The structure of regulatory revolutions

Austen Saunders and Rajan Patel

What can the history and philosophy of science teach us about regulatory reform? In this post, we borrow Thomas Kuhn’s idea of ‘scientific revolutions’ to argue that radical overhauls of regulation often occur after crises but that, once major reforms have been completed, it’s normal to have periods when rules do not change so much. For instance, major reforms made to banking regulations after the Global Financial Crisis of 2007–08 are now coming to an end with future change likely to be more incremental. This post is about why different circumstances call for these different approaches to regulatory change.

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Separating deposit-taking from investment banking: new evidence on an old question

Matthieu Chavaz and David Elliott

On 16 June 1933, as the nationwide banking crisis was reaching a new peak, freshly elected US President Franklin D. Roosevelt put his signature at the bottom of a 37-page document: the Glass-Steagall Act. Eight decades later, the debate still rages on: should retail and investment banking be separated, as Glass-Steagall required? In a recent paper, we shed new light on the consequences of this type of regulation by examining the recent UK ‘ring-fencing’ legislation. We show that ring-fencing has an important impact on banking groups’ funding structures, and find that this incentivises banks to rebalance their activities towards retail mortgage lending and away from capital markets, with important knock-on effects for competition and risk-taking across the wider banking system.

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The art of the deal: what can Nobel-winning contract theory teach us about regulating banks?

Caterina Lepore, Caspar Siegert, Quynh-Anh Vo

The 2016 Nobel Prize in economics has been awarded to Professors Oliver Hart and Bengt Holmström for their contributions to contract theory. The theory offers a wide range of real-life applications, from corporate governance to constitutional laws. And, as the post will hopefully convince you, contract theory is also helpful in regulating banks! To this end, we will unpack the outline of the theory and apply it to a number of real-world conundrums: How to pay banks’ chief executives and traders? How to fund a bank’s balance sheet? How to regulate banks?
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From Berlin to Basel: what can 1930s Germany teach us about banking regulation?

Tobias Neumann.

Two of the country’s largest banks collapse. The subsequent panic brings the banking system to its knees and only a costly government bail-out prevents even greater catastrophe. A radical re-think of regulation is needed. No, it’s not London or New York in 2008. It is Berlin in the 1930s. It’s when risk-weighted capital regulation was born, notably to be used alongside a range of other tools; for example, liquidity requirements and such modern ideas as bonus deferrals and capital conservation. But the idea that no single regulatory measure is likely to be sufficient on its own was forgotten. In 2008 it had to be painfully re-learned making this episode a striking example of the importance of studying past financial crises.

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It’s a model – but is it looking good? When banks’ internal models may be more style than substance.

Tobias Neumann.

Most large banks assess the capital they need for regulatory purposes using ‘internal models’. The idea is that banks are in a better position to judge the risks on their own balance sheets. But there are two fundamental problems that can arise when it comes to modelling. The first is complexity. We live in a complex world, but does that mean a complex model is always the best way of dealing with it? Probably not. The second problem is a lack of ‘events’ (eg defaults). If we cannot observe an event, it is difficult to model it credibly, so internal models may not work well.

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Are mortgages like potatoes? Unintended consequences in a world of many constraints

Authors: Renzo Corrias and Tobias Neumann.

When banks are subject to both a leverage and a risk-weighted constraint they may violate a fundamental law of economics: that of demand. In our theoretical model, some banks constrained by the leverage ratio react to an increase in capital requirements by investing more in the asset. This so-called ‘Giffen’ behaviour is very counterintuitive. One would assume the opposite to be the case: higher capital requirements should discourage lending. In our theoretical model, Giffen behaviour is likely to occur for firms that hold predominantly low-risk weighted asset and are therefore bound by the leverage ratio. The real-world equivalent in the context of mortgages would be building societies and, in the future, ring-fenced banks.
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