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Advanced Finance, Banking and Insurance

Dr. Peter Wierts & Prof. Dirk Schoenmaker

College 1: Functions of the Financial System

Learning objectives course:

- Financial manager: understand financial markets & institutions
- Learning objectives: insight in
the functions and dynamics of financial markets and institutions in the European
key policy areas for the financial sector

Learning objectives chapter 1:

Explain the main functions of the financial system
Differentiate between the roles of financial markets and financial
Explain why financial development may stimulate economic growth
Describe the advantages and disadvantages of bank-based and market-based financial
Explain the various corporate governance mechanisms

Working of the financial system:

Primary function financial system: allocation of resources from sectors that have
a surplus to sectors that have a shortage of funds.
Main functions of financial system:
1. Reducing information costs: overcome an information asymmetry between borrowers
and lenders, which can occur ex ante (adverse selection) and ex post (moral hazard)
A higher return makes saving more attractive (substitution effect), but fewer savings are needed
to receive the same returns (income effect)
2. Reducing transaction costs, e.g. by pooling funds
3. Facilitating the trading, diversification, and management of risk: e.g. by providing
liquidity and through securitisation
Securitisation = the packaging of particular assets and the redistribution of these packages
by selling securities, backed by these assets, to investors

Financial and economic development:

Functioning of financial systems is vitally linked to economic growth: countries with
larger banks and more active stock markets grow faster over subsequent decades

Some recent studies conclude that at intermediate levels of financial depth, there is a
positive relationship between the size of the financial system and economic growth
But at high levels of financial depth (private credit 100% GDP), more
finance is associated with less growth
Government intervention (regulation, policy) is needed:
to protect property rights and to enforce contracts
to encourage proper information provision (transparency)
in order to ensure soundness of financial institutions. Savers are unable to
properly evaluate the financial soundness of a financial intermediary. Government
regulation may prevent financial intermediaries from taking too much risk.
Financial intermediaries have incentive to take on too much risk by:
If they fail depositors bare a large part of the costs (deposit-guarantee system
may provide even bigger incentive)
Contagion = a sound financial intermediary may fail when another intermediary goes
bankrupt due to taking too much risk
In order to ensure competition via competition policy. Example prevent price
fixing (kartelvorming)
Financial liberalisation: opening up of domestic financial markets to foreign capital
and foreign financial intermediaries - Allowing foreign capital to freely enter domestic
increases the availability of funds, stimulating investment and economic growth
enhances competition in the financial system
may lead to a constitution for institutional reforms that stimulate financial
development (domestic financial intermediaries may support transparency so
they can compete better with foreign intermediaries)
Bank- versus market-based
Direct finance: sector in need of funds borrows from another sector via a
financial market
Indirect finance: a financial intermediary obtains funds from savers and uses
these savings to make loans to a sector in need of finance
In most countries, indirect finance is the main route for moving funds from
lenders to borrowers; these countries have a bank-based system, while countries
that rely more on financial markets have a market-based system

- EU is more bank-based (high % bank credit, low % corporate bonds and medium % stock
market) (NL, UK more market-based, Germany, Italy, Greece, Spain more bank-based)
- US more market based (low % bank credit, high % corporate bonds and stock
- In the EU there is a wide difference between
countries see sheet 15 lecture 1

Free-rider problem: investors do not have strong incentives to properly acquire information,
because they cannot keep the benefits of this information (other investors will ride along on
the investment).

Banks have the right incentives to do research as they do not immediately reveal their
decision and have more resources to monitor and to pressure for repayment

Corporate governance:
= The set of mechanisms arranging the relationship between stakeholders of a firm and the
management of the firm.
Principal-agent theory predicts that the managers, the agents, may not always act in the
best interest of the owners, the principal.
Investors can use several tools to ensure that management of a firm acts in their
interest; the most important tools are:
appointment of the board of directors
executive compensation
the market for corporate control: proxy contests (shareholder tries to
persuade other shareholders to act in concert with him), friendly mergers and
takeovers, and hostile takeovers
Take overs may not be effective, because (1) of the information asymmetry between
insiders and outsiders, a possible free-rider problem (2) and (3) firms often take various
actions to prevent a takeover which may cost harm to the firms position
concentrated holdings
monitoring by financial intermediaries (bank-based system)
may be most effective to ensure management acts in shareholders interest, by:
- Having a long-term relationship between financial intermediary and firm
- Holding both equity and debt by financial intermediary
- Active intervention by financial intermediary when firm has financial distress

But also bank managers may act in their own interests which will cost the same or even
bigger problems as explained in the principal-agent theory.

Market-based financial systems claim to provide greater flexibility when it comes to risk.

Two big recent changes before the financial crisis:

Traditional banking model, in which the issuing banks hold loans until they
are repaid, was increasingly replaced by the originate and distribute banking model:
banks pool loans (like mortgages) and then tranche and sell them via securitisation.

Securitisation led to non-regulated shadow banking system: institutions that

support bank-style maturity transformation funding of long-term assets with
short-term debt outside banks and without access to central bank liquidity

To facilitate securitisation, off-balance sheet vehicles were needed; special

purpose vehicles (SPVs). The economic rationale for setting up these vehicles
was to reduce capital requirements imposed by bank regulation.

This SPV contains the loans and asset-backed securities. They convert the
ABS into collateral debt obligations which contains super senior tranche
(AAA), mezzanine tranche (medium) or equity tranche (also toxic waste or

Buyers of these can protect themselves by purchasing credit default swaps

(CDSs) contracts insuring default.

From originate and hold to originate and distribute
Leading to a long chain of financial intermediaries involved in channeling funds from
the ultimate creditors to the ultimate borrowers (Long intermediation chain):

Household (MMF shares) Money market fund (Short-term paper) Commercial
bank (Repo) Securities firm (CDO) SPV (MBS) Mortgage pool
(Mortgage) Households

Main task financial system is to allocate funds from surplus sectors to
sectors with a shortage. Although most investments are financed though
retained earnings (internal finance). Financial systems performs two
1. Reducing information and transaction costs
2. Facilitating trading, diversification and management of risk
Government regulations are needed and consists of:
Protect property rights and enforce contracts
Encourage proper information provision
Regulate and supervise financial institutions to ensure their
Competition policy
Market-based systems have to deal with the free-rider problem and the
principal-agent problem
Bank based systems might be better at dealing with the free-rider problem and
the principal-agent problem (but bank managers can act similar to firm manager
(agents) as well)
No clear evidence that one financial system is better for growth than the other.
Differences in financial systems may influence the type of activity in which a
country specializes.

Financial intermediaries are necessary for the successful functioning of markets
(provide complementary growth-enhancing financial services)
Due to several recent changes (securitization and shadow-banking), market-
based financial intermediaries have become very important
Overall, more useful to distinguish countries by national legal systems than by
whether they are bank- or market-based (law and finance view)

College 2: Financial Crises (H2)

Learning objectives:
Explain the characteristics of different types of financial crises
Understand the link between sovereign and banking crises
Explain the main theoretical models of banking crises
Understand the pro-cyclicality of the financial system
Explain the main drivers and contagion mechanisms of the 2007-2009
financial crisis
Explain the euro crisis

Type of crisis
- Banking crisis
(Large) part of a countrys banking system has become insolvent after heavy
investment losses, banking panics or both
Systemic banking crisis: a countrys corporate and financial sectors experience a
large number of defaults and financial firms face great difficulties repaying contracts on
time (most of banking system capital will be exhausted)
typically preceded by credit booms (growth above GDP trend) and asset price
bubbles (Reinhart & Rogoff, 2009)
- Sovereign debt crisis
Outright default on payment of debt obligations
Occurs when a government fails to meet interest or principal payments on its debt
External debt: loans issued under another countrys jurisdiction (often in foreign
currency and held by foreign creditors)
Domestic debt: issued under a countrys own jurisdiction (often in domestic currency
and held by domestic creditors)
Government restructures debt on terms less favorable to the lender (i.e. lower
interest rate)
- Currency crisis
The value of a countrys currency falls precipitously
Countries with fixed exchange rate vulnerable to crisis of confidence
Twin crises: Banking crises often precede or accompany sovereign debt crises. (mostly
countries with fixed exchange rate)
Cost of banking crisis
Not only cost of rescuing banks: Fiscal costs (already larger than bank bailouts)
But more importantly loss of GDP: Output loss
And: Increase in public debt

