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2020 | Book

Why Banks Must Be Supervised? Read chapter Read first chapter

A Political Economy of Banking Supervision

Missing a Chance

Author: Damir Odak

Publisher: Springer International Publishing

Part of: Springer Professional "Wirtschaft+Technik" , Springer Professional "Wirtschaft"

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About this book

This book examines the effect of banking on the real economy and society, focusing on banking supervision as the decisive factor in steering banking activities and determining the social outcome of the game of finance.
Banking is like a cardiovascular system for our society. If it functions correctly, it allows the economy to operate smoothly. On the other hand, if it malfunctions it becomes a doomsday device. This creates an asymmetry of risks – the asymmetry between the potential dire consequences and the modest rewards of accepting those risks.
Banking was one of the critical technological factors enabling the transition from the middle ages and the creation of modern society. However, while today it contributes little to economic growth, its malfunction has a profound and lasting adverse impact.
The book explains why, how and what. Why is it important to keep tight supervision of the banks? How can banking supervision improve stability, not only of the financial system but also of the whole human society? What went wrong with the regulation in the past?

Table of Contents

Frontmatter
1. Why Banks Must Be Supervised?
Abstract
The banking provides the perfect breeding ground for the moral hazard. Banks create externalities called “financial or banking crises”. When crises occur, they cause immense damage to everyone. A critical feature of banking is its interconnectedness. It causes spread of the failure through the system and creates the “forest fire” effect. Control over the risks accepted by banks preserves financial stability. The financial stability is the precondition for economic growth and political stability. The market proves inefficient in achieving it. As a consequence, the government organises banking supervision. Fulfilment of the task requires the balanced regulation which keeps the banking system free enough to be competitive, while sufficiently restrained to prevent it from causing a mishap.
Damir Odak
2. How that All Come to Be?
Abstract
Finance is, always was and always will be a source of instability. By putting volatility into motion and controlling it, finance provides tremendous service. Bankers create money out of thin air—how could that be stable? The fruits of this instability facilitate trade, production and employment for improving people’s lives. The emergence of finance in the late thirteenth century facilitates the development of long-distance trade, ending medieval autarchy. The finance converts debt into money, removing limitations for business emerging from a limited amount of specie. Its attraction to law and order turned the rule of law into a competitive advantage. The price for all the benefits we have from finance is instability. Banking supervision has a task to keep it on the check.
Damir Odak
3. Big Depression—Events Forcing the Regulator’s Hand
Abstract
The consequence of relying on market discipline to guide finance is the worst global economic crisis ever. President Roosevelt decides to intervene radically. He stabilises heavily distressed banking by the introduction of deposit guarantee, strong supervision and structural separation. This scheme makes the banks’ liabilities more stable and cheaper.
Damir Odak
4. Great Recession—The Ugly Daughter of Deregulation
Abstract
The banking system in the Western world is stable during the Glass-Steagall period, from 1935 until the beginning of the “great recession”. Until the implementation of the Act, there are periodic banking crises in the US, followed by depressions. After 1935 there is no major banking crisis or depression until 2008. In the late twentieth century, investment bankers are itching to lay their hands on the liquidity in boring commercial banks. They convince the economists and politicians that liberalisation will create benefits for the economy. Economists get convinced despite lacking theoretical ground for such an expectation. Facing consensus of “industry and academy”, politicians then took a deep breath and jump. Later it is easy to blame supervisors for the consequences.
Damir Odak
5. The Asymmetry
Abstract
The growth of the financial system modestly influences the growth of the economy, while sharply increases the instability of the system. We do not live much better if the water supply pumps more water, but a failed water supply ruins our lives. During the Glass-Steagall period, structural separation keeps the asymmetry at bay. Innovative investment banking makes waves in capital markets freely, while protected by a legal wall, the dull commercial banking is what it is supposed to be, dull. The financial industry’s most devastating social impact emerges from the impact financial crises have on political stability. The failure of a large bank creates such a disruption that regulators reached a consensus that such banks should not “fail disorderly”.
Damir Odak
6. How Can Supervision Prevent Financial Crises?
Abstract
Supervision cannot prevent market disturbances, potentially causing a crisis. It retains its impact through long-term measures making the banking system more resilient to externals shocks. This process consists of five steps: setting standards, licencing, oversight, rectifying action and firefighting. The supervision is the application of those five steps in a coordinated manner. Performed in the correct order, they enable banks to withstand shocks without causing them. However, the regulatory requirement should be so balanced that investment in bank shares remains attractive. Otherwise, banks cannot raise the capital and meet the requirements.
Damir Odak
7. What Should Supervision Do?
