The Economist reports about a proposal by Jeremy Bulow and Paul Klemperer for equity recourse notes (ERNs) that could bolster a bank’s equity after negative shocks. While contingent convertible bonds (CoCos) are converted into equity when bank capital falls below a defined threshold, ERNs would convert when the share price fell below a trigger price. Moreover, the new shares would be valued at the trigger price even if the share price had fallen much lower. Low share prices thus would trigger both a conversion and a partial default.
Tag Archives: Bank
Fintech Competition for Banks
In a series of articles, The Economist reports about technology companies that compete with traditional banks in areas ranging from lending to payments and wealth management.
The introductory article refers to AngelList and references reports by Goldman Sachs (The Future of Finance, copy posted here), BCG and Accenture. And it highlights two factors driving the structural change which I have also emphasized in a recent article: Technology and vanishing trust in banks. The other articles cover:
- Peer-to-peer lending, mentioning Lending Club, Prosper, SoFi, Zopa, RateSetter, Lendable and Kreditech.
- Crowdfunding of businesses, mentioning Funding Circle and OnDeck.
- Wealth management, mentioning Wealthfront, Betterment, Personal Capital, FutureAdvisor, nutmeg and motif and offering this comparison:

- International money transfers, mentioning TransferWise. (See also my earlier blog post.)
- Payments, mentioning Venmo as well as Square, Stripe and others.
- Emerging markets.
- bitcoin’s blockchain technology, summarized in the following figure, and mentioning Ripple and CoinSpark:

- A conclusion, mentioning Currency Cloud.
Updates—some more firms in the business:
“Bankensektor im Umbruch (Structural Changes in Banking),” FuW, 2015
Finanz und Wirtschaft, April 18, 2015. PDF. Ökonomenstimme, April 20, 2015. HTML.
- Banks increasingly face competition in bread-and-butter businesses like term deposits, lending and payments.
- Two trends shape the sector’s changes: Falling trust in banks, both at the political level and by individual clients; and the rise of the internet.
- Trust has been squandered. But with cheap access to information, it also has lost importance.
- Asymmetric information in financial markets might become less of a friction. This could turn into an existential threat for banks.
- When trust is less important and technology more versatile, increasing returns to scale in the provision of financial services might be a thing of the past. And so the universal bank. New regulatory and tax regimes could foster the process of structural change.
Here are some links to background information:
- SavingGlobal provides a marketplace for term deposits. It intermediates between German savers and European banks.
- Peer-to-peer lending gains market share, as reported by The Economist (25 October 2007; March 1, 2014; December 13, 2014; see also the Wikipedia page).
- Competition in other areas rises as well, see my earlier post on cross-border money transfers.
Expensive Keywords
According to WordStream, the most expensive keywords in Google AdWords relate to financial services.
International Money Transfers
Cross-border (-currency) money transfers are bound to become cheaper, due to TransferWise, azimo, worldremit and the like.
Negative Interest Rates
The Economist argues that negative interest rates appear not to spur inflation or growth but to weaken exchange rates. And they put pressure on banks.
Reserves for Everyone—Towards a New Monetary Regime?
In the first and third of his Munich Lectures in Economics (and in an earlier oped in the FT), Kenneth Rogoff argued in favour of phasing out cash, at least high denominations and in some developed economies, see my post. Rogoff emphasised two beneficial consequences. First, the abolition of the zero lower bound on nominal interest rates and thus, the relaxation of a constraint on monetary policy. And second, the abolition of a means of payment that guarantees anonymity and thus, facilitates criminal transactions, money laundering, tax evasion and the like.
Both Rogoff and other academics have discussed the topic before. More than in academic papers, the end of cash has been the subject of intense debate in the blogosphere. By far the clearest discussion I know (and a very comprehensive one) is due to Willem Buiter in a blog post I summarise here. But the list of authors that have contributed to the discussion is much longer. Here is a selective overview:
- As far as solutions to the zero lower bound problem are concerned, Buiter in his post referred to several academic contributions, namely Eisler (1932), Goodfriend (2000), Buiter and Panigirtzoglou (2001, 2003), Davies (2004) and Buiter (2004, 2007). Rogoff in his lectures referred to Silvio Gesell as well as writers in the blogosphere including Mankiw, Buiter and Kimball.
- Concerning the loss of tax revenue due to anonymous currency holdings, Rogoff referred to his own earlier work (Rogoff 1998).
- On April 19, 2009, Gregory Mankiw discussed the zero lower bound in the New York Times. He reported a proposal by a graduate student to relax the bound by taxing currency: The Fed should announce that all notes whose serial number ends in a particular digit would cease to be legal tender within a certain time period; and the digit should be determined by a lottery. (According to Buiter, Charles Goodhart made the same proposal earlier.)
- On May 7 and 19, 2009, Willem Buiter strongly argued in favour of negative nominal interest rates in his FT maverecon blog (see my post). He identified currency’s status as a bearer security as the cause of the zero lower bound and discussed three strategies to relax the bound: Abolishing currency; taxing it (difficult); and separating the medium-of-exchange role of money from the unit-of-account function by creating a unit of account dollar (think of reserves) on the one hand and a medium of exchange dollar (think of currency) on the other. The former would pay positive or negative interest, the latter would pay no interest. Both would trade at an exchange rate, and interest parity conditions would hold in equilibrium.
- Other FT bloggers took up Buiter’s proposal. An early post, on May 20, 2009, is due to Izabella Kaminska in FT Alphaville.
- On April 19, 2012, Matthew Yglesias argued in Slate that the abolition of the zero lower bound would facilitate expectations formation about monetary policy.
- On November 5, 2012, Miles Kimball took up the issue in a blog post. In another post, he discussed Marvin Goodfriend’s (2000) contribution to the debate.
- On April 15, 2013, Izabella Kaminska suggested in FT Alphaville that direct access of consumers and investors to government provided electronic money would allow central banks to bypass commercial banks, improve the monetary transmission mechanism and help end a shortage of safe assets.
- On April 16, 2013, Jean-François Groff argued in FT Alphaville that electronic money should be provided by the government instead of private companies (“digital legal tender”). Governments then could (re-)gain seignorage and consumers would benefit from lower fees and user costs.
- On July 27, 2014, John Cochrane discussed Sheila Bair’s opposition against letting the broader public hold reserves. On August 21, September 17 and September 22, 2014, he approvingly discussed (here, here and here) the Fed’s balance sheet policy from a financial stability/narrow banking perspective (see my post on narrow banking proposals). On November 21, 2014, he interpreted minutes of an FMOC meeting as suggestive evidence of plans to establish segregated cash accounts.
When evaluating the merit of these discussions, it is important to distinguish between (i) introducing government provided electronic money and (ii) doing so in combination with an abolition of currency. Consider first the former option, namely to have the government grant the broad access to central bank reserves. This could be useful as it opened up the possibility to eliminate the risk of bank runs and as a consequence, abolish the fragile and costly system of deposit “insurance.” If, that is, most savers opted to move their deposits to the central bank rather than keeping them with commercial banks. If they didn’t, then governments would most likely feel obliged to continue bailing out depositors in failing commercial banks.
Another advantage of introducing government provided electronic money would be to eliminate a disgraceful contradiction in public policy. Mostly for reasons related to the deterrence of tax evasion, governments increasingly force citizens to use electronic means of payment although these are not legal tender and declare the use of currency illegal although currency is legal tender. In effect, governments force citizens to use liabilities of private companies for their transactions and in doing so, expose citizens to various financial risks. (These risks are partly borne by the public sector, due to deposit insurance, but that insurance creates other problems.) This absurd situation would end if the government provided a legal tender for electronic payments.
But granting the public access to central bank reserves could also create new problems. Inducing savers to move their deposits from commercial banks to the central bank would undermine a central activity of the former, namely deposit financed credit creation. Douglas Diamond and Philip Dybvig (1983) have shown in a classic article that the insurance characteristics of a deposit contract help improve outcomes relative to a situation without such a contract. How large are those benefits? And how large are they relative to the social costs of bank deposits, namely inefficiencies due to deposit insurance (moral hazard) and costs of run-induced fire sales and defaults?
There are other open questions. One concerns the transition from the current system where savers hold deposits at commercial banks, to a new system where they hold central bank reserves. Would the central bank assist commercial banks and convert deposits into reserve holdings? And if not, how could runs be avoided?
In addition, questions of a more technical nature would have to be addressed. Should banks (in the interbank market of reserves) and the general public (when paying their bills) use the same payment system? Or should the existing system linking the central bank and commercial banks be kept separate from a new, to be designed, system that serves consumers? How would monetary policy in this new world look like and how would the monetary transmission mechanism work? Would the central bank lend funds to households, and would it set the same policy rates for banks and the general public?
Turn next to the more ambitious proposal, namely to augment the introduction of government provided electronic money with an abolition of currency. This suggestion is more problematic, because the promised benefits are likely overstated and the costs misjudged. Consider first the benefits. As far as the relaxation of the zero lower bound is concerned, the fundamental objective—to lower real interest rates in order to incentivise earlier consumption and investment—cannot only be achieved through monetary policy but also by tax policy. A trend increase in consumption or value added tax rates acts like a low or negative real interest rate. And even if the objective is to relax constraints on monetary policy rather than relying on fiscal policy, this is feasible without eliminating cash altogether (and without moving to a higher inflation target which is costly for other reasons). As explained by Buiter, all that is needed is a floating exchange rate between reserves and cash. Killing currency amounts to an overkill unless one fears negative consequences due to such a floating exchange rate (see, e.g., Goodfriend, 2009, fn. 23).
As far as the second objective—limiting tax evasion as well as criminal and black economy transactions—is concerned, the elimination of currency is not a sufficient measure. True, those seeking anonymity would need to incur additional costs to secure it. But these additional costs would likely be mostly fixed costs (e.g., fees for incorporating a shell company in Nevada and hiring a lawyer). The implicit tax on black market activity due to the abolition of currency thus would be a regressive one and the revenues it generated would likely be smaller than hoped for. Professional criminals directing large operations could easily afford the higher cost of securing anonymity while the tax dodging middle class plumber in a badly run country could not.
Turning to the disadvantages, eliminating currency has severe consequences for privacy. (Buiter’s suggestion of ‘cash-on-a-chip cards’ could limit those consequences somewhat.) This point is widely acknowledged in the debate but it is not given sufficient weight. Related, forcing savers to hold means of payment—and a significant share of their savings—exclusively with a branch of the government (the central bank) might cause concern, particularly in countries with a history of expropriation.
Finally, there is a completely different reason to be worried about the prospect of putting an end to currency; when pointed to the proposal under question, some mothers I talked to immediately articulated it: In a world without physical money it is harder to acquire basic financial literacy skills. This might appear like a third-order problem, but is it?
The ECB and Ireland: Bailout But no Bail-In
Vincent Boland and Peter Spiegel suggest in the FT that the ECB coerced Ireland into applying for a bailout in 2010, based on letters recently released by the ECB. The ECB, in contrast, argues that the bailout was unavoidable anyway, and that the Irish Minister for Finance shared this view. In a Q&A section on its website the ECB writes:
While the ECB always acted within its remit and in line with rules established for the whole of the euro area, there are limits to the support that the Eurosystem can provide to banks in the Member States. … First, collateral has to be adequate; and second, counterparts have to be financially sound and solvent. The letter dated 15 October 2010 from the former ECB President recalled these rules and their implications for Ireland. … [Another letter dated 19 November 2010] explained the conditions under which further provisions of ELA to Irish financial institutions could be authorised. In his already public reply of 21 November 2010, the Irish Minister for Finance stated that he fully understood the concerns raised by the ECB Governing Council.
The ECB also addresses the question why it opposed the bail-in of bondholders in 2010:
As regards the possible bailing-in of senior debt in late 2010, it is important to recall the words of EU leaders in a European Union statement of 29 October 2010 and during the G20 meeting in South Korea on 12 November, according to which burden-sharing of senior debt would not be applied until mid-2013. … Furthermore, the necessary EU governance tools to address the bail-in of creditors, which were set out in the Bank Recovery and Resolution Directive (BRRD) and have been fully endorsed by the ECB, were not available in late 2010. … any potential burden-sharing of senior debt in the immediate aftermath would first and foremost have had negative spillover effects on the financial stability of Ireland, as well as on other European countries.
ECB Takes up Banking Supervision
René Höltschi reviews in the NZZ how the ECB became European bank supervisor within just two years. The article also surveys the pillars of the European Banking Union—supervision, resolution and safety nets—and its fundament, the Single Rulebook.
ECB Bank Stress Test
Claudia Aebersold Szalay reports in the NZZ on the findings of the stress test conducted by the ECB. The article contains a map and tables.
The ECB downgraded the quality of bank assets (mostly bad loans) relative to banks’ own estimates. This is reflected in lower estimates of banks’ equity positions. Moreover, the ECB conducted a stress test and considered two scenarios. According to the adverse one, banks’ equity positions would fall by more than 250 billion Euros. Italy, France and Germany would be hit hardest.
Claire Jones and Alice Ross as well as Martin Stabe offer additional insights in the FT, FT. A report in the FAZ. The ECB‘s page with press release and other information.
Conference on “Law and Economics” with Focus Session on “Bank Resolution” at the Study Center Gerzensee
Joint with CEPR, the Study Center Gerzensee organised a conference on law and economics. The program can be viewed here and papers can be downloaded from CEPR’s website. The focus session on bank resolution featured contributions by
- Patrick Bolton and Jeffrey Gordon (paper)
- Martin Hellwig (paper, slides)
- Mathias Dewatripont (slides)
- Gerard Hertig
- Wolf-Georg Ringe (paper)
- Paul Tucker (paper)
In his talk, Jeff Gordon explained how Dodd-Frank extends the FDIC’s resolution technology from the 1930s to “non-banks” that engage in banking business. Dodd-Frank establishes an “Orderly Liquidation Authority” and in title II a “Single Point of Entry” by putting a holding company (topco) into receivership. The objective is to minimise disruption costs for large institutions, to preserve the going-concern value of the company and to avoid collateral damage. Single point of entry also helps resolve cross-border issues. No comparable institutional framework is available in the EU. In the crisis, US authorities implemented ad-hoc alternatives to bankruptcy: Mergers (which require the approval of shareholders and therefore make it hard to wipe out the target’s shareholders) worked for Bear Stearns (JPMorgan Chase, Maiden Lane, Fed) but not for Lehman Brothers (Barclays, Fed) because the UK authorities refused to waive Barclays shareholder approval, fearing fiscal implications. Recapitalisation with third party funds (Fed) in the case of AIG also required shareholder approval and protected creditors and counter-party claims.
Patrick Bolton cautioned that the rules for the topco are still not clear and discussed alternatives to Dodd-Frank in the bankruptcy code. He emphasised the role of qualified financial contracts and debtor-in-possession interventions.
Martin Hellwig argued that the government rescue of Hypo Real Estate reflected the political will to help influential creditors rather than systemic importance. He questioned the viability of single-point-of-entry arrangements in cross-border resolution, pointing to lack of trust among national regulators. He questioned whether internationally active banks can ever be resolved in an efficient manner and asked whether, in that light, they are socially valuable.
Mathias Dewatripont warned that excessive emphasis on bail-in arrangements can undermine financial stability, for example by having the expectation of a small haircut applied to senior debt tranches trigger a run on all senior debt. To avoid such an outcome, he favoured a clearly identified seniority structure with a significant balance-sheet share of “bail-inable” liabilities. He questioned the usefulness of higher capital requirements, arguing that “prompt corrective action” is politically infeasible unless the equity ratio has fallen below a very low value, 2 percent say.
Wolf-Georg Ringe favoured holding-company structures with sufficient “bail-inable” debt.
Paul Tucker discussed potential problems with the holding-company/single-point-of-entry strategy, related to centralised operations (IT). He raised the issue of accountability and the potential lack thereof if companies are resolved by regulators rather than judges, and he wondered whether national regulators can commit to collaborate across borders if need be. He favoured “bail-inable” debt over equity because the former gives incentives to monitor without the incentive to speculate on the upside.
Gerard Hertig warned that regulatory incentives lead to bank mergers rather than resolution, in particular because authorities tend to be more lenient in crisis times. He argued that because of deposit insurance, resolution worked well in Japan until recently.
Patrick Bolton argued that cocos are badly designed as their triggers are too low and they refer to accounting equity. Instead, he favoured reverse convertible bonds that can be converted by the issuer.
Oliver Hart argued that resolution has the advantage over cocos that the management gets replaced.
Many panelists voiced scepticism towards narrow banking proposals. They feared that control over the money supply might turn into control over credit, referring to the discussion in the US during the 1930s.
The Financial Crisis
The Economist’s “schools briefs” on the financial crisis: Parts 1, 2, 3, 4, 5. Quoting from the first part:
… it is clear the crisis had multiple causes. The most obvious is the financiers themselves—especially the irrationally exuberant Anglo-Saxon sort, who claimed to have found a way to banish risk when in fact they had simply lost track of it. Central bankers and other regulators also bear blame, for it was they who tolerated this folly. The macroeconomic backdrop was important, too. The “Great Moderation”—years of low inflation and stable growth—fostered complacency and risk-taking. A “savings glut” in Asia pushed down global interest rates. Some research also implicates European banks, which borrowed greedily in American money markets before the crisis and used the funds to buy dodgy securities. All these factors came together to foster a surge of debt in what seemed to have become a less risky world.
“Bankensanierung durch Bail-in (Bank Bail-In),” FuW, 2013
Ring-Fencing Global Banks’ Operations
The Economist reports about US plans to force global banks to organise their US operations in separately capitalised and regulated subsidiaries.
“Banken und Staaten (Banks and States),” FuW, 2012
Finanz und Wirtschaft, June 20, 2012. PDF. Ökonomenstimme, June 22, 2012. HTML.
- Changes in bank regulation reflect changed views about whether banks contribute to the social good. Those views have become less favourable.
- In Switzerland, bank secrecy is no longer defended because the perceived cost to the general public exceeds the benefits to the banks.
- Similar doubts start to arise regarding money creation by banks. A proposal to shift to a 100% money regime offers some advantages.
