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TA B L E   1 8 . 2

The Cost of Rescuing Banks in a Number of Countries

Country

Date

Cost as Percentage of GDP

1980–2007

Indonesia

1997–2001

57

Argentina

1980–1982

55

Thailand

1997–2000

44

Chile

1981–1985

43

Turkey

2000–2001

32

South Korea

1997–1998

31

Israel

1977

30

Ecuador

1998–2002

22

Mexico

1994–1996

19

China

1998

18

Malaysia

1997–1999

16

Philippines

1997–2001

13

Brazil

1994–1998

13

Finland

1991–1995

13

Argentina

2001–2003

10

Jordan

1989–1991

10

Hungary

1991–1995

10

Czech Republic

1996–2000

7

Sweden

1991–1995

4

United States

1988

4

Norway

1991–1993

3

2007–2009

Iceland

2007–2009

13

Ireland

2007–2009

8

Luxembourg

2007–2009

8

Netherlands

2007–2009

7

Belgium

2007–2009

5

United Kingdom

2007–2009

5

United States

2007–2009

4

Germany

2007–2009

1

Source: Luc Laeven and Fabian Valencia, “Resolution of Banking Crises: The Good, the Bad and the Ugly,”

IMF Working Paper No. WP/10/46 (June 2010) and Luc Laeven, Banking Crisis Database at

http://www.luclaeven.com/Data.htm

.

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Chapter 18 Financial Regulation

447

“Déjà Vu All Over Again”

In the banking crises in these different countries, history keeps repeating itself. The

parallels between the banking crisis episodes in all these countries are remarkably

similar, creating a feeling of déjà vu. They all started with financial liberalization or

innovation, with weak bank regulatory systems and a government safety net.

Although financial liberalization is generally a good thing because it promotes com-

petition and can make a financial system more efficient, it can lead to an increase

in moral hazard, with more risk taking on the part of banks if there is lax regulation

and supervision; the result can then be banking crises.

4

However, the banking crisis episodes listed in Table 18.2 do differ in that deposit

insurance has not played an important role in many of the countries experiencing

banking crises. For example, the size of the Japanese equivalent of the FDIC, the

Systemic

banking crises

Episodes of

nonsystemic

banking crises

No crises

Insufficient

information

F I G U R E   1 8 . 2

Banking Crises Throughout the World Since 1970

Source: World Bank: “Episodes of Systemic and Borderline Financial Crises” by Gerard Caprio and Daniela Klingebiel. ©January 2003.

4

A second Web appendix to this chapter, can be found on this book’s Web site at 

www.pearsonhighered

.com/mishkin_eakins

, discusses in detail many of the episodes of banking crises listed in Table 18.2.

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Deposit Insurance Corporation, was so tiny relative to the FDIC that it did not play

a prominent role in the banking system and exhausted its resources almost imme-

diately with the first bank failures. This example indicates that deposit insurance is

not to blame for some of these banking crises. However, what is common to all the

countries discussed here is the existence of a government safety net, in which the

government stands ready to bail out banks whether deposit insurance is an impor-

tant feature of the regulatory environment or not. It is the existence of a government

safety net, and not deposit insurance per se, that increases moral hazard incentives

for excessive risk taking on the part of banks.

The Dodd-Frank Bill and Future Regulation

The recent global financial crisis, discussed in detail in Chapter 8, has led to bank-

ing crises throughout the world, and it is too soon to tell how large the costs of res-

cuing the banks will be as a result of this episode (which is why they are not listed

in Table 18.2). Given the size of the bailouts and the nationalization of so many finan-

cial institutions, the system of financial regulation is undergoing dramatic changes.

Dodd-Frank Wall Street Reform and

Consumer Protection Act of 2010

In July 2010, after over a year of discussion, the Dodd-Frank bill was passed. It is

the most comprehensive financial reform legislation since the Great Depression. It

addresses five different categories of regulation that are discussed next.

Consumer Protection

This legislation creates a new Consumer Financial Protection

Bureau that is funded and housed within the Federal Reserve, although it is a com-

pletely independent agency. It has the authority to examine and enforce regulations

for all businesses engaged in issuing residential mortgage products that have more

than $10 billion in assets, as well as for issuers of other financial products marketed

to poor people. It requires lenders to make sure there is an ability to repay residen-

tial mortgages by requiring verification of income, credit history, and job status. It

also bans payments to brokers for pushing borrowers into higher-priced loans. It

allows states to impose stricter consumer protection laws on national banks and gives

state attorney-generals power to enforce certain rules issued by the new bureau. It

also permanently increases the level of federal deposit insurance to $250,000.

