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Journal of Financial Services Research

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18-04-2018

The Interplay among Financial Regulations, Resilience, and Growth

Authors: Franklin Allen, Itay Goldstein, Julapa Jagtiani

Published in: Journal of Financial Services Research | Issue 2-3/2018

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Abstract

Interconnectedness has been an important source of market failures, leading to the recent financial crisis. Large financial institutions tend to have similar exposures and thus exert externalities on each other through various mechanisms. Regulators have responded by putting in place more regulations with many layers of regulatory complexity, leading to ambiguity and market manipulation. Mispricing risk in complex models and the arbitrage opportunities through the regulatory loopholes have provided incentives for certain activities to be more concentrated in the regulated entities and for other activities to leave the banking into new shadow banking areas. How can we design an effective regulatory framework that would perfectly rule out bank runs and TBTF and to do so without introducing incentives for financial firms to take excessive risk? It is important for financial regulations to be coordinated across regulatory entities and jurisdictions and for financial regulations to be forward looking, rather than aiming to address problems of the past.

next article Financial Stability and Resolution of Federal Reserve Goal and Implementation Conflicts

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However, large and complex banking institutions grew during the recent financial crisis because of the government bailouts.

The threshold based solely on asset size of $50 billion has recently been a popular topic of debate, but it is not the focus of this paper. Of the approximately 6500 banks in the United States, 38 banking firms have assets exceeding the $50 billion threshold.

Of the 6500 U.S. banking firms, 66 have assets between $10 billion and $50 billion.

See Brewer III and Jagtiani (2013) for discussion on how much banking firms were willing to pay to become TBTF.

For example, Bear Stearns became financially insolvent because it could not meet liquidity demand, and it was bailed out in March 2008. Its shares were traded as high as $93 per share as of February 2008, and it was purchased by JPMorgan Chase through a government-assisted merger at a much lower price of initially $2 per share in March 2008 (this was subsequently revised to $10 per share in the official final deal).

In 2014, regulators rejected living wills submitted by 11 large banks, leading the industry to revise trillions of dollars in contracts so they would remain in place for up to 48 h after a bank fails, giving governments more time to restructure banks without having to take them over; see Onaran (2017) and the International Monetary Fund (2014).

A large number of mortgage defaults during the recent crisis resulted in a sizable backlog of foreclosures, thus expanding the foreclosure timeline to a few years or longer in some areas and allowing defaulted borrowers to live in their homes at no cost for years. This provided more incentive to strategically default on mortgage loans; see Jagtiani and Lang (2011).

There has been significant support for the current stress testing as an effective method for enhancing public confidence and U.S. financial stability overall; see Allen et al. (2016).

As stated in Carney (2016), bank capital is not costless to society. If capital requirements are increased, some of those costs will be passed on to households and businesses in the real economy.

Citibank did not fail based on its 2015 submitted plan, where significant improvement had been made from the previous plan, but Citibank also failed the previous resolution plan review. Goldman Sachs Group Inc. and Morgan Stanley also made it through without getting labeled with the term not credible, because neither was found insufficient by both agencies, although Goldman Sachs was faulted by the FDIC and Morgan Stanley by the Fed.

Similarly, the Federal Reserve Bank of Minneapolis, led by President Neel Kashkari, has proposed an alternative supplemental plan to end TBTF; see Federal Reserve Bank of Minneapolis (2016). If the resolution plan fails to effectively resolve insolvent SIFIs in a timely fashion without spillover effect on the economy, an alternative proposal is that the big banks should be broken up. The proposal was out for public comments until January 17, 2017, and the final plan was released almost 12 months later; see Federal Reserve Bank of Minneapolis (2018). The final proposal calls for, among other things, a significant increase in capital requirements at large banks.

Allen et al. (2016) discuss whether the new resolution authorities contained in the Dodd–Frank Act are sufficient to end TBTF and to contain the systemic impact of the failure of one or more SIFIs.

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Title: The Interplay among Financial Regulations, Resilience, and Growth
Authors: Franklin Allen
Itay Goldstein
Julapa Jagtiani
Publication date: 18-04-2018
Publisher: Springer US
Published in: Journal of Financial Services Research / Issue 2-3/2018
Print ISSN: 0920-8550
Electronic ISSN: 1573-0735
DOI: https://doi.org/10.1007/s10693-018-0291-z

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