk that is taken in a firm, we start with financial institutions' corporate governance. We analyse whether, in their strategic decisions, board members consider their own bonuses, short-term stock price movements, shareholders' short-run interests (rather than stakeholders' long-run ones) or simply the financial institution's culture of risk. We next turn to the misperception of risks, related to managers' and shareholders' understatement of the business-cycle risk of downturn, as the procyclicality of capital may lead to excessive lending, the emergence of bubbles and a financial accelerator effect. The regulatory proposal of Basel III on countercyclical buffers is intended to solve this issue. Still, rigorous analysis of the procyclicality of banks' capital may indicate that the matter is more complicated than it seems. In a third chapter, we ask why neither supervisory authorities nor market discipline, which was given a preeminent role in Basel II, did a proper job. Is it true that information disclosure was inaccurate? Finally, in our last chapter we consider whether excessive risk-taking was the result of implicit guarantees such that all banks in distress expected to be bailed out. This implies that the way regulatory agencies and treasuries organise banks' resolutions is critical in determining future moral hazard. It is therefore worth considering how a bank in distress can be restructured in an orderly way - whether it is to be closed or bailed out in such a way as to preserve banks' incentives and be credible while limiting contagion to other banks. This volume will provide the analytical ammunition required to rigorously examine regulatory policy at a time when it is undergoing a complete metamorphosis.
Publisher: Centre for Economic Policy Research
Number of pages: 153
Dimensions: 246 x 172 mm
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