Abstract
The supervision decides how much capital each bank needs. If new capital does not bring pro-rata new income, the return on the existing shares will decrease. Their value will fall. That is the reason why an increase in the capital never happens without compulsive regulation. A short trip through the accounting mirror presents a wonderland where the meaning of the word real is unreal, supervisors are white knights, and mighty accounting magic keeps zombie banks wandering around alive. The answer to the question: “What should supervision do?” is “Whatever it takes to make sure that the bank has required capital (and some more on top of it) and enough liquidity to timely meet all its obligations.”
Damir Odak
8. What Supervisors Should Not Do?
Abstract
Supervisors should not receive other tasks besides improving the resilience of the banking system. There are at least three reasons why it is not a good idea: distracting focus, public pressure on supervisor not related to supervision and the conflict of interest. A broader scope of supervisory responsibility potentially infringes the equality of banks before the law. Their rights can be significantly diminished compared with other persons, natural and legal. Should supervision consider the effects its measures have on the banks’ clients and should it use available tools and authority to achieve other political objectives besides the resilience of the banking system?
Damir Odak
9. Basel 1, 2, 3, 3&1/2
Abstract
The Basel Accord is an international standard in banking supervision. It is an agreement between supervisors. Based on it, jurisdictions create regulation. BiS checks compliance of authorities with the standard. Basel I—first international standard in banking supervision appears in 1988, 14 years after Basel committee begins its work. That is a bold step in the right direction, enabling global standardisation of the banking industry. Basel II—announced in 2004. Introducing the three-pillar approach and dealing with the risks Basel I neglected. Besides, it introduced IRB, probably the most devastating idea in the banking regulation. Basel III—2014 and 2017—nicknamed three and a half, an attempt to undo worst part of the Basel II. Unfortunately halfhearted, as reluctance to recognise mistake remains.
Damir Odak
10. Bank Failure and Resolution
Abstract
The perfect banking system would be too expensive. Therefore, the failure of banks is imminent, and we should be ready for it. Failing of individual weak banks is acceptable. However, only if the failure is correctly managed. The failed bank goes through resolution. It is a deliberately vague word with a lot of meanings. EU resolution framework assumes “open bank” resolution for strategic banks. It means that the bank would fail and resolve without any discontinuity in operations. Only shareholders and junior creditors of the bank are involved in the resolution. However, a lot of work needs to be done to achieve all preconditions for such a resolution. Most importantly, it would require improvement of the banks’ reputation.
Damir Odak
11. Banking Regulation in the EU
Abstract
The EU banking regulation is, as the EU itself, a unique structure in the world. Two unique features of EU banking regulation are single jurisdiction with several legal frameworks and several jurisdictions sharing the same legal framework. The pile of regulation applying to banks is enormous. Such nature of the regulation emerges from the nature of the EU. It is maybe unavoidable but is it useful to apply such a complex regulation on the institutions having literary all the money in the world to pay lawyers? There are promising recent changes, but as politics initially got cold feet the term gradually in their implementation now really means it. Our children will see their full impact.
Damir Odak
12. European Banking—Yesterday and Today
Abstract
US financial market is “the market”. It tells you the price, whether you like it or not. European financial markets are different. EU and Euro-area are very much bank-centric. The bulk of the assets is here immersed in stagnant pools of “hold to maturity” and “historical cost”. In the EU, everything is slower and exposed to judgement and discretion. The reality always catches up at the end, but it takes a while before it shows up. The crisis 2008–2009 demonstrated the difference very convincingly. While American banks had two terrible years and remained profitable ever after, EU banks were profitable throughout the crisis. However, from 2012 onwards they desperately try to crawl away from the grasp of reality going after them.
Damir Odak
13. What Now?
Abstract
What is the purpose of the extreme complexity of the banking rules? It creates a smokescreen for loopholes left there for good purposes. To help banks to finance the economy and abundantly shower homeowners and government with almost free financing. The strategy works well. Banking is stable, interest low, inflation almost non-existent. However, the approach is reasonable only if we are confident that no significant systematic event would happen soon. Summarising earlier chapters, this one tries to offer ways forward in the specific EU regulatory environment. It proposes regulatory reset, not as a radical change of the rules, but through adjustment of the parameters in the existing regulation. The purpose is single-minded, an increase in the resilience of the EU financial system.
Damir Odak
14. Glossary
Abstract
This chapter contains materials needed to understand other chapters if the reader is not familiar with the theory of economics, or is interested in going deeper into the mathematics behind some subjects. This chapter is not intended for reading as single integral text, but its parts are given as the references in the other chapters.
Damir Odak
Metadata
Title
A Political Economy of Banking Supervision
Author
Damir Odak
Copyright Year
2020
Electronic ISBN
978-3-030-48547-4
Print ISBN
978-3-030-48546-7
DOI
https://doi.org/10.1007/978-3-030-48547-4