Europe's failure to prepare for the next financial crisis affects us all.

Author:Hartlage, Andrew W.
Position:I. Introduction through III. U.S. and European Approaches to Financial-Firm Resolution A. Resolving Insolvent Firms 1. Traditional Banks, p. 847-873
 
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TABLE OF CONTENTS I. INTRODUCTION II. MODERN FINANCIAL INTERMEDIATION AND MODES OF FAILURE A. The (Old) Risks: Finance and Instability 1. Leveraged Lending and Insolvency 2. Liquidity Transformation and Illiquidity 3. The Linkages Between Insolvency and Illiquidity. B. The (New) Actors: Traditional Banks and Shadow Banks 1. Leveraged Lending in the Shadow Banking System 2. Liquidity Transformation in the Shadow Banking System III. U.S. AND EUROPEAN APPROACHES TO FINANCIAL-FIRM RESOLUTION A. Resolving Insolvent Firms 1. Traditional Banks a. The United States b. The European Union and Its Member States 2. Shadow Banks a. The United States b. The European Union and Its Member States B. Supporting Illiquid Firms 1. Traditional Banks a. The United States b. The European Union and Its Member States 2. Shadow Banks a. The United States b. The European Union and Its Member States C. Policing the Line Between Insolvency and Illiquidity IV. FUTURE PATHS FOR REPORM A. Responses to Gaps in Crisis Preparedness 1. Separate Financial Activities from One Another 2. Improve Financial-Firm Resolution Mechanisms 3. Strengthen Prophylactic Regulation B. Possible Spillover Effects into Better-Prepared Jurisdictions V. CONCLUSION I. INTRODUCTION

The events of the autumn of 2008 reached from financial centers in the United States and Europe to affect nearly every country on the globe. Governments were unprepared to manage the failures and near-failures of large, interconnected financial institutions at the center of the modern financial system, and were compelled to resort to extraordinary governmental interventions. These ad hoc responses to the crisis were, and continue to be, deeply unpopular among citizens and spurred international efforts to shore up global financial stability.

When the crisis abated, policymakers began the work of replacing this flawed framework. In the United States, these efforts reached a milestone with the passage in July 2010 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). (1) Europe does not yet have a comparable watershed event in its post-crisis path to reform, although it has advanced parts of a reform agenda at the national, pan-European, and international levels.

Despite the general solidarity among U.S., European, and other world leaders in addressing systemic risk, (2) the concrete reforms in these economies are shaped by highly dissimilar market composition and policy tradeoffs. This Note investigates the issues behind, and the divergent responses to, financial-crisis management in the United States and Europe. In doing so, the Note argues that despite the United States' clear progress in strengthening its ability to defend against future crises, Europe's failure to construct a credible financial-crisis- management framework not only threatens to increase the cost of future crises for Europe, but also imposes present-day costs on economies globally through overly prescriptive financial regulation. In this way, I seek to reveal the urgency for meaningful European reform.

My argument proceeds as follows: Part II frames further discussion of U.S. and European crisis-management mechanisms by describing the risks of financial insolvency and illiquidity, and explaining how these risks spread in recent decades from the traditional banking system to the shadow banking system. Part II concludes that a robust framework for combating modern financial crises must deal with both insolvency and liquidity risks across all parts of the financial system. Part III evaluates U.S. and European management of the recent financial crisis and subsequent reforms along each mode of systemic failure (i.e., both insolvency and illiquidity) and major component of the banking system (i.e., both traditional and shadow). Part III argues that the United States' comprehensive crisis-management system as enacted through post-crisis legislation will better enable regulators to respond rapidly and effectively to financial stability issues across the financial system. Part III further argues that Europe's crisis-management system still contains significant weaknesses that could increase the costs of future financial crises. Part IV examines further areas for reform, particularly in Europe, and addresses the viability of these further reforms in view of current law. I argue that the most likely future path of reform--the strengthening of international prophylactic regulation--may, by means of international regulatory coordination mechanisms, lead to spillovers and restrict financial activity injurisdictions better prepared to handle crises.

