Jean Charles Rochet (SFI and Zürich University) NIESR Financial Regulation Conference Bank of England, March 18 th 2016

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1 Jean Charles Rochet (SFI and Zürich University) NIESR Financial Regulation Conference Bank of England, March 18 th

2 Based on on-going research Aggregate Bank Capital and Credit Dynamics with Nataliya Klimenko (UZH), Sebastian Pfeil (U.Bonn) and Gianni Di Nicolò (IMF) Unconventional Monetary Policy and the Safety of the Banking System with Michael Magill (USC) and Martine Quinzii (U.C. Davis) 2

3 INTRODUCTION The Global Financial Crisis has shown that our understanding of banking activities was flawed. Both bankers and regulators were (and are still) using wrong models. This has led banks to take on excessive leverage. Urgent need to develop new models that can be useful to policy makers. 3

4 SCIENCE VS LOBBYING The finance industry has been extremely good at influencing regulators and business school economists. The counter-lobbying campaign lead by Anat Admati was useful but it has its limits. Science is about measurable quantities: repeating equity is not costly is not enough. We need facts and reliable quantitative models. 4

5 Fact number 1: banks create money Bank capital regulation has a micro-economic impact (probability of banks default) but also a macroeconomic impact on money, credit and growth. When money creation is taken into account, each economy has a natural bank equity to assets ratio (Magill-Quinzii-Rochet 2016). 5

6 The natural equity to assets ratio Some investors want liquid and riskless assets (depositors, cash investors). Other investors have a longer horizon and are ready to take risks (equity and long term investors). Supply functions of both types of assets are elastic: if the demand for equity increases, equity investors will require a higher rate of return. 6

7 The natural equity to assets ratio (2) At the social optimum (natural equity to assets ratio) the marginal costs of bank debt and bank equity are equalized. The problem is that banks debt is subsidized (deposit insurance, tax reductions) This is why bank managers take too much leverage. Capital regulation is needed to steer the banks into adopting the natural equity to asset ratio. 7

8 The natural equity to assets ratio (3) In Magill-Quinzii-Rochet (2016) we show that this natural equity to assets ratio depends not only of banks individual risks but also on: Supply functions of depositors and cash investors. Supply functions of equity and long term investors. Demand for credit by firms. Expectations about future macroeconomic risks. 8

9 DON T FORGET THE GLOBAL PICTURE 9

10 Fact 2: Aggregate Bank Equity Matters Klimenko,Pfeil, Rochet and De Nicolò (2016) studies the impact of aggregate bank equity on individual banks returns on assets. On a panel of 1300 banks in 43 advanced and emerging countries over the period , we find a robust and significant negative effect. 10

11 Fact 2: Aggregate Bank Equity Matters(2) A one standard deviation increase in aggregate bank equity associated with significant decrease in individual banks ROA: 147 bp in the US, 134 bp in Japan, 94 bp in other advanced countries, 30 bp in emerging countries. Banks returns on assets are not exogenous but depend on aggregate bank equity! 11

12 Fact 2: Aggregate Bank Equity Matters(3) We construct a dynamic general equilibrium model that explains this fact. The main idea is that when the banking sector capitalization is higher, banks lend more. Then there is more competition between banks and this puts a downward pressure on banks ROAs. 12

13 Too much focus on M&M! Modigliani-Miller takes returns on assets as given (partial equilibrium) and only looks at future cash flows (corporate finance). General equilibrium effects are neglected: changing the capital ratio for one bank is not the same as changing it for all the banks together. The role of banks in money creation is neglected: it is also impacted by capital regulation. 13

14 CONCLUSION We have spent too much time on ideological quarrels, not enough on science. Central Banks have started new policies (quantitative easing, macro-prudential tools) that have long term consequences that nobody really understands. Instead of recycling old ideas, academics should join forces to develop new models that can be used by policy makers. 14