University of Gothenburg

CFF Conference June 1-2, 2015

CFF conference June 1-2, 2015. The theme for this conference was financial intermediation and dealt with bank stability, macro- and microprudential regulation, Basel III and capital requirements.

Anjan Thakor, Olin School of Business, Washington University in St. Louis; "Financial Markets: A Diverse System Is the Key to Commerce"

Deborah Lucas and Sung Kwan Lee; "Toward Comprehensive Measures of the Costs and Risks of Development Banks: The Case of the KDB"

Joao A.C. Santos, Federal Reserve Bank of New York and Nova School of Business and Economics; "Banks' Incentives and the Quality of Internal Risk Models"

Giorgia Piacentino, Washington University in St Louis; "Bank Capital, Bank Credit, and Unemployment"

Piero Gottardi, European University Institute and University of Venice; "Capital Structure, Investment, and Fire Sales"

Nittai K. Bergman, MIT; "Financial Accelerator at Work: Evidence from Corn Fields"

Paolo Fulghieri, University of North Carolina; "Uncertainty Aversion and Systemic Risk"

According to Deborah Lucas government financial institutions lack transparency and are not valuing risks carefully enough. As they play a major role in society they should at least be scrutinized in the same way as private financial institutions. Deborah Lucas is professor of finance at MIT Sloan School of Management and director of MIT Center for Finance and Policy, and was one of the participants at the conference Bank Stability and Regulation organized by CFF on June 1-2, 2015.

What is your research about?
My research focusses on government financial policies. I am looking at the various ways governments intervene in capital markets to try to better understand the economic implications of those interventions. At MIT I am running a new centre called The Center for Finance and Policy which sponsors research and educational initiatives on government financial institutions, financial market regulations and systemic risk.

What do you see as the largest challenges to the financial system?
I feel that overall the financial system functions well although there are areas that could be improved upon. One of the biggest challenges for regulators is to strike a balance between adequate and excessive regulation. For government financial institutions, my main area of interest, one of the biggest and often overlooked problems is that compared to their private counterparts they lack transparency. When governments themselves run financial institutions there is no independent watchdog ensuring that they offer good products or make efficient investment decisions. And those institutions can be a source of systemic risk. For instance, the policies of Fannie Mae and Freddie Mac, the largest providers of mortgage capital in the U.S. and basically government institutions, arguably contributed to the financial crisis. While there can be a legitimate role for government financial institutions, because they play such a major role they should receive the same kind of scrutiny as private institutions.

Didn’t they learn that after the financial crisis?
Fannie and Freddie were rescued and taken over entirely by the government, and are now playing a bigger role than ever. But there hasn’t been much change since then and the government still exempts itself from new regulations designed to reduce the likelihood of future crises.

Does the centre give any policy advice on this matter?
We do not make recommendations, but we do provide policy analysis. Although it can be a fine line, our goal is to provide objective information that help policy makers themselves make better decisions.

How much do they listen?
Many policymakers are looking for good ideas and they listen to some extent. Objective information informs the policy debate, and making it available leads to better outcomes at least on average. Another centre initiative to encourage better policy decisions is an educational initiative for policy makers. Many government officials have gone to law school or a public policy school but lack the kind of financial education offered at business schools. We are developing curricular materials so that finance can be taught in a way that is relevant to future policymakers, and also creating some executive programmes to help people who are already working as financial professionals in the government.

What is your conference talk about?
I am going to talk about development banks, a type of government financial institution. They are important because they are responsible for funding a large share of investments in infrastructure all over the world. Infrastructure banks provide project financing on terms that are better than what would be offered by private financial institutions. Implicit in those favourable terms are subsidies, and development banks take uncompensated risks on behalf of society. The paper I am presenting is developing a model helpful in estimating the full value of these subsidies and the associated risks. Development banks themselves do a poor job of estimating costs. By systematically underestimating cost, they create incentives for overinvestment.

