1. Competition Policy for Modern Banks Lev Ratnovski Presentation by Gerard Hertig

2. Presentation Outline 1.Competition policy 2.Traditional approach 3.Modern approach A.TBTF B.Dealing with structural issues C.Crisis management 15.01.2015G. Hertig2

3. 1. Competition Policy and Banks Focus of competition policy – Non-financial sector: Efficiency = Competitive pricing – Financial sector: Systemic risk = Negative externalities When d° competition  risk taking incentives, must be taken into account by competition policy 15.01.2015G. Hertig3

4. 1. Traditional Approach Theory: Competition may  or  bank risk-taking – Lowers interests in the economy  Borrower safer  less risk for banks – Lowers margins and charter value (discounted stream of profits) Banks more willing to gamble and less able to withstand negative shocks Maintain market share instead of screening borrowers Confirmed by empirical analysis – Oligopolies produce larger banks subject to operational risk – Competition lowers loan quality, higher probability of failure 15.01.2015G. Hertig4

5. Policy Implications Link Competition – Risk Taking – Stability – Theory and data ambiguous – Monopolistic  +  competition  -  Destabilization Intermediate degree seems optimal – No excessive restriction to bank activity, no unbridled competition – Lowers costs, increases access to finance Good for industrial firms Good for households – Not perfect due to information issue Information sensitive borrower may be disadvantaged Restriction of credit in downturns 15.01.2015G. Hertig5

6. Implementation Policies that focus on market structure – Issue 1: Market definition and market share – Issue 2: Measure adequacy Consolidation via mergers in times of crisis Rules on barriers to entry and to exit for both domestic and foreign banks Restriction of activities: Non lending activities of banks, bank-like activities of non-banks Policies that focus on market contestability – Issue 1: Market definition and market share – Issue 2: Measure adequacy Establishing credit registries (information on borrowers) Equal access to infrastructures Enabling the switch from one bank to another 15.01.2015G. Hertig6

7. 2. Modern View Major IT developments in past decades Impact for relations with bank customers – Increase in the availability of hard (quantifiable + verifiable) borrower information – Reduction in the soft (proprietary/relationship) information grip banks have on their customers – Bank operations made scalable (open to larger operational demands) as bank can more easily access new customers Impact on tradability of bank assets – Banks can use markets to buy/sell assets (securitization) – Banks can engage in proprietary trading Banking has become more contestable – Lower bank profits – Reduced bank charter value 15.01.2015G. Hertig7

8. Switching to Market-Based Activities Originate to hold  originate to distribute – Making loans and keeping them on books until maturity – Making loans and syndicating them or selling them on the market (e.g. CLOs) – Allows non banks to enter the market Core, non-core and market-based activities – Blundered boundaries – ≠ d° hard/soft information – ≠ d° marketability for tranches related to hard or soft information 15.01.2015G. Hertig8

9. Policy Implications New prudential challenges – More contestability  Higher incentives to take risk – Hard information and scalability  banks can become bigger – Market-based activities  Banks can take large-scale, opportunistic gambles (low probability but extreme losses) Competition policy implications – Charter values respond less to changes in market structures  Change in policy approach as traditional policy tools are less effective – Prudential issues have become more important for the economy  Better take into account 15.01.2015G. Hertig9

10. 3 New Policy Challenges Too big to fail banks – Restricting bank size (in view of scalability) – Uneven playing field (smaller banks at disadvantage) Understanding interactions with structural issues – Market operations – Interactions with non-banks Facilitating crisis management – Financial crises as extreme events (?) – Allowing temporary competition distortions State ownership and state aid Restructurings and higher market concentration 15.01.2015G. Hertig10

11. A. Dealing with TBTF Complex and interconnected banks, not easy to wind down Traditional rescue: de facto bailout – Reduces funding costs and creditor monitoring – Incentivizes banks to take more risks – Results in race to become TBTF: Easy to scale up Subsidy and network centrality 15.01.2015G. Hertig11

12. New Approaches to TBTF Directly restrict bank size – Can be done via mergers and spin-offs – Hard to justify from efficiency perspectives: Economies of scale + TBTF operate efficiently Adopt macro-prudential objectives (like central banks) Focus on sub-segments of bank operations – Price-based approach – Address cheap funding issue (uneven playing field) via taxes or fines, which also has stability benefits 15.01.2015G. Hertig12

13. B. Dealing with Structural Issues Restricting bank or non-bank activities that contribute to systemic risk (securitized credits, originate to distribute, proprietary trading) Better targeted competition measures in wake of efforts to prohibit proprietary trading and segregate of non-core activities Foster level playing field in lending and deposits taking by targeting laxer regulatory standards 15.01.2015G. Hertig13

14. C. Crisis Management Credit crisis displays conflicts between competition policy and crisis management – Competition policy: Minimize government involvement in banks (level playing field) – Bank crisis management: Government takes ownership stakes, provides guarantees and directs restructurings Competition policy – Balance between effective resolution and level playing field – Temporarily allow for higher bank concentration 15.01.2015G. Hertig14