The Restructuring of Banks and Financial Systems in the Euro Area and the Financing of SMEs

F. Calciano, F. Fiordelisi, G. Scarano, F. Calciano, F. Fiordelisi, G. Scarano

• Publisher: Palgrave Macmillan
• Year: 2015
• ISBN:
  9781137518736
• Topic: Economics
• Subtopic: Macroeconomics
• Index: Economics

The 2007-2009 financial crisis has had a worldwide impact on banks and financial systems. It has also brought about major changes in Europe's financial regulatory framework which could lead to financing problems for SMEs. The book explores the restructuring process of banking and financial systems to its impact on the financing of SMEs.

I – RESTRUCTURING BANKS AND FINANCIAL SYSTEMS IN THE EURO AREA

Regulating Core and Non-Core Banking Activities. The Unanswered Question^◊

Giampaolo Gabbi*	Andrea Sironi^#
University of Siena	“Luigi Bocconi” University, Milan

The debate on structural reforms of the banking system, particularly devoted to break-up commercial and investments banks, finds out whether a full or partial banking split could reach the goal to make banks more safe and sound and to reduce the cost of bail-out. We compare different proposals pointing out their theoretical assumptions and expected results. Since the regulatory reaction to the crisis was a reinforcement of the prudential model along with structural solutions, we conclude that such a mixed model could fail the purpose to resolve the trade-off between safety and efficiency.

[JEL Classification: G18; G21; G24; G28].

Keywords: financial regulation; investment banking; financial crisis.

1. - Introduction. The Structural Reforms as a Reaction to the Financial Crisis

According to the Citizens’ Summary of the structural reform of the EU banking sector published on 29^th January 2014, even after the recent financial crisis, «the EU banking sector remains large in absolute (eur 42.9 trillion) and relative terms (nearly 350 percent of EU GDP). Some banks still remain too-big-to-fail, too-big-to-save and too-complex-to-resolve».

Along with prudential proposals to increase the overall systemic stability of banking and financial system (Gabbi et al., 2014), a debate arose on the role played by investment banks in the financial crisis and on the ways to avoid the banking system to be involved in a systemic collapse.

During the financial crisis, many governments found themselves facing a dramatic trade-off: let big, systemically important banks fail, or bail them out. The failure of a bank could prove particularly severe and damaging for the entire economy in the case of “systematically important financial institutions” (SIFIs). Indeed, the failure of a bank can generate a contagion effect to other financial institutions in two ways: through direct exposure to the failed institution and through a loss of confidence in the financial system in general. Both this phenomena are particularly severe in the case of a SIFI, which then becomes “too big to fail” (TBTF) and, also, “too interconnected to fail”.

Avgouleas (2010) identifies a TBTF financial institution as a bank whose failure would cause a breakdown in the functioning of the financial system. That is, introducing distortions into the financial system’s ability to facilitate orderly payments and to settle transactions between institutions and consumers in domestic or international markets. This could generate a failure of confidence in the financial system, leading to a chain of defaults.

TBTFs are large, interconnected financial institutions whose failures could have an impact on the financial system as a whole. The Group of Thirty (2009) defines SIFIs making reference not only to size but also considering three other dimensions: leverage, interconnectedness, and systemic significance of its infrastructure services, such as custody, clearing, settlement, and payment services. These services have a systemic importance as they require strong credit linkages between service providers and service users.

To avoid moral hazard and lack of market discipline, SIFIs should not be prevented from defaulting. This is why regulators and academics started to investigate and propose reforms that could make it possible to allow SIFIs to fail without excessive costs for the entire economy.

One possible solution to the “too big to fail” issue is to prevent financial institutions from becoming TBTF. This in turn can be achieved by breaking-up large, interconnected financial institutions and limiting by law their risk-taking activities. Following this line of reasoning, during the last few years a number of legislative proposals have been presented, and in some cases approved, in the United States and in Europe (Germany, France, the United Kingdom and Belgium). More recently (January 2014), the European Commission adopted a proposal for a regulation “to stop the biggest banks from engaging in the risky activity of proprietary trading. The new rules would also give supervisors the power to require those banks to separate certain potentially risky trading activities from their deposit-taking business if the pursuit of such activities compromises financial stability”. We compare the different proposals to find out whether they could reach the purpose.

2. - Theoretical Frameworks behind the Debate

The theoretical foundations of the debate on optimal structure of banking by business line can be found both in economics and in finance.

Within economic theory, Lucas reformulate the classical view of economics in a new version that could claim to be at the same time uncompromisingly anti-Keynesian in method, theory and policy implications. The anti-Keynesian revolution had started in the late 1960s and was led by two schools of thought: the monetarism of Friedman based on partial-equilibrium Marshallian foundations and the school of Phelps advocating rigorous microeconomic foundations. Lucas reformulated Friedman’s monetarism providing new foundations in the general equilibrium model of Arrow and Debreu.

This approach implies that any optimal business mix will be driven, in the short as well in the long run, by market forces. Therefore, trying to calibrate the best banking portfolio mix within a regulatory framework would be useless and damaging. According to Fama (1980), banks are not regulated because they are special but rather they are special because they are regulated. Therefore banks suffer from a competitive disadvantage (cost of regulation) when compared with other less regulated market participants. If the market suffers from institutional differences, without any kind of structural regulation the market would be able to find the best allocation and mix of businesses. Moreover, the disadvantage due to regulation originates banking regulation costs which are expected to be transferred to customers (Fama, 1985).

The mainstream literature affecting more than others the regulation applied since the Eighties in the banking system was strongly affected by the intermediation theory (transaction costs, uncertainty and asymmetric information). This in turn is based on the idea that markets suffer from imperfections which open the opportunity for banks and other intermediaries to operate more efficiently (Klein, 1973; Pyle, 1971; Akerlof, 1970; Leland-Pyle, 1977). Therefore, regulation should be designed to manage inefficiencies and reach an optimal market allocation. Dombret (2014) believes, within this approach, that the issue on financial stability should be faced as follows: “Why not let the market determine which business models work and which don’t? […] the state certainly has to set boundaries to guide this selection process”.

At the same time, these imperfections could affect banks’ activity and need to be regulated in order to reach the equilibrium from which it slightly deviates. Particularly, the asymmetric information theory provides many clues not only for explaining the existence and the crucial role of banks in financial markets and in the economy as a whole, but also for explaining financial fluctuations and their recurring degeneration into serious, sometimes devastating, financial crises. The causal mechanisms, triggered by an increase in the interest rate producing a positive feedback with asymmetric information, are liable to trigger cumulative processes bringing about recurring fluctuations and, under particular circumstances, financial collapse.

In the more recent case of the financial crisis, the asymmetric information approach splits between two different basic explanations having radically different policy implications. The crucial divergences between them are rooted in a different understanding of the evolution of banking since the early 1980s and in particular of the crucial role that the process of securitization came to play. To simplify the analysis we focus on two polar approaches as represented respectively by Mishkin (the originate-to-distribute hypothesis, 2011) and Gorton (shadow banking system hypothesis, 2009).

The two main branches of the asymmetric information theory have radically different policy implications. The “hold-to-distribute” hypothesis points to the correction of the most significant shortcomings of the new model of banking mending the distortions of investment banking activities, securitization and shadow banking. The opinions differ, however, on which are the most effective and urgent measures to be adopted. Generally speaking they should go in the direction of an effective repression of shadow-banking and securitization and the request that all the transactions, including those that are currently off balance sheet, be rigorously registered in the balance sheets of banks.

While “shadow banking” is seen by the first point of view as a degeneration of the traditional banking system that in principle should be repressed, the second point of view sees it as the banking system of firms that should be controlled and regulated. In this view the banking panic of 2007 has originated not in the traditional banking system but in the shadow banking system. In order to understand this crucial point, the recent evolution of banking is put in a long-run perspective in the conviction that, unless we learn from history, we are condemned to repeat past mistakes. Gordon (2009) draws pregnant policy indications from the comparison between the recent bank panic originated in the US and those occurred in the same country before 1934. He distinguishes two periods: the National Banking Era (1864-1934) following the approval of the national Banking Act, and the Quiet Period (1934-2007). In the National Banking Era in the absence of a central bank, “bank themselves developed increasingly sophisticated ways to respond to panics […] centred on private banks clearing-houses. […] In response to a panic, banks would jointly suspend convertibility of deposits into currency […] the clearinghouse would also cease the publication of individual bank accounting information […] and would instead only publish the aggregate information of all the members. Finally, banks issued loan certificates […] a kind of deposit insurance” (Gorton, 2009, page 19).

This response strategy aims at making the liabilities of individual banks more informationally insensitive while giving also a tangible protection to clients in the form ...

Table of contents

• Cover
• Title
• Introduction
• I  – Restructuring Banks and Financial Systems in the Euro Area
• II  – New Tools for the Financing of SMEs