Bank runs
Banking crises explained by the liability side:
Banks transform short-term deposit funding into long-term loans. When deposit withdraws
increase (because of confidence loss), the bank is forced to liquidate assets. If all banks do
this at the same time, the market dries up

Multiple equilibria a confidence shock can cause a jump from the good equilibrium to the:
- Bad equilibrium
Depositors demand their deposits back (run)
- Why?
Sun spots: bank run is self-fulfilling prophecies (Diamond and Dybvig)
Two equilibria:
1. Depositors will withdraw if they believe other depositors will (panic occurs)
2. Depositors withdraw according to consumption needs (believe no panic)
which one will occur?
Business cycle: no panic at first, with a recession banks
assets will reduce in value, raising possibility that banks cannot meet their
commitments, depositors response and withdraw (Allen et al, 2009)
Crises rather response of depositors to bad news than random events

Allen and Gale (box 2.5) (how cyclical fluctuations in assets values can produce bank runs)
- Important to understand basics of model
Early (c1) and late consumers (c2)
Early consumers/ withdrawers:
1 + c21 = L (safe asset)

Late consumers: c22 = R X (risky asset

with return R)
Early-withdrawing consumer: c21
Equilibrium: c1(R)= c21(R)= c22(R); early consumer =
early-withdrawing late consumer = late consumer
Leading economic indicator: R depends
on business cycle
Feasible contract: C1 (R) = c (met streepje erboven)
Optimal contract: c (met streepje erboven) = L

Minsky model Financial-instability hypothesis -

Links the business cycle to financial crises
- Credit boom-bust starts with a displacement like an invention or something that makes
investors excited:
1. credit expansion, characterised by rising assets prices;
2. euphoria, characterised by overtrading;
3. distress, characterised by unexpected failures;
4. discredit , characterised by liquidation; and
5. panic, characterised by the desire for cash (banks cut bank on their lending;
- In which stage are we now?
- We cannot prevent the cycle, but the Central Bank tries to soften it, by releasing money
when the economy goes down and tightening the economy when it goes up.
- Financial cycle is much more volatile since the eighties than the business cycle

Factors that contribute to pro-cyclicality:

- risk assessment (risk underestimated in good times, overestimated in bad times)
- the amount of debt (the more leverage in good times, the more deleveraging in bad
- pro-cyclical of collateral. Investors do not collect costly information so lending against low
quality collateral is possible, only until small shock.
- capital requirements

Financial crisis of 2007-2009

Run up to 2007-2009 financial crisis
- Sub-prime mortgages: housing loans to high-risk borrowers with weak/bad credit history
Low step-in rates, affordable for low-income
Low interest rate environment (Greenspan)
When housing prices started to fall, subprime owners could not refinance mortgage
before low interest rate were set back to market rates, thereby defaulting.
Why did banks provide these subprime mortgages?
low interest rates in general, banks could charge high interest rate for subprime
mortgage and default risk was low because of house booming.
Why did this lead to a global financial crisis? Because instead of financing through
deposits (traditionally), securitization took place
- Securitizations (CDOs, RMBS, etc)
Banks were selling on (no incentive to monitor, because risk was for third party)
Credit rating agencies triple A ratings, same procedure as with corporate
bonds (even for subprime mortgages gathered in a CDO)
Investors were buying without checking,
because risk-free rate was very low and
prices were rising

Expansion of financial sector

- Expansion of shadow banking system
Investment banks
Hedge funds
- Key role leverage (remember Minsky debt!) difference with dotcom bubble: that
one was financed primarily by equity
Who should check credit expansion?
- Underlying cause of crisis is macro:
Bursting of US housing market bubble
liquidity through marketability hold long-term assets funded by short-term liabilities as
assets could rapidly be sold if needed
increased risk aversion and deleveraging caused a shock

Shin: loss spiral for the financial sector through the balance sheet

Crises management
- First, Lehman failure
- Afterwards, AIG rescue
- US: TARP fund (= Troubled Assets Relief Program, buying loans by the
- Europe: Action plan Sarkozy
Liquidity by ECB for short term funding
Government guarantee for medium term funding
Recapitalizing banks
- Did the US and Europe do enough?
Role stress tests to regain trust in banking sector

Why turned it into a Great Financial Crisis

- Features of financial system
1. Strong expansion of financial sector: leverage
2. Long intermediation chain: securitisation
3. Strong interconnections: contagion (=besmetting)
4. No check on aggregate developments: macro side

Causes of the euro crisis:

Lack of fiscal discipline: a lack of budgetary discipline (macroeconomic and financial
imbalances were a major factor behind deterioration of public finances)
Diverging financial cycles: Characteristics of financial cycle (De Haan et al, 2014);
1. Driven by growth credit and housing prices
2. Much longer durations than business cycles
3. Wider amplitude (grootte). Correction often accompanied by financial crises (Drehmann et
al., 2012)
- Ireland and Spain were hit hard, because relied heavily on external funds
- Turn of financial cycle larger effect on public finance (due to effect on government
Diverging competitiveness: Competitiveness deteriorate, work labour increased in GIIPS,
larger deficit, foreign funding, push up money growth, increasing inflation, further negative
effect on competitiveness
Doom loop: (also diabolic loop) Governments engaged in large bailouts. This increased
sovereign credit risk. Two consequences:
1. Believing government needs higher taxes for increase debt underinvestment
slowdown economy further increasing sovereign credit risk
2. Deterioration in sovereigns creditworthiness may have negative affect on financial sector
1: Declining financial sectors creditworthiness (due to lower value debt government)
2: Value of collateral reduces
3: Downgrading rates for banks located in downgraded country
4: Credit quality financial sector declines because value government guarantees to financials
sector decreases
Solution: European Stability Mechanism (ESM): directly capitalize problematic banks without
impacting national debt
Policy reactions: Establishing an European Banking Union: common safety net, no more
national budgets, problems in banking sector will no longer directly affect governments fiscal

College 3: Monetary Policy of the European Central Bank (H4)

- Book focusses on European monetary policy, but we also talk about other regions.
- Article send on BB about monetary policy & quantitative easing. If interest rates go up,
yield go up, stock market goes down (when its unexpected), exchange rates (Euro goes
down & Dollar goes up), spending will go down and savings go up, inflation goes up.

Learning objectives:
Explain the monetary policy instruments of the ECB
Describe the unconventional policy measures of the ECB
Explain monetary transmission
Describe the monetary policy strategy and the ECBs communication policies
Fiscal Policy: explain basics Stability and Growth Pact

Why would a financial manager want to know about monetary policy?
Key impact on external environment
Low inflation adds up to ECBs easing conundrum
Its time for us [i.e. the FED] to break the habit of zero interest rates
(source: FT, 1/2-09-2015)
Interest rate
Bank lending if rate goes down, greater change of repayment.
Balance sheet if rate goes down, value of assets go up, future liabilities go up)
Risk taking if rates are low, companies have to take more risk, because they want
higher returns)

- Transmission mechanism: the process from monetary policy to objectives.
- Yield curve (now the overnight is at 0%, the 10 years is about 1% & 20 years = 2%)
- MRO = main refinancing operations = 0.05%
- LTRO = longer-term refinancing operations (LTROs)
- MLR = marginal lending rate = 0.3% (only use it when banks have liquidity problems)
- Deposit rate (saving at the ECB)= -0.2%

Monetary policy strategy

Instruments Monetary Transmission Objectives

Structure of ECB: Executive Board, Governing Council and General Council

1. The Maastricht Treaty: price stability is primary objective of ECB:
inflation below but close to 2 per cent (measured by Harmonized Index of Consumer
Prices, HICP)
2. ECB supports general economic policies in the Union, which includes high level of
employment and sustainable and non-inflationary growth
ECB extended the period/maturity to 3 years so that the whole yield curve would go
down and the economy will be stimulated.

