May we still trust banks? Yes, but… October 8, 2007 Course: International financial markets and International banking Andrea Fondi Topic 7 Group 3 Source:

Agenda  Introduction  Bank environment  Resuming unsolved problems in the financial market  The activity of Regulators (Fed and Ecb)  What are the real interactions between Regulators and banks? (focus on European market)  Ecb: Objectives  Ecb: Functions and role  Interconnections and delegation of functions between Ecb and national central banks  Lending and borrowing among Ecb, national central banks and commercial banks  An example  Reasons for trusting the system  Conclusion

Introduction From my paper: –Question: may we still trust banks? –Answer: yes if Regulators will regain full control on banks …but: –How are Regulators operating in the banking sector? –Why should we trust Regulators to act for the public welfare?

Unsolved problems in the financial market Lack of information and complexity of inter-bank relations  difficulty in forecasting Demand for more profitable activities  incentive for “Moral hazard” of investment banks New financial instruments and innovations  redistribution of risk and higher possibility of contagion

Who can solve these problems? Regulators can, with the following instruments: –Restrictions on banks’ assets –Requirements of bank capital and of reserves –Bank supervision: chartering –Disclosure requirements –Limits of competition (e.g. restriction on interest rates required for deposit)

How are Regulators operating in the banking sector? Focus on the European Regulator: Ecb –Founded in 1999 within the European Union –It operates in coordination with national central banks of EU countries –It is independent from every Government and institution –Main objective: Maintain price stability –Other objectives: High level of employment Sustainable and non-inflationary growth

Ecb: functions and organization 3 main organs: –Executive Board Day-to-day business management Administration Personnel management Monitoring of the markets –Governing Council Definition of guidelines for monetary policy Supervision of the adoption of the guidelines Internal organization management –General Council Examination of economy conditions in EU countries Monitoring of collaboration and coordination among countries Collection of information for each country

Interconnection and delegation of functions between Ecb and national central banks Centralized in Ecb: –Vigilance on banking systems –Fully paid-up subscription of capitals addressed to national central banks –Portfolio management (managing official foreign reserves) –Definition of monetary policy –Promotion of the smooth operation of payment systems –Power of authorizing banknotes issuances –Coordination with extra-EU institutions Decentralized to national central banks: –Remaining authority in banking supervision and vigilance –Treasury (but it’s not possible to grant lending to public administration) –Printing of banknotes –Collection of information on monetary and financial trends

Lending and borrowing from Ecb and national central banks to banks Type of operations: Open market operations (on Ecb initiative through national central banks) –Main refinancing operations  decentralized –Long-term refinancing operations  decentralized –Fine-tuning operations  decentralized or (exceptionally) centralized –Structural operations  decentralized Standing facilities (on counterpart initiative) –Marginal lending facilities  decentralized –Deposit facilities  decentralized

ECB National central bank (e.g. Banca d’Italia) Bank A (e.g. Banca San Paolo) Bank B (e.g. Unicredit) Bank C (e.g. Banca Antonveneta) 1. Gives instructions 2. Supply of funds Public auction 3. Ask for loans 4. Information flows 5. Grants lending 6. Information flows Open market operations:

National central bank (e.g. Banca d’Italia) ECB Public auction Bank A (e.g. Banca San Paolo) Bank B (e.g. Unicredit) Bank C (e.g. Banca Antonveneta) 1.Ask for overnight loans (2. Asks for instruction) (3. Gives instruction) 4. Supply of funds 5. Reply to the offer of funds 7. Grants lending Standing facilities: 6. Information flows

RateAmount in million € Bank ABank BBank CTotal Total Total sum available to national central bank for lending: 94 million € Example of auction for a main refinancing operation Source:

Why should we trust Regulators to act for the public welfare? 3 main reasons: –This is their exclusive objective  will –They have most of information  knowledge –They fix rules of the financial market  power Did these three reasons work in the recent sub-prime crisis? Yes/No –Yes: will and power –No: knowledge

Conclusion: what lesson banks and Regulators should have learnt? Banks: –Dealing with more profitable assets could be too risky –The danger of contagion in the market is increasing –Profitable activity in the short run could be disastrous in the long  The right balance between risk and profit is also in the interest of the bank, not only of the investor Regulators: –The financial market has become more complex than in the past –The risk has been spread on a broader basis –The financial crisis are more difficult to forecast  The prevention through rigorous regulations and information sharing is necessary and better than late correction

Thanks for your attention!! Any questions?

References: Armando Serra, 2000, Politica monetaria e mercati: La Banca Centrale Europea Francesco Giavazzi and Alberto Giovannini, 19/8/2007, La caduta delle Borse: Crisi, “predicatori” e la lezione del mercato CE.pdf