Resolution Authority

Although before this legislation, the FDIC had the ability to

seize failing banks and wind them down, the government did not have such a reso-

lution authority over the largest financial institutions—those structured as holding

companies. Indeed, the U.S. Treasury and the Federal Reserve argued that one rea-

son they were unable to rescue Lehman Brothers and instead had to let it go into

bankruptcy was that they did not have the legal means to take Lehman over and break

it up. The Dodd-Frank bill now provides the U.S. government with this authority

for financial firms that are deemed systemic, that is firms who pose a risk to the over-

all financial system because their failure would cause widespread damage. It also gives

regulators the right to levy fees on financial institutions with more than $50 billion

in assets to recoup any losses.

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Chapter 18 Financial Regulation

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Systemic Risk Regulation

The bill creates a Financial Stability Oversight Council,

chaired by the Treasury secretary, which would monitor markets for asset price bub-

bles and the buildup of systemic risk. In addition, it would designate which financial

firms are systemically important. These firms would be subject to additional regula-

tion by the Federal Reserve, which would include higher capital standards and stricter

liquidity requirements, as well as requirements that they draw up a “living will,” that

is, a plan for orderly liquidation if the firm gets into financial difficulties.

Volcker Rule

Banks would be limited in the extent of their proprietary trading,

that is trading with their own money, and would only be allowed to own a small per-

centage of hedge and private equity funds. These provisions are named after Paul

Volcker, a former Chairman of the Board of Governors of the Federal Reserve, who

argued that banks should not be allowed to take large trading risks when they receive

the benefits of federal deposit insurance.

Derivatives

Financial instruments whose payoffs are linked to (i.e., derived from)

previously issued securities are known as financial derivatives. As is discussed

in Chapter 8, derivatives such as credit default ended up being “weapons of mass

destruction” that helped lead to a financial meltdown when AIG had to be rescued

after making overly extensive use of them. To prevent this from happening again, the

Dodd-Frank bill requires many standardized derivative products to be traded on

exchanges and cleared through clearinghouses to reduce the risk of losses if one

counterparty in the derivative transaction goes bankrupt. More customized deriva-

tive products would be subject to higher capital requirements. Banks would be

banned from some of their derivatives dealing operations such as those involving

riskier swaps. In addition, it imposes capital and margin requirements on firms deal-

ing in derivatives and forces them to disclose more information about their activities.

Future Regulation

The Dodd-Frank bill leaves out many details of future regulation and does not address

some important regulatory issues at all. Here we discuss several areas where regu-

lation may be heading in the future.

Capital Requirements

Regulation and supervision of financial institutions to ensure

that they have enough capital to cope with the amount of risk they take are likely to

be strengthened. Given the risks they were taking before the recent financial crisis, banks

and investment banks did not have enough capital relative to their assets and their risky

activities. Similarly the capital at AIG was not sufficient to cover the high risk it was

taking by issuing credit insurance. Capital requirements will almost surely be beefed

up for all of these institutions. Banks’ sponsoring of structured investment vehicles

(SIVs), which were supposedly off-balance-sheet but came back on the balance sheet

once the SIVs got into trouble, indicate that some off-balance-sheet activities should

be treated as though they are on the balance sheet, and this will be a focus of future reg-

ulation. In addition, because of the too-big-to-fail problem, systemically important finan-

cial institutions are likely to take on more risk, and so the regulations to increase capital

requirements for these firms are likely. Also capital requirements are likely to be adjusted

to increase in booms and decrease in busts so that they become more countercyclical

in order to restrain the boom-and-bust cycle in credit markets.

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Compensation

As we saw in Chapter 8, the high fees and executive compensation

that have so outraged the public created incentives for the financial industry to push

out securities that turned out to be much riskier than advertised and have proved

to be disastrous. Regulators, particularly at the Federal Reserve are closely studying

regulations to modify compensation in the financial services industry to reduce risk

taking. For example, regulators are in the process of issuing requirements that bonuses

be paid out for a number of years after they have been earned and only if the firm

has remained in good health. Such “clawbacks” will encourage employees to reduce

the riskiness of their activities so that they are more likely to be paid these bonuses

in the future.

Government-Sponsored Enterprises (GSEs)

A major gap in the Dodd-Frank

bill is that it does not address the privately owned government-sponsored enter-

prises such as Fannie Mae and Freddie Mac. As we saw in Chapter 8, both of these

firms got into serious financial trouble and had to be taken over by the govern-

ment. The likely result is that taxpayers will be on the hook for several hundred

billion dollars. To prevent this from occurring again, there are four routes that

the government might take: