Caroline Roulet

Bank business models, capital rules and structural separation policies

Purpose – The study examines the roles of capital rules, macro variables and bank business models in determining the safety of banks as measured by the “distance-to-default” (DTD) with the purpose of drawing implications for regulation of bank capital and business models. Design/methodology/approach – A panel regression study using pre- and post-crisis data for 108 US and European banks is used to explore the issue empirically. A new technique is also used to back out the amount of capital banks would have needed during the crisis to keep the “DTD” in the very safe zone. Findings – The simple leverage ratio has a strong relationship with “DTD”, while the Basel ratio does not. The most important business model features are derivatives and wholesale funding, which have a strong negative relationship with “DTD”. Trading and available-for-sale securities have a positive influence. Calculations show that it is not possible for any reasonable capital rule to compensate for the risks created by business model fe...

The Business Models of Large Interconnected Banks and the Lessons of the Financial Crisis

This paper looks at the urgent and ongoing need to change the business models of global systemically important banks — particularly those that dominate the OTC derivatives markets which carry massive counterparty risk via collateralisation practices. It explores the three main lessons of the financial crisis: too big to fail, excess leverage and conflicts of interest. While regulatory reforms have been plentiful, none have adequately addressed the main source of the problems which lie in the very nature of the business models of large interconnected banks.

Why Bank Separation Must Complement the Leverage Ratio

The authors’ empirical evidence is used to show that there is no reasonable capital rule that can protect the financial system in the face of events like 2007–2008: large interconnected banks would need 4 times the amount of capital to avoid default without government aid. They argue that separating deposit-guaranteed banks from investment banking, while maintaining a leverage ratio, is the policy mix supported by empirical evidence. They suggest the best threshold for separation should be derivatives exposure (with no netting) at or above 10%. They compare their own legal separation proposal to the Volcker rule, the UK Vickers rule and to those European proposals that were quietly dropped to please banks. They rebut 5 criticisms of separation proposals and review the 2017 Mnuchin Treasury modification of the Volcker Rule.

Assessing the Finalised Basel III Banking Regulation Regime

The authors summarise the final version of Basel III, reducing thousands of pages to a necessary few. They argue that supervisors appear to believe the problem all along was just the need for greater granularity and more model-based sensitivity, rather than fundamental flaws in the framework itself (its one-size-fits-all and portfolio invariance assumptions; and contaminating bank risk models by linking them to regulatory capital charges). They opine that banks have defended their risky business models very well and thus the reform process is not over: separating investment banking and imposing a sufficient binding leverage ratio (LR) remain on the table. They suggest that such a pre-emptive approach is needed to deal with the underpricing of risk and are dismissive of mechanical modelling of stress scenarios to estimate capital requirements.

Managing the Crisis, Exit and Requirements of Reform

The authors set out how all crises should be managed according to four key steps and contrast this with what authorities actually did in different jurisdictions following 2008 (showing the USA to be closer to the mark than Europe). They raise two questions that have occupied policy makers since then: how to exit from emergency measures and what reforms are needed. The authors present and analyse the different proposals including inter alia: dealing with too big to fail; improving corporate governance; ensuring capital adequacy; and separating investment and deposit banking. Based on observed facts about the crisis, they present a number or a priori ideas about capital regulation and bank business models, setting the scene for a fuller discussion based on empirical evidence in subsequent chapters.

The Watershed Year of 2004: Origins and Causes of the Crisis

The authors focus on causality in the narrow sense of place and time: the preconditions for the crisis were global, but it all started in the USA and traced back to 2004. They argue that structural features of the US, including the role of Fannie Mae and Freddie Mac and SEC regulatory changes, were instrumental in the sharp acceleration of leverage and mortgage-backed securities (MBS) origination. They ask why bank management was unable to contain excessive risk and use corporate governance indicators for key US banks, and examples from Europe, to explain the dangerous equity culture in play. They argue that corporate governance cannot substitute for sound rules concerning leverage and what banks do with respect to their business models—models that led to the ‘Lehman Moment’.

Globalisation Sets the Background to the Crisis

The authors explain globalisation and provide an interesting history of its various stages—including reasons why emerging countries turned away from the advanced nations as a model for economic development. Turning to recent decades, they counterpose two very different parts of the world economy that have begun to butt-up against each other. Topics such as the China saving glut, exchange rate management and foreign buying of US securities, subsidies to state-owned enterprises (SOEs), rising Chinese import penetration following WTO entry and the creative destruction technological responses of large companies are brought together as key preconditions for the 2008 crisis. With new empirical evidence, they link these developments to the hollowing out of jobs, low inflation, the price of US treasuries, mortgages rates and asset price inflation.

Business Models of Banks and Global Contagion

The authors argue that the elephant in the room on bank risk is their business models which are largely untouched by reform. They contrast traditional deposit banking from models based on multiple collateralised counterparty agreements, where derivatives and structured products funded via securities transactions cause contagion risk—including adverse valuation shifts and/or defaults at various points in the hypothecation chains. Balance sheets of actual banks during the crisis and the size of derivatives transactions are used by the authors to illustrate these issues and they document bank losses which, despite all the support, are sobering. The authors argue that the underpricing of this risk (helped by credit ratings) was the core of the crisis and the AIG insurance debacle is shown to be one of its most dangerous events.

Financial Innovation and Basel II

The authors argue that the Basel capital rules not only were unable to contain the pressures building from globalisation, but they actually contributed leverage via off-bank-balance-sheet activity and the use of derivatives. The authors provide insights on the history of securitisation and how it works; and the history of derivatives and how the main derivative contracts operate. They then turn to how innovations with these instruments were used to exploit regulatory and tax arbitrage opportunities as banks ‘gamed’ the system to maximise their return on equity. The authors point out that finance is a system of promises and that it is the inability of regulators to treat promises in the same way that gives the banks endless opportunities to shift them around to create unacceptable risk.

The Determinants of the Riskiness of Banks

The authors argue that settling the issue of what reforms are required must be based on empirical evidence. They first set out the key bank risks, including those associated with collateralised agreements at the heart of complexity and interdependence problems. They point out that in normal times these risk positions mostly cancel out (one’s loss being another’s gain), but when risk is mispriced these positions become pro-cyclical, correlated and concentrated activities involving chains of counterparties that create interconnectedness risk. The authors choose bank distance-to-default (DTD) data as their dependent variable and show that 4 business model features have a much stronger impact on risk than any capital rule: the size of (un-netted) derivatives, the extent wholesale securities financing, the availability of liquid assets and a measure of interdependence.