Costs of deflation:
1. Increase real value of debt
2. Postponing consumption/investment
3. Deflationary spiral of falling prices, profit etc

Why price stability? (otherwise costs of inflation)

1. Easier to disentangle relative price changes from changes in the general price level
2. Creditors will not demand an inflation risk premium
3. No diversion of resources to hedge against inflation
4. Inflation exacerbates perverse incentives of tax systems, which distort economic
5. Inflation acts as a tax on holdings of cash
6. Unexpected inflation causes arbitrary redistribution of wealth and income
7. Inflation leads to sudden revaluations of financial assets

Monetary transmission
- credit channel
- interest rate channel

Monetary Policy Instruments (Conventional)

1. Policy rates
ECB provides marginal lending facility and deposit facility that banks can use if
they need liquidity or if they want to stall liquidity (=deposit); both facilities have an
overnight maturity. Banks only use in absence of better alternatives
Rate on the marginal lending facility and rate on the deposit facility normally
provide a ceiling and a floor, respectively, for overnight rate in interbank money
market (EONIA, euro overnight index average); crisis has changed this (rates
were lowered)
2. Open market operations
The Eurosystem affects money market interest rates by providing more (or less)
liquidity to banks if it wants to decrease (increase) interest rates; it allocates an
amount of liquidity that allows banks to fulfill their liquidity needs at a price that
is in line with the ECB policy intentions
To manage liquidity in the money market and steer short-term interest rates, the
Eurosystem uses open market operations by buying (or selling) financial assets; if
assets are bought from (sold to) a bank, the reserves of that bank at the central
bank increase (decrease) (MROs, LTROs, FTOs, structural operations, zie schrift)

3. Minimum reserve requirements

Banks are required to hold compulsory deposits with NCBs; for most liabilities
included in the reserve base the reserve ratio used to be 2 per cent; now it is 1 per
The minimum reserve system serves two main purposes:
1. to create sufficient structural demand for central bank credit
2. to contribute to the stabilisation of money market interest rates

Unconventional Instruments
Different phases (reasons) of ECBs unconventional monetary policies:
Start of global financial crisis in September 2008 (Lehman collapse)
Start of euro crisis in May 2010 (Greek crisis)
Re-intensification euro crisis coupled with banking strain from mid-2011 on
Declining inflation and sluggish economic recovery after 201

1. Credit easing
Enhanced Credit Support (less standards to collateral, extension of maturity of LT
refinancing operations, outright purchases of covered bonds, currency swap agreements
and unlimited excess to liquidity against main refinancing rate)
Securities Markets Program (SMP)
- In addition to the ECS the ECB introduced the SMP in response to tensions in the
Eurosystem interventions were carried out in the euro-area public and private
debt securities markets to ensure depth and liquidity in dysfunctional market
segments and to restore the proper functioning of the monetary policy
transmission mechanism
Purchases of government bonds were strictly limited to secondary markets; to
ensure that liquidity conditions are not affected, all purchases were fully
neutralized through liquidity-absorbing operations (to avoid monetary
- The governments are not allowed to print extra money (monetary financing of the
government), which would raise inflation. If a government needs money they can raise
taxes or lend it.

Further unconventional measures:

1. Longer-Term Refinancing Operations (LTROs):
with maturity of three years (December 2011 and February 2012)
2. Targeted Longer-Term Refinancing Operations (TLTROs):
liquidity provided to banks if they extend credit to private sector
3. Outright Monetary Transactions (OMTs)
in secondary sovereign bond markets; a necessary condition for OMTs is strict and effective
conditionality (preceded by Securities Markets Program, SMP)
4. Outright purchases of ABS and CBPP3

2. Quantitative easing
- Asset purchase program to counter possible deflation (purchases of government/EU
bonds since march 2015 every month until December 2017 or beyond)
= Securities must be bought in secondary market, are based on NCBs shares and
maturity between 2-30 years

Monetary policy strategy of the ECB

2 pillars:
Economic analysis: focuses on the assessment of current economic and financial
developments and the implied short- to medium-term risks to price stability

Monetary analysis: focuses on a medium- to long-term horizon.

Alternative: Inflation Targeting
IT involves the public announcement of numerical targets for inflation, a strong
commitment of the central bank to price stability as a final monetary policy
objective, and a high degree of transparency and accountability
Central bank sets policy instruments such that its inflation forecast (after some
time) equals the inflation target
Communication policies
Central bank communication has two main objectives:
* it contributes to the accountability of the central bank
* it helps the central bank in managing expectations.
Central banks ability to affect the economy critically depends upon the degree to
which it can influence market expectations regarding the future path of overnight
interest rates.
Three conditions under which central bank communication may matter:
* non-rational expectations
* absence of commitment to unchanging policy rules
* asymmetric information between firms and ECB (about ECBs
reaction function & the economic outlook)
ECBs communication policies
Following Governing Council meeting, the ECB announces the monetary policy
decisions at 13:45 CET; some 45 minutes later, the ECB President and Vice-
President hold a press conference
Publishing of monthly Economic Bulletin with information used for monetary policy
Testimonies of the ECB President to the European Parliament (EP)
ECB officials often give speeches or interviews on monetary policy

Zero lower bound

In recent years central banks frequently reduced policy interest rate to such a low
level that it could not be reduced any further; this is the zero-lower bound (ZLB),
although minimum is not necessarily zero, can be negative too.
Several economists have argued that by offering what is called forward
guidance monetary policy may be effective even under the ZLB
forward guidance: means that a central bank communicates about its future
Guidance that policy interest rate remains at zero until T. At the zero lower bound the
ECB can announce that they will keep the interest rate low for long. This has a
stimulating effect just like actually lowering it. But at the zero lower bound, its not
possible to lower anymore (Odyssean forward guidance)

Goal of communication ECB = forward guidance = communicate actions and thereby set
several expectations where after the actions do not have to be taken anymore, because only
the announcement already created the desired outcome

College 4: European Financial Integration (H3, H6)

Financial integration is achieved within an area when all economic agents face identical
rules, have equal access to financial instruments or services and are treated equally in
these markets
Definition of integration closely linked to law of one price

How to measure?
Theory: measure all frictions to financial integration and check whether these have
asymmetric effects on areas (i.e. tax regimes, reporting standards, corporate governance)
Practice: law of one price (if assets have identical risk and returns, price should be same)

Rise of EU: 28 member states

Harde kern: Netherlands, Germany, Italy, Belgium, Luxembourg and France
1951: European Coal and Steel Community (ECSC) = make war materially impossible
Treaties to formalize co-operation (are legal basis)

Two approaches on integration:

1) Supranational: international institution that is independent from national governments is
responsible for policy making (neo-functionalism) (by majority rule)
2) Intergovernmental: international institution basically fulfils a secretariat role for
governments and has no real power (liberal intergovernmentalism) (by unanimity)
key difference is the transfer of sovereignty from the Member States to the supranational

- Started with Treaty of Rome in 1957

- Single Act of 1987 (objectives: remove barriers by 1992, increased powers to institutions of
EU to complete Internal Market, White Paper on Internal Market)
- Maastricht Treaty (1992) (EU and EMU Economic and Monetary Union)

5 major institutions:
1) European Council (28 heads of state)
only request legislation
2) European Commission (33.000 staff) (supranational)
most independent from Member States
main objective: legislation
decision by majority vote
3) European Parliament (751 members)
legislation and budget
control is limited but EC is accountable to EP
4) European Court of Justice (28 judges)
fosters integration (strong European feeling)
5) Council of Ministers (Ecofin)(28 ministers) (intergovernmental)

Legal instruments:
Regulation: Binding and directly applicable in all member states (overrules national
legislation) fosters financial integration
Directive: Binding, but gives national authorities the choice of form and methods (limited
integration) limited integration

