Razvan Vlahu

Capital Regulation and Tail Risk

The paper studies risk mitigation associated with capital regulation, in a context where banks may choose tail risk assets. We show that this undermines the traditional result that higher capital reduces excess risk-taking driven by limited liability. Moreover, higher capital may have an unintended effect of enabling banks to take more tail risk without the fear of breaching the minimal capital ratio in non-tail risky project realizations. The results are consistent with stylized facts about pre-crisis bank behavior, and suggest implications for the optimal design of capital regulation.

Strategic Loan Defaults and Coordination: An Experimental Analysis

This paper experimentally studies the impact of uncertainty about bank and borrower fundamentals on loan repayment. We find that solvent borrowers are more likely to default strategically when stricter disclosure creates common knowledge about bank weakness. Borrowers are also less likely to repay in the presence of higher uncertainty regarding other. Borrowers’ financial health, regardless of disclosure rules. We show that uncertainty about fundamentals changes the risk dominance properties of the coordination problem, and that these changes subsequently explain borrowers’ default. For the individual borrower, loss aversion and negative past experiences reduce repayment, suggesting that bank failure can be contagious in times of distress.

The economics of bank bankruptcy law

1 Introduction.- 2 General Issues in Bankruptcy Law.- 3 Are Banks Special? Implications for Bank Bankruptcy Law.- 4 Systemic Crises.- 5 General Issues on the structure of Banking Industry.- 6 Current Bank Bankruptcy Regimes and Recent Developments.- 7 Optimal Design of Bank Bankruptcy Law and the Bank Failures from the 2007-2009 Financial Crisis.- 8 Conclusions.- 9 Appendix.

Understanding Bank-Run Contagion

We study experimental coordination games to examine through which transmission channels, and under which information conditions, a panic-based depositor-run at one bank may trigger a panic-based depositor-run at another bank. We find that withdrawals at one bank trigger withdrawals at another bank by increasing players JEL Classification: D81, G21, G28

The Economic Perspective of Bank Bankruptcy Law

This paper argues that a special bank bankruptcy regime is desirable for the efficient restructuring and/or liquidation of distressed banks. We first explore the principal features of corporate bankruptcy law. Next, we examine the specific characteristics that distinguish banks from other corporations, and argue that these features are largely neglected in corporate bankruptcy law. Finally, we make recommendations for optimal closure and reorganization policies, which should allow regulators to better mitigate disruptions in the financial system and minimize the social costs of bank distress. We compare the U.S., UK, and German bank bankruptcy frameworks and describe the EU framework for cross-border bank bankruptcy. We support our recommendations with a discussion of the Lehman Brothers and Fortis bank failures.

Franchise Value and Risk-Taking in Modern Banks

Traditional theory suggests that high franchise value limits bank risk-taking incentives. Then why did many banks with exceptionally valuable franchises get exposed to new financial instruments, resulting in significant losses during the crisis? This paper attempts to reconcile theory and evidence. We consider a setup where a bank takes risk by levering up, to invest in risky market-based instruments. High franchise value allows the bank to borrow more, so it can take risk on a larger scale. This offsets lower incentives to take risk of given size. As a result, a bank with a higher franchise value may have higher risk-taking incentives. The proposed effect is stronger when a bank can expand the balance sheet using inexpensive senior funding (such as repos), and when it can achieve high leverage thanks to better institutional environment (with more protection of creditor rights). This framework captures well the stylized patterns of bank risk-taking in the run-up to the crisis.

Bank Profitability and Risk-Taking

Traditional theory suggests that more profitable banks should have lower risk-taking incentives. Then why did many profitable banks choose to invest in untested financial instruments before the crisis, realizing significant losses? We attempt to reconcile theory and evidence. In our setup, banks are endowed with a fixed core business. They take risk by levering up to engage in risky ‘side activities’(such as market-based investments) alongside the core business. A more profitable core business allows a bank to borrow more and take side risks on a larger scale, offsetting lower incentives to take risk of given size. Consequently, more profitable banks may have higher risk-taking incentives. The framework is consistent with cross-sectional patterns of bank risk-taking in the run up to the recent financial crisis.

Current Bank Bankruptcy Regimes and Recent Developments

We now review the general characteristics of bank bankruptcy laws around the world. Then we focus on selected bank bankruptcy laws in more detail. We analyze characteristics of the Swedish proposal towards the bank insolvency legal framework, the bank bankruptcy regimes in the European Union, Germany, and the U.S., including the provisions of Dodd-Frank Wall Street reform and the consumer protection act, and the recently implemented UK bank bankruptcy regime. Although it is beyond the scope of this study to provide a detailed cross-country legal analysis of bank resolution procedures, our aim is to review, compare, and evaluate the most economically significant characteristics of the selected bank bankruptcy laws.

General Issues on the Structure of Banking Industry

We now explore the main critiques of the general bank regulatory framework and suggest necessary reforms that can address the specific aspects of bank bankruptcy. We first address prudential regulation in banking. Second, we analyze whether systemically important public infrastructure can be separated from the rest of the banking system. Third, we analyze the rationale for netting, and last of all we propose how to contain systemic repercussions caused by the closeout netting provisions of derivative contracts.

Optimal Design of Bank Bankruptcy Law and the Bank Failures from the 2007–2009 Financial Crisis

This chapter first gathers together our proposals for optimal bank bankruptcy law. Subsequently, it reviews several cases of bank failures from the 2007–2009 financial crisis. The cases demonstrate the need for bank bankruptcy law and give the first and admittedly imprecise evidence for the validity of the proposals that we make.