Last autumn, Charles Goodhart gave a special lecture at the Bank. In this guest post he argues that regulators should focus more on the incentives of individual decision makers.
The incentive for those in any institution is to justify and extol the virtues of the decisions that they have taken. Criticisms of current regulatory measures are more likely to come from outsiders, perhaps especially from academics, (with tenure), who can play the fool to the regulatory king. I offer some thoughts here from that perspective. I contend that the regulatory failures that led to the crisis and the shortcomings of regulation since are largely derived from a failure to identify the persons responsible for bad decisions. Banks cannot take decisions, exhibit behaviour, or have feelings – but individuals can. The solution lies in reforming the governance set-up and realigning incentives faced by banks’ management.
Deposit insurance schemes guard against bank runs by reducing or removing individual depositors’ incentives to withdraw their funds if they believe their bank to be in trouble. They help protect depositors but they risk also protecting risky bank business models by removing depositors’ incentives to avoid riskier banks. What can be done about this? In the past the answer was sometimes to make small depositors bear part of the risk through “co-insurance”. This was proven not to be credible. In this blog I consider some of the options available, including the risk-based levies currently being introduced in the EU and elsewhere, and increased transparency, drawing on recent literature on the saliency of tax in consumer choices.
The collapse of Northern Rock in 2007 and Bear Sterns, Lehman Brothers, and AIG in 2008 renewed the debate over how a lender of last resort should respond to a troubled systemically important financial institution (SIFI). Based on research in the Bank of England Archive, this post re-examines a crisis in 1890 when the Bank, supported by central bank cooperation, rescued Baring Brothers & Co. and quashed a banking panic and a currency crisis, while mitigating moral hazard. This rescue is significant because it combined features similar to those mandated by recent U.K., U.S., and European reforms to ensure an orderly liquidation of SIFIs and increase the accountability of senior management (e.g. Title II of the Dodd-Frank Act (2010); the U.K. “Senior Managers Regime”).
We find evidence that certain types of macroprudential regulation are avoided by borrowing from abroad. Borrowing by the non-bank sector from abroad increases after an increase in capital requirement, but not after an increase in lending standards. This is likely to be because of the way that the two regulations are applied and is supportive of strong frameworks for reciprocating capital regulation.
In June of 1974, a small German bank, Herstatt Bank, failed. While the bank itself was not large, its failure became synonymous with fx settlement risk, and its lessons served as the impetus for work over the subsequent three decades to implement real-time settlement systems now used the world over. Documents from the Bank of England’s Archive shed light on a lesser known aspect of Herstatt’s failure – the chain reaction it caused across financial centres as banks in different countries delayed settling their payments to each other. The lesson for policymakers today to grapple with is: when a bank fails, could we still expect surviving banks to delay making payments, with a potential chain reaction in the payment system?