Supranational versus intergovernmental

Supranational: an international organization in which member states transcend national
boundaries to share in the decision making on issues pertaining to the wider grouping
Intergovernmental: Member states do not transfer power or authority to the
intergovernmental organization
Balance of power different:
- Qualified Majority Voting (QMV) versus unanimity voting
- Regulations versus directives

Three stages leading to EMU

Stage 1: 1 July 1990
Complete freedom for capital transactions
Increased co-operation between central banks
Free use of the ECU (European Currency Unit forerunner of the )
Improvement of economic convergence
Stage 2: 1 January 1994
Establishment of the European Monetary Institute (EMI)
Ban on the granting of central bank credit to the public sector
Increased co-ordination of monetary policies
Strengthening of economic convergence
Process leading to the independence of the national central banks. To be
completed at the latest by the date of establishment of the European system of
central banks
Prepare for stage three
Stage 3: 1 January 1999
Irrevocable fixing on conversion rates
Introduction to the euro
Conduct of the single monetary policy by the European system of central banks
Entry into effect of the intra-EU exchange rate mechanism (ERM II)
Entry into force of the stability and growth pact
Stability and growth pact (to monitor fiscal policy of national governments)
With supranational monetary policy need to
maintain fiscal discipline and
coordinate economic policies
Stability and Growth Pact (SGP)
* Members submit stability / convergence programs (preventive arm)
* Excessive Deficit Procedure (corrective arm)
But it failed to impose discipline (lack of enforcement)
* Ecofin does not automatically impose sanctions because of intergovernmental
* Member states have no incentive to monitor each other. In particular, large
countries did not bring down deficit

Can supranational monetary policy with national fiscal and economic policies be
made to work?
Even with stronger rules, which inherently have an intergovernmental
Or do we ultimately need a Political Union?
Centralising fiscal powers implies centralising political powers

Macroeconomic Imbalance Procedure (MIP): prevent large imbalances based on continuous

monitoring of a set of 11 indicators covering the major sources of macroeconomic imbalance

History of Financial Integration

- Internal market: single license & home country control
- Single currency (1999, 2001)
- Financial Services Action Plan (1999): remove all barriers to get free flow of capital
within EU
- Banking Union (2014): Single Supervisory Mechanism (SSM) (Supervisory by ECB)
Euro Crisis made clear that national responsibility for supervision and stability doesnt
work, because of large, cross-border banks and interconnections between national banking
systems and banks and sovereigns
Framework: zie notities
Consists of:
1) Single Rulebook
2) SSM Single Supervisory Mechanism
3) SRM Single Resolution Mechanism
4) European deposit system
SRB Single Resolution Board
ESM European Stability Mechanism
Paradigm shift of Banking Union from national to European
- Capital Markets Union (2015): create more balanced EU financial system
Short term: encourage high quality securitization, improve credit information on SMEs for
easening investing and Review Prospectus directive (easier for smaller firms to raise
Long term: remove barriers in tax, insolvency and securities laws
- Single Resolution Mechanism (2016)

Drivers of financial integration:

1) Market forces (encourage competition)
2) Collective action (EURIBOR, interbank rate; EONIA, overnight rate; SEPA Single
European Payment Area): take collective action to benefit individual participant which
individual person cannot do alone
3) Public action action by public authorities when market forces and collective
actions are not enough.

Measuring financial integration:

1) price-based indicators: differences in prices/return caused by geographic origin
measure by difference between local yields and some benchmark (German yield)
measure by dispersion of prices: standard deviations of yields across countries, when
its decreasing financial integration increases (after crisis high standard deviations, low
measure by common factor portfolios (Pukthuanthong & Roll, 2009), integratrion
measured as average of R-squares across countries

2) news-based indicators: common/global news should be relatively more important. News

with regional character should have little impact on price
differentiate between common and specific country news. Yield change in benchmark
asset is proxy for common news

3) quantity-based indicators: quantify effects of frictions faced by demand and supply

cross-border activities in specific market (reduced entry barriers should increase cross-
border holdings of securities)
home bias: agents invest in domestic assets even though risk is more effectively shared
in foreign asset

Empirical evidence:
Money market: most complete integration after euro introduction, also hit hardest during
crisis, standard deviations now declining again
degree of integration depends on market segment and is correlated with degree of
integration of underlying financial infrastructure
financial/euro crisis resulted in temporary decrease in integration
improvements, but still fragmentation in some market segments
Benefits of integration:
better risk sharing and diversification
better allocation of capital
contribution to financial development (foster competition)

Costs of integration:
more cross-border contagion
Transmission of economic shocks becomes easier (euro crisis)
Transmission channels:
1) integrated markets (H5-6)
2) Cross-border financial institutions (H9-11)
This has consequences for:
financial supervision and stability (H12-13)

College 5: Financial Markets & Institutional Investors (H5, H9)

1. European Financial Markets
Pecking order thesis = companys perspective on capital structure
because of asymmetric information, companies prefer internal- over external financing
(external financing premium)

Stock markets Money/debt markets

Risk sharing Liquidity provision/lending
Price discovery Obviating price discovery
Information sensitive Information insensitive
Transparent Opaque
Big investments in info Modest investments in info
Many traders (exchanges) Few traders (bilateral)
Trading not urgent Trading urgent
Volatile volume Stable volume

As long as the market value and book value of debt are the same there is no problem
with debt. But when a firm gets into distress the market value of debt decreases and the
debt becomes information sensitive
Once the value of assets drops towards information-sensitive region (due to new
information on neglected risks), investors start to question safety and sell them off causing a
drop in the value of these debt securities (H8)

- Bonds are more stable than bank loans during crises

- Share of bonds increase in corporate debt

Functions of Financial Markets:

1) Price discovery (pre-trading phase) market facilitates dissemination of information
2) Trading mechanism (trading phase) platform to facilitate trade
3) Clearing and settlement arrangements (post-trading phase) ensure terms of agreement
are honored

Types of participants in financial markets:

1) Public investors ultimately own securities
2) Brokers agents, trade for public investors
3) Dealers trade for themselves, buy and sell, make profit out of difference

Trading mechanisms
- quote-driven markets (dealer markets)
Dealers quote firm bid-ask prices (prepared to deal) (gets privileges from stock market)
Buyer pays ask price; seller receives bid price
= spread for dealer: pa pb (dealer keeps inventory)
- order-driven markets (auction markets) (more transparent than quote-driven)
Participant issue instructions for specific actions (buy or sell at pre-specified price)
Limit orders (max buy/min sell price) versus market order (best available price)
highly formalized, clear auction rules, order book
- Hybrid markets
Combination of both

Secured money market increases after crisis, unsecured is decreasing

Long term = average of short terms, because more risk over longer period of time, long term
more influenced that short-term
general interest rate increase = price of bond decrease = yield will increase
Term structure (of interest rates)
Yield curve measure of the markets expectations of future interest rates given the
current market conditions (based on government bond yields)
Influenced by:
expected short term interest rates
term premium (spread) (higher for longer maturities)
Yield differentials (spreads) measured against benchmark (German Bunds)
credit risk premium: risk of default by borrower
liquidity premium: spread between liquid and less liquid bonds

dropped after crisis
revival = crucial to enable banks to deleverage

Financial markets:
1) the money market: short-term up to one year
2) the bond market: for debt securities with a maturity of more than one year
3) the equity market: issuing equity that grants residual claim on firms income
4) the derivatives market: value is derived from value of underlying financial instrument (risk-
management tool)
interest derivatives largest market, corporates want to manage risks
- Forward contract (Futures & Swaps)
- Options (not obligated but choice)
5) the foreign exchange market: relative values of currencies determined

Types of institutional investors:

1) institutional investor: specialized, manages collectively savings from small investors
special types:
Hedge fund: pool capital from a number of investors and invest in securities and other
instruments (leverage and derivatives)(reduce volatility and risk) (most regulation do not
apply to hedge funds)
Private equity: invest in non-public companies (often large amount of debt)(typically
2) pension funds: collect, pool and invest fund to provide for future pension
defined benefit (DB) versus defined contribution (DC)
3) life insurance companies: offer mix of long-term saving and insurance products
4) mutual funds: investment vehicles (pooling of funds). Investors buy a share of the mutual
fund and depend on the performance of the mutual funds assets/portfolio

= a marketable security that tracks an index. Unlike mutual funds, ETF trades look like a
common stock and have higher daily liquidity and lower fees than mutual fund shares

DB = Defined Benefit pension scheme = a known future payout

DC = Defined Contribution pension scheme = money is contributed and invested, final sum
depends on investment return

Evolving investment policy from fixed income to balanced investment mix of fixed, equity
and other

Move from banking to institutional investment. It is growing!