What do you think about this conference?
It’s fantastic that there is a centre on financial intermediation here in Gothenburg. This is obviously an issue that is more important than ever. With the financial crisis we saw that when financial institutions don’t work the whole economy doesn’t work. Presently in Europe there is still a great deal of uncertainty about the stability of banks and the financial system, so it is important to have researchers doing work that can shed some light on these issues. The conference is a good way to meet people from all parts of the world who are doing really interesting research on important topics.

Link to paper: Toward More Comprehensive Measures of the Costs and Risks of Development Banks

Link to Deborah Lucas’ website

Central banks have gone too far in regulating the bank sector. The complexity of regulation creates uncertainty in the system and excessive costs. Unnecessary regulation doesn’t reduce the risk for future financial crises, says Anjan Thakor, professor of finance at Washington University in St.Louis and part of CFF:s advisory board, at the CFF conference on Bank Stability and Regulation held in Gothenburg on June 1-2.

First of all, what do you think of the conference?
I think the conference has been a tremendous success with very good papers presented and we have had very good discussions. This conference was by invitation only, which makes it small and that is nice. If we will do something similar again I would like to see some policy people involved. Getting regulators in the same room, and to mix academics, policy makers and practitioners we could further the discussions.

What are the messages of the conference?
I think that there are a number of messages that have come out of this conference. One of the most important issues is how governments cope with systemic risks in banking. To a certain extent systemic risk is an outcome of a central bank's behaviour. A systemic risk is when the whole banking sector is at risk as we saw in 2007-09. It wasn’t just the financial system in one country but the whole global financial system that was threatened to collapse. One of the goals of central banks is to deal with systemic risk but one of the drivers of systemic risks is actually the central banks themselves.

Can you explain this a bit further?
This is because central banks make prudential regulation decisions that determine banks' capital levels, which can affect systemic risk. Set capital requirements too low and, the research shows, that you get failure contagion among banks. Central banks also determine monetary policy. Have an excessively easy money policy and you get price bubbles like we saw in housing prior to the 2007-09 crisis.

What was your talk about?
The paper I presented basically says: look, if governments and central banks insist on bailing out failing banks, then that actually raises the probability that you will have failing banks. Experience show that in economies where governments have intervened more, these countries have had harder times recovering from the crisis and industries have become weaker. We are intervening in the market to an unprecedented extent through the central banks, and at the end of the day somebody has to pay for it – the taxpayers.

You have mentioned that after a crisis there is a tendency to introduce too strong regulations as a fear of repeating the problems. What do you say about the present situation?
I think a lot of things have improved, but there are two things with the present situation that concern me: one is that we have excessive and complex regulation. When we increase the complexity of the regulation it means that the behaviour of the regulatory institutions and the response to regulation has become more difficult to predict, which creates uncertainty in the system. In that sense we pay too much attention to the crisis and we are inhibiting economic growth because of the cost of excessively complex regulation.
Secondly, I think we have sort of collective amnesia as we are already forgetting what got us into trouble in the crisis. Due to low economic growth in the Euro-zone and rather low GDP growth in the US, we now hear governments and central banks talking about pushing banks to lend more. But that is like a call to go back to the lending booms that got us into trouble in the first place.

Is it possible use regulations to prevent another financial crisis or are crises inevitable?
That is what I have written about and presented to the US Chamber of Commerce. I think we should do two things. First, we should try to lessen the burden of regulation on banks when it comes to things that don’t have to do with safety and soundness. In exchange I would like to increase the capital requirements in banks especially when they are doing well. In good times we should raise capital requirements and during bad times we should lower them. We need to do that very deliberately because the more regulations we impose on banks the more activities tend to go outside banking into the so called shadow banking system. So if you impose capital requirements you should also impose them on shadow banks, such as hedge funds and investment banks. We need regulate by functions rather than labels.

Link to Anjan’s conference paper: International Financial Markets: A Diverse System Is the Key to Commerce

Link to Anjan’s website