  1. MODERN FINANCIAL INTERMEDIATION AND MODES OF FAILURE

    Financial crises are not new phenomena; they have been with us throughout the history of money and credit. (3) History has shown that financial crises unfold by means of well-understood modes of failure. What sets financial crises apart from one another are the particular financial instruments and markets at the center of each crisis. This Part discusses how the recent financial crisis is in these respects no different from past crises, involving old risks in new parts of the economy. Section II.A discusses the classical risks of financial intermediation, insolvency and illiquidity, and shows how these risks inevitably arise from socially useful activities. Section II.B discusses the rise of shadow banking and describes its parallels to the traditional banking system. The development of this shadow banking system as a functional alternative to traditional banks allowed well-understood risks of insolvency and illiquidity to spread to new areas of the financial system, namely, securities companies and debt markets. Part III of this Note uses these two elements--failure mode and type of banking system--to evaluate the effectiveness of U.S. and European financial-firm resolution mechanisms.

    1. The (Old) Risks: Finance and Instability

      Finance lies at the center of our capitalist system. Though financial crises may impose large costs on the real economy, in normal times finance fills a number of socially useful roles: facilitating clearing and settlement of payments, pooling resources, transferring resources across time and space, managing risks, disseminating information, and aligning incentives. (4) However, not all of these functions are conducted without risk to the intermediating firm; some of the most useful functions of financial institutions--leveraged lending and liquidity transformation--create fundamental instability that can threaten financial firms with failure. This Section describes more fully the benefits and inherent risks of leveraged lending and liquidity transformation, and restates the case for effective financial-firm resolution mechanisms.

      1. Leveraged Lending and Insolvency

        Perhaps the most-fundamental function of financial firms is leveraged lending, that is, lending to borrowers using, in part, funds the firm has itself borrowed from creditors. To illustrate this function, consider the example of a bank that accepts $100 from a depositor. This deposit appears as a liability on the bank's balance sheet. Per the contract between the depositor and the bank, the depositor agrees to keep the deposit with the bank until some future time t;, in return, the bank pays the customer interest at a rate [r.sub.d]. The bank (in the absence of contrary regulation) could lend this $100 to a borrower, who promises to repay the principal on or before time t, and agrees to pay the bank interest at a rate [r.sub.l]. This loan appears on the bank's balance sheet as an asset. Provided the borrower performs on his contract, the bank has the funds to perform its contract with the depositor, and has earned interest at a rate [r.sub.l] - [r.sub.d]. In this way funds flow from those with surplus money (i.e., bank creditors, including depositors), pool in the bank's balance sheet, and flow out to fund the activities of those with a demand for money (i.e., borrowers of bank loans). (5)

        The bank in the above example has balanced itself on a razor's edge. If the borrower does not repay the loan principal in full by time t, and the net interest earned by the bank cannot cover the unpaid amount, the bank would be unable to repay its loan principal with the depositor, and would fail due to insolvency, the first of two archetypal modes of financial firm failure.

        Financial firms employ several safeguards to insure themselves against insolvency. First, firms can fund loans in part with equity capital. Because shareholders' claims on a company's assets are residual--that is, shareholders are paid after creditors in liquidation--the firm may absorb some losses without becoming insolvent through reduction in the value of equity capital. Firms raise most of the basic forms of equity capital--common stock--directly from equity investors, or build capital over time from retained earnings. (6) Second, firms can increase the scale and diversity of their loan portfolios to lower the probability that any one borrower's default would cause a large enough loss to exhaust the equity capital buffer and plunge the firm into insolvency. Financial firms can use insights from probability theory, such as the Law of Large Numbers, as well as estimates of how borrower defaults are interrelated, to make judgments on the overall...

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