Little institutional investment yet though in NMS (new Member States)

Drivers of growth:
Supply factors
superior risk return profile (diversification)
shareholder protection (corporate governance) = institutions more bargaining power
regulatory issues (more competition and deregulation of FI)
fiscal advantages (pension and life insurance) (deferred tax at payout stage)
International CAPM: each investor holds world market portfolio

International diversified portfolio increase return and decrease risk. From A to B: lower
risk and higher return. From A to A: same risk, higher return

Home bias:

EHB = Equity Home Bias

The lower foreign equity, the higher the home bias
foreign equity = 0 1-0 = 1; no diversification
also REB (Regional Equity Bias), measures if EU has preference for EU equity in
comparison with US equity
Strong decline of home bias in euro area
What driver home bias?
1) openness bias: GDP lowers home bias, country with large trading volumes considered to
be more open
2) professionalism bias: size of institutional sector, the bigger the size the smaller the home
bias. Institutional investors are professionals who diversify international
3) corporate insider bias: insider ownership increases home bias by
1) domestic investors holding shared that cannot be owned by foreign investors
2) domestic investors allocate a lower amount to foreign equity

Demand factors
Wealth accumulation (longer investment horizon when wealthier)
Demographic factors (ageing, saving for retirement dependency ratio = retired people /
working people, increasing)
Social security system (institutional investment substitute for declining benefits)

College 6: Infrastructure of Payment Systems (H6)

Guest lecture by Wilko Bolt
Payment is the quintessential economic activity that binds together the gains from trade. It is
a crucial part of the financial infrastructure no well-functioning economy can do without
plumbing of the economy

But, payment systems impose resource costs

Task for the ESCB: promotion of sound and safe payment system (oversight and regulation)

Evans (2004): Payment economics lies at the intersection of monetary theory, banking and
industrial organization.

Payment system = everything (payment instruments, banking procedures) that ensures the
circulation of money
Large-value payment systems: transfer system between banks and central banks
Main issue: access, liquidity, system risk, settlement
Retail payment systems: transfer systems between consumer, merchant, and banks
Main issue: pricing, competition, fraud, innovation (this lecture focusses on retail payment)
payment scheme: set of interbank rules, standards and practices for the provision or
operation of specific payment instruments
- pull transaction initiated by the payee
- push transaction initiated by the payer;

- payment volume increase, differs per country, shift to electronic payment
SEPA: Harmonization of EU payment market for credit transfers, direct debits and payment
cards (2014)

Contactless payments
Instant payment (24/7)
FinTech = financial technology (non-bank) companies entering the market

Basic Network of Payment (four-party payment scheme, open, i.e. Visa/Mastercard)

also three-party scheme; when issuer/acquirer is the same, closed)

Wholesale payment systems large-value/time-critical funds transfer between financial

institutions (for customers or themselves)
- Correspondent banking payment: payment between two banks that is made through an
intermediary (the correspondent bank or settlement bank)
- Real-time gross settlement (RTGS): each payment is immediately settled on a gross basis

Good Euro(payment)system important for:

1) a sound currency
2) the conduct of monetary policy
3) the functioning of financial markets
4) the maintenance of financial stability

- Who benefits and who pays the costs? Optimal structure of payment fees between
consumer and merchant?
- Much regulation and innovation, what will be the future?
2SMS: two-sided markets; markets where one or several platforms enable interactions
between end-users, and try to get the two (or multiple) sides on board by appropriately
pricing each side (Rochet-Tirole, 2006) (two or more groups provide each other with
beneficial network effects)
besides total price, also price structure matters for total volume of demand
one side of the market is subsiding the other
i.e. acquirer pays fee to issuer, this raises price the merchant pays for the card transaction,
while cardholder pays less, thereby increasing the willingness of the cardholder to make use
of the payment card, which increase volume

Benefits Bi differs across consumers and merchants (heterogeneity)

Monopolist maximizes profits by getting both sides on board

Given any value of PB, the lower is PS the more sellers choose to be on board this platform
seeking buyers, the more transactions then occur, and, it can be shown, the more valuable
each of these transactions is to buyers. Similarly, the number of buyers on board this platform
is determined by PB, and more buyers lead to more transactions and more value for sellers

*Zie collegeblok voor formules

optimal price structure depends on:

- costs
- market side price elasticities and externalities

Interchange fees may be too high or too low, but never zero and never fully cost-based
Network effect play important role (perfect competition or monopoly)
--> too much regulation can stifle innovation leading to inefficiencies
Post-trading: after a trade is complete, it goes through the post-trading process where the
buyer and seller compare trade details and approve the transaction whereafter the
ownership is changed and the transfer of securities and cash is arranged

College 7: European Banks (H10)

Bank profitability:
1) lending business (originate to hold model)
--> p = Loans x rL + Reserves x rF - Deposits x rD - C
2) fee based business (trading, securitisation etc) (originate to distribute model)

Banks provide liquidity to financial institutions, firms, and households

Asymmetric information = core of banking (monitoring costs)
Bank loans are non-marketable and have high degree of private information
--> banks monitor borrowers by: (who monitors bank?)
- screening projects ex ante (adverse selection)
- preventing opportunistic behaviour (moral hazard)
- auditing/punishing borrowers who fails to meet contractual obligations (costly state

Cost of delegation:
Bank has an incentive to repay depositors, otherwise bankruptcy
--> fixed deposit rate, only audited if assets are insufficient to repay depositors
Expected cost of auditing Cn is fixed cost (advantage)

When to delegate?
*Zie collegeblok

Banks have advantage in borrowing if:

1) n is large --> economics of scale
2) m is large --> capacity of lender is small: each project needs several lenders who would
need to monitor borrowers
3) Cn is small --> cost of delegating monitoring to bank is small

Risk management model

Economic capital: amount of capital a bank needs to be able to absorb unexpected losses
(allows for centralisation of risk management)
--> unexpected losses: to secure survival in worst-case scenario
--> expected loss: anticipate average loss over measurement period (part of operating
profits, cost of doing business)

Modern risk management:

Risk adjusted return on capital (RAROC): revenues - costs - expected losses / economic
economic capital = worst case loss - expected loss

*Zie collegeblok voor types risk + distribution

VaR = value at risk
Tool for measuring market risk (also used by banks to calculate for Basel capital
--> the expected maximum loss (Value-at-Risk) over a target horizon of N days within a
given confidence interval of X per cent
But VaR underestimates market risk of portfolio, so extreme value theory (one-day losses of
5 per cent or larger instead of N=10 and X=99%) to get better estimation of downside risk of

Next to credit, market and operational risk (all incorporated in capital) there is also liquidity
Can be managed in two ways:
1) maintain pool of liquid assets (reserves, government bonds and illiquid loans (higher
return though)
2) preserving a diversified funding base (funding liquidity) --> lending in interbank market -->
most important 'asset' trust amongst banks

Because of all risks, banks tend to move to shadow banking (no/less regulation) --> market-
base finance

Traditional banking

Shadow banking
Open ended (investment) fund --> type of mutual fund that does not have restrictions on the
amount of shares the fund can issue

Financial Stability Board (2016) --> structural vulnerabilities from asset management
Recommendations to authorities to address:
1) Liquidity mismatch between investment assets and redemption terms and conditions
2) Leverage within funds

The European banking system

Cross-border penetration: assets of banks from other EU countries or third countries as a
percentage of a country's total banking assets
--> Banking systems of New Member States dominated by banks from other EU countries
--> Assets of banks from third (non EU) countries well below 15% for all EU Member States

Banking market integration

Cross-country standard deviations
--> standard deviations have been rising
--> for smaller loans even higher dispersion, because local knowledge can help reduce
information asymmetry so SME rather use local banks than foreign banks
--> law of one price is unlikely to hold (different tax, legislation, preference for domestic bank
because of language etc)

- Wholesale markets are highly integrated (where financial institutions deal with each other)
- Retail markets national orientantion (corporate loans)

Small banks: <2 billion Euro

Medium-sized banks: 2-100 billion Euro
Large banks: >100 billion Euro

Europe is most internationalized > 53% hometown, 23% rest of region, 24% rest of world
Does concentration lead to a lack of competition?
Structure-conduct-performance paradigm --> in markets with a high degree of concentration,
firms have more market power, which allows them to set prices above marginal costs and
achieve higher profits
But, no empirical evidence (Claessend and Laeven, 2004; Jansen and De Haan, 2006)
Two alternative theory suggesting concentration does not reduce competition:
1) contestability theory--> a concentrated banking market can still be competitive as long as
the entry barriers for potential newcomers are low
2) efficiency hypothesis --> the most efficient banks gain market share at the cost of less
efficient banks (fierce competition)

The new Banking Union landscape

Paradigm shift --> BU creates sub-market within the EU
- Banks can manage balance sheet at aggregate BU level
- ECB conducts supervision with European perspective
When will consumers allow bank from elsewhere in BU?

BU market similar to US market

= large bank with strong domestic orientation (around 70%)
Biggest bank within BU: Credit Agricole, BNP Paribas (by market share)

Global systemically important banks (G-SIBs) --> list produced by FSB (HSBC, Deutsche
Bank, Barclays)

College 8: Financial innovation (H8)

Looking at financial innovations from the perspective of physiology instead of
pathology one sees them as the force driving the global financial system toward its
goal of greater economic efficiency. (Merton, 1995)

Financial innovations: derivatives, securitization, automatic teller machine

Financial innovation: the act of creating and popularizing new financial

instruments, as well as new financial technologies, institutions, and markets
It may enhance efficiency of financial system and financial inclusion, but also give
rise to new risks

Different from other types of new product development:

financial system interconnected
financial innovations dynamic
regulation complex
Explaining financial regulation as supply side factor:
ETF = Exchange Traded Funds = investment vehicles that track an index
EU Synthetic ETFs: obtain the desired return through entering into an asset swap
instead of replicating the index physically

Banks are often ETF provider and swap counterparty, so investor may be exposed to
default of bank at a large extend
synthetic ETF may be option for bank to raise funds against an illiquid portfolio
since there is no requirement for collateral (when repo market is not an option)

US Physical ETFs: replicate the index by simply reconstituting the basket of

physical securities underlying the index
Difference can be explained by differences in regulation

Consequences of financial innovation:

1) improve payments efficiency
Examples of innovations in payments: ATM, credit/debit card, digital currencies, like
Bitcoin; driven by three factors,
1) ideology designed to avoid central control and minimize degree of trust
participants have to put in any third party
2) financial return digital currencies are viewed by some as an asset class for
financial investment
3) pursuit of lower transaction fees

2) new savings and investments opportunities

Examples of innovations in savings and investments: mutual fund, hedge fund,
private equity fund, venture capital fund, inflation-linked bonds (principle indexed to
Open-end funds and closed-end funds close-end fund shares are listed on stock
exchange, cannot be sold back to fund. With open-ended can be sold back to fund at
Advantages open-ended: are very liquid and can grow as long as investors are
willing to invest
NAV = funds assets minus liabilities / number of shares outstanding
Money market fund (MMF) fixed-income mutual fund that invests in debt
securities which are characterized by their short maturities and minimal credit risk
3) increase risk sharing
Derivatives (i.e. options, futures and swaps) (benefits are hedging and risk
management, price discovery and enhancement of liquidity)
Swap arrangement (interest rate, currency, credit default swap)
Home equity insurance: insurance policy to protect individuals against risk of
declining home price (Shiller and Weiss, 1999)
4) foster financial inclusion (access to finance)

Pros and cons of financial innovation

Litan (2010) analyses net impact of recent financial innovations, using three criteria:
1) access to finance
2) convenience for users of financial services
3) performance of productivity or total output


Hedge funds and private equity are financial limited partnerships, therefore they
are not easily accessible
Investment (and saving) help access and convenience for individuals, but this also
helped the housing boom-bust which is negative for GDP

Risk of financial innovation

ABS used to originate and sell subprime mortgages thanks to an innovation in
how investors were paid
By structuring the payments like a waterfall-like fashion and layer with insurance,
subprime mortgages were transformed into higher-rated securities (with first
tranche of AAA)
when housing price bubble burst, derivatives, SPV and chain of securities, were
so complicated that location and size of risk could not be determined

1) Are the financial innovations of past decades a net benefit or risk for the
2) Can the right structuring turn risky assets into safe assets?

Breaking the buck: suspending or stopping the return of money on demand at par
Gai et al. (2008) suggest financial crises in developed countries less likely, but
greater impact. Crises in emerging market economies more frequent, but less severe
(higher macroeconomic volatility, lower value-to-loan ratio)
Hoggarth et al. (2002) empirical evidence that crises in developed countries are
more costly than in emerging market economies

Credit Rating Agencies (CRA)

a forward-looking opinion on credit risk
concentrated market (Standard & Poors, Moodys, Fitch Group)
Perform two key functions:
1) independent assessment of ability of issuers to meet debt obligations
2) offer monitoring services through which they influence issuers to take corrective
actions to avert downgrades

Discussing the role of CRAs:

- conflict of interest: CRAs are mainly paid by the issuers of these instruments to
publish a rating
- underestimation of credit risk: associated with structured credit products
- condemned for exacerbating: (beschuldigd van verergeren van European debt
crisis) when they downgraded countries during financial turmoil
more competition may not lead to more reliable ratings, as more suppliers may
give more opportunities for rating shopping

Shadow banking = credit intermediation involving entities and activities outside

the regular banking system. It comprises a chain of interconnected financial
intermediaries that conduct either all three or any one of the classis banking
functions (maturity, credit, liquidity transformation), but without access to safety
net/deposit guarantee
opportunities have increased substantially as financial flows have become less
tied to national borders and specific sectors
financial innovations is one of the drivers of this process, but so are supervisory
and tax arbitrage

Shadow banking provides various benefits (more access to credit, alternative to bank
deposit, funding and risk diversification etcetera), but also systemic risk:
1) excess leverage and amplification of procyclicality
2) instability of wholesale funding and potential for a modern-style bank run
3) transmission of systemic risk, through links with the regular banking system
4) regulatory arbitrage and circumvention

Fintech hype or revolution? (financial innovation enabled by technology)

Examples: virtual currencies, crowdfunding, smart contracts, robo-advice
Regulation of new players are lagging behind rapid growth
Challenges for regulation:
- third-party dependencies (like data services)
- cyber risks
- governance of big data analytics
- cross-border legal issues

College 9: Insurers and Financial Conglomerates (samenvoegen)

Law of large numbers
protect individuals against adverse events by pooling risks
1) life insurance (premature death, retirement)
big part, because for life-insurance the premium is much higher than for example
2) non-life insurance (P&C/L)

Assets = (collect) premiums

Technical provisions (TP) = pay-out on claims

Non-life insurance; drivers of profitability

C + Exp / P = Claims + Expenses (salary etc) / premiums
investment return also important; Return on Assets Claims Expenses /
Premiums (premiums are invested before claims are paid out)

Mathematics of insurance;
small claims
- random, many small claims (high probability, low impact)
- distribution with light tails

Total claims (C) = number (N) x size (X)

*zie collegeblok
Premium setting;
Loading premium by P(t) = (1+p)xE[C(T)]
Initial capital E(0)
Surplus or risk process of portfolio = E(t) = E(0)+P(t)-C(t)

pooling equilibrium everybody can be charged the same premium (high- and low
separating equilibrium co-insurance and deductible with self-selection to
separate high-risk and low-risk individuals (two-tier market). Two types of contract.
One general for the unhealthy, one specific at a discount for healthy people. They
have to prove they are not ill.

large claims
- few big claims (low probability, high impact)
- distribution with heavy tails

re-insurance shifting part or all of the insurance originally written by one insurer
(ceding company) to another insurer;
1) proportional re-insurance
2) excess-of-loss re-insurance (retention limit)
Cat bonds catastrophic bonds corporate bonds that permit the issuer of the
bond to skip or defer scheduled payments if a catastrophic loss beyond a certain
threshold occurs

Modern risk management

4 types of risk;
market risk (ALM, asset-liability management)
credit risk
operational risk
underwriting risk (is important)
= longevity risk: future trends in survival rates prove to be higher than projected
comparable with risk management in banking
Need to adjust for risk so RAROC Risk Adjusted Return on Capital =
Revenues Costs Expected Claims / Economic Capital
Developments & challenges in the European insurance industry
Penetration rate = 7,46 = insurance premiums / GDP
Centralization of risk management hub and spoke organization model = spokes
are responsible for risk management within business lines, while hub provides
centralized oversight of risk and capital at the group level
the rules of the game are being determined at central level in the hub and that
the local managers in the spokes determine how the game is actually being played
within the margins of these rules

Insurance companies are domestic when 75 per cent of more of their premiums
comes from the home country, semi is between 50 and 75 percent, European insurer
has less than 50 per cent

Types of insurance companies:

limited-liability (joint-stock): owned by shareholders, whose liability for losses is
restricted to the share capital
mutual insurer: owned by policyholders
Trend towards demutualization mutual are converted into limited-liability
insurance companies

Distribution channels:
direct writing: sold directly via employees or Internet
brokers (independent) and agents (more dependent)
bancassurance: the combination of a bank and an insurance company within a
financial institution (the other way round is called assurfinance)

financial conglomerates: combine banking and insurance activities (arguments are

commercial integration, financial integration and operational integration) (arguments
against are inefficient allocation of capital and difficulty in getting clear risk profile)

Insurers as systemic important institutions;

Criteria by FSB
1) Size (5%)
2) Global activity (5%)
3) Interconnectedness (45%)
4) Asset liquidation (40%)
5) Substitutability (5%)

Current challenges;
1) low interest rate environment (Dutch insurers increase their mortgage portfolio)
2) shrinking life business (in NL) (changes in tax regulation, reputational damage)
3) longevity risk = the risk to which a pension fund or life insurance company could
be exposed as a result of higher-than-expected payout ratios (increasing life
life insurance: insurer pays out after the death (trigger event) of the policy holder
life annuity: insurer pays periodically until the death of the policyholder (tax
preferred nature)
4) solvency II directive (UFR rate) *zie aantekeningen

Harmonisation at a European level = Furthering EU market integration through the

harmonization of supervisory regimes and increased international competitiveness of
EU insurers

EIOPA = European Insurance and Occupational Pensions Authority

Pillar 1: ensure a firm is adequately capitalized to deliver policy holder protection
SCR = Solvency Capital Requirement
MCR = Minimum Capital Requirement
Pillar 2: standards of risk management and governance on firms
Pillar 3: ensures what information insurers report on their business and how it is

5) climate change (more nature disasters)

6) technological developments (fintech, insurtech, risks?)

life insurance under pressure
low interest rates main challenge, but not completely reflected in the solvency
position of insurers
need for additional supervisory tools (i.e. resolution)
Like stress test (by EIOPA) or ex ante resolution planning for G-SIIs (globally
systematically important insurers)
Towards a European resolution framework?
College 10: Financial Regulation and Supervision (H12)

Government intervention is to correct market failure (occurs when the private sector
if left to itself, without government, would produce a suboptimal outcome)

Reasons for government intervention (in finance);

asymmetric information Financial supervision aims to protect customers
against information asymmetry (this chapter)
= prudential supervision = customers are generally unable to assess properly the
safety and soundness of a financial institution because that requires extensive effort
and technical knowledge
= conduct-of-business supervision = customers may not be in a position to assess
properly the behavior of a financial institution
Systemic supervision aims to foster financial stability and to contain the effects of
systemic failure (H13)
market power
Competition policy aims to protect consumers against monopolistic exploitation

Government failure
occurs when government intervention causes a less efficient allocation of goods
and resources than would occur without that intervention
1) government-induced protection could have a detrimental impact on incentives for
consumers (why should customers be careful if they are protected?)
2) Regulation may lead to bureaucracy (red-tape) which restricts financial institutions
from activities
3) because information is needed, administrative burden on the sector

Laissez-faire leave alone the less the government is involved in the economy,
the better off business will be (free market capitalism)
most academics and policy makers consider supervisory independence as the
most adequate response to minimize distortive political interventions

Microprudential supervision
= aims to protect customers by ensuring the soundness of financial institutions
(individual), 4 stages;
1) Licensing, authoring or chartering (entry into the business)
2) Ongoing monitoring (asset quality, liquidity etc)
3) Sanctioning (fraud, bad management)
4) Crisis management (lender of last resort, deposit insurance, insolvency

Home-country control financial institution is supervised in home country and can

expand throughout EU without additional supervision by host-country authorities
(country in which the financial institutions establishes)
Mutual recognition host-country has to recognize supervision from the home-
country authorities
Minimum standards minimum requirements for prudential supervision have been
laid down in the EU Directives

Macroprudential supervision
= aims to foster financial stability and to contain the effects of systemic failure (H13)
(mass), focus lies on crisis management
1) ex ante: preventive
2) ex post: curative

Key banking risks

credit risk default by a borrower
country risk risks associated with environment of borrowers home country
market risk unfavorable movements in market prices
interest rate risk unfavorable movements in interest rates. Influence on banks
earnings and value of assets and liabilities
liquidity risk when there is not enough liquid resources to meet liquidity demand
operational risk risk from internal processes or external events
legal risk inadequate or incorrect legal advice, changes in law affecting the bank
reputational risk may arise from operational failures

Capital requirements: Basel I

Banks are required to hold a minimum level of capital (Basel Committee)

Basel I Accord (1988):

- minimum capital requirement of 8%
- move to requirement based on the riskiness of a banks assets (RWA)
(risk weights differ per asset, i.e. sovereign bonds are weighted 0)
RWRC = (Capital / Risk weight * Asset Class) > higher or equal to 8%

Criticism: regulatory versus economic capital?

Basel II Accord (2004):

First pillar: minimum capital requirements for credit, operational and market risk
(banks allowed to use internal models to calculate requirement amount of capital)
Second pillar: supervisory review
Third pillar: enhance market discipline by increasing transparency (incentive for bank
to act safe and efficient)

Financial crisis revealed weaknesses:

Banks held too little capital which was of poor quality
Banks were not holding enough liquid funds (shortage of cash when needed
Banks took on too many assets compared to capital (highly leveraged) (asset
value fell in crisis)

More granular risk-weighting: standardized approach (external credit ratings)

For advanced banks:

Internal Ratings Based Approach banks were allowed to calculate capital
requirement and credit risk internally (aligning regulatory and economic capital)

Basel III more & better capital; belts and braces

through Capital Requirements Regulation (CRR) and Capital Requirements Directive
IV (CRD IV) introduces capital reforms (increase quality of capital) and new
liquidity standards
Two types of capital:
1) going concern capital: allows an institution to continue its activities and helps to
prevent insolvency (Tier 1; purest form is Common Equity Tier 1 (CET1)) (best form
of capital)
2) gone concern capital: helps to ensure that depositors and senior creditors can be
repaid if institution fails (Tier 2; hybrid capital, subordinated debt) (supplementary

Banks still have to hold 8% capital of RWA, but of better quality (more Tier 1)
Different buffers have been introduced (see figure):
capital conversation buffer 2.5% of total exposures of a bank (CET1) (on top of
countercyclical buffer counteract the effects of the economic cycle on banks
lending activity, making supply of credit less volatile (0% to 2.5% of additional CET1
global systemic institution buffer when a bank is globally systemically important
(G-SIFI criteria) (1% to 3.5% CET1 of RWA)
other systemically important institutions buffer domestic/EU important (O-SIIs
criteria) (2% of RWA)
systemic risk buffer Member State specifically, prevent/mitigate long-term non-
cyclical systemic or macro-prudential risks (3% to 5%)

Minimum leverage ratio (LR): between non-risk-weighted assets and Tier 1 capital
= LR = Capital / Total Assets = Capital / Asset Class > higher or equal to 3%
to constrain excess leverage and against risk-based capital requirements

New liquidity standard:

1) Liquidity Coverage Ratio (LCR): enough cash/cash equivalent securities to meet
net cash outflows of short (30 day) period;
LCR = high quality liquid assets / total net cash outflows over 30 day period > or -
100% (implementation 2015)
2) Net Stable Funding Ratio (NSFR): have sufficient available stable funding to
support operations over at least one year period;
NSFR = available stable funding over 1 year period / required stable funding over 1
year period > or 100% (implementation 2018)

Liquidity ratios do not distinguish between low or high risk assets, thus incentives for
banks to invest in high-risk assets.
therefore, a combination of capital metrics (RWCR & LR, also liquidity
requirements) (Le Lesle and Avramova, 2012)

equity requirements are considered too low
banks still underestimate risk weights (RWA) with internal models
perverse incentive, try to maximize ROE by managing RWAs down (less equity
needed for lower RWA)
The crisis has shown that zero risk weights such as EU sovereign exposures can
carry significant risk, so
need for risk weights for sovereign exposures
more importantly: (limits on) large exposure rules of sovereign debt on banks

Current Basel III.5 discussion:

Reducing risk weight variability
Risk weight floors discussion; 70-75% of standardized approach

Conduct-of-business supervision
= how financial institutions conduct business with their customers and how they
behave in markets, by prescribing rules about appropriate behavior and monitoring
behavior that can be harmful to customers and to the functioning of markets

1) protecting retail customers
mandatory information provisions to give the right information
objective and high-quality service
duty of care (i.e. for Netherlands, expensive and opaque unit-linked insurance and
pension products)
Challenge to find balance between empowering customers by providing information
(financial literacy) and protecting customers by setting minimum standards for
financial institutions behavior

2) maintaining well-functioning and orderly markets (market functioning)

transparency of trading (disclose quotes, see H5)
prohibition of insider trading and market manipulation
information requirements for issuers (prospectus and financial report) and for
shareholders (disclose acquisitions above 5% of shares)

EU Markets in Financial Instruments Directive (MiFID) is most important piece of

rules on transparency of trading from regulated markets (stock market, exchange)
to multi-trading facilities (investment fund, MTFs)
promotes competition in trading and requires best execution for client (in-house
MiFID II (2017) also covers high frequency trading and derivatives

Supervisory structures, three models;

sectoral model: separate banking, insurance, and securities supervisors
functional model: separate supervisors for prudential supervision (macro and
micro) and conduct-of-business
integrated model: single supervisor for banking, insurance, and securities (and also
prudential and conduct-of-business combined) (macro supervision separate for CB)
Financial supervision in Europe
Drawback of national supervision in an integrated market:
fragmented supervision (some EU, some national) causes extra costs
potential conflict of interest among national supervisor

So, supervision at national level or European level?

The financial trilemma

Not all 3 objectives can be obtained choose 2 (see H13)

Assuming objective 1:
supra-national (keep international banks, Banking Union)
national (limited integration)
Banking Union (2012);
1) Single Rulebook: harmonized legislative texts
2) Single Supervisory Mechanism (SSM): ECB central microprudential
supervisor in euro area and non-euro Member States who choose to join.

Can take over supervision of less significant banks at any time (current
supervised by national supervision)
main task of ECB and national supervisors is to work together to ensure
single rulebook is applied correct and timely take action when bank is in
breach of regulatory requirements
3) Single Resolution Mechanism (SRM): applies to all banks covered by SSM.
4) A financing regime for exceptional situations (Single Resolution Fund SRF,
ESM direct capitalization, alignment of deposit guarantee scheme, DSG)
Challenges for financial supervision
EU versus euro area: SSM only for euro area, but others can join
Transparency/Accountability of financial supervisors
Expectations and demands (of legislative branch, supervised institutions,
depositors etcetera)
Regulatory capture of supervisory by industry (supervisors tend to respond to the
wished of the industry they regulate and supervise)
Going from co-ordination towards full Banking Union

College 11: Competition Policy (H14)

Competition = market situation in which firms or sellers independently strive for the
patronage of buyers in order to achieve a particular business objective
Competition policy = aims to ensure that competition in the marketplace is not
restricted in a way that is detrimental to society
Economic rationale for competition policy monopoly is bad
Monopoly = single seller in the market (1), no close substitute products or services
(2) and barriers to entry for potential sellers (3)

Market/Monopoly power = ability to maintain price above level that would prevail
under competition
Result of market power is reduced output at high price (1), lack of innovation (2) and
loss of economic welfare (3)
Natural monopoly = single firm can produce at lower costs than a situation in which
there are two or more firms (i.e. airport)

Welfare loss from monopoly (Tirole, 1988)

Welfare/deadweight loss: Total surplus under monopoly minus total surplus under
marginal-cost pricing

Motta (2004);
1) Competition policy is not concerned with maximizing the number of firms
(maybe higher costs)
2) Competition policy is concerned with defending market competition in order to
increase welfare, not defending competitors

Quantify the level of market power by Lerner Index (LI) = degree to which a firm is
able to price its products above marginal costs
LI = ( Price Marginal Costs ) / Price = 1 / E
E = price elasticity of demand

Competition policy also needed because firms may resort to actions that increase
profit but harm society;
collusion any formal/informal agreements to raise or fix prices or to reduce
output in order to increase profits (cartels)
predatory behavior one firm drives out its competitors by setting very low prices
(form of exclusionary behavior)
Other forms of exclusionary behavior;
tying making purchase of product A conditional on the purchase of product B
bundling selling two or more products in one package
price discrimination customers in different segments are charged different
prices, with reasons unrelated to costs

Why European competition regulation?

enables to proper functioning of markets
enhances market integration (Internal Market)
Achieved by;
- Prevent/punish collusive behavior
- Prevent/punish abuse of a dominant position (antitrust)
- Control mergers and acquisitions
- Liberalize monopolistic sectors
- Prevent illegitimate state aid

What about regulation itself?

National prudential regulation developed separately per country (harmonization is
National competition regulation derived from European Treaty (harmonized)
Many corporations operate cross border (thus need consistent treatment, Internal

Organization of jurisdiction;
national competition authorities deal with cases that have major effect on their
cartel/merger case with main effects in territory in 2/3 Member States, national
authorities work together
case with larger geographical scope European Commission
Why competition supervision?
Benchmark perfect competition / perfect market
*zie slide 8 en aantekeningen

Competition forces firms:

- to become more static efficient
- to offer greater choice of products and services; and at lower prices
- to innovate (dynamic efficiency)

Perfect market: Pareto optimum

Pareto efficiency no one can be made better off without making someone else
worse off
TFEU / European policy makers; an open market economy, with free competition,
favoring an efficient allocation of resources

Structure conduct performance > Regulation is on behavior (collusive actions or

abuse of market dominance)

Article 101 TFEU (Treaty on Functioning of European Union) prohibits
anticompetitive behavior in market (horizontal and vertical agreements)

Article 102 TFEU prohibits abuse of dominant position

Dominant position, if firm is able to;
- setting prices above the competitive level
- sell products of an inferior quality, or
- reduce its rate of innovation below the level that would exist in a competitive market

Causes of a dominant position;

sunk costs costs which, once incurred, cannot be (easily) recovered (entry
lock-in effects/switching costs costs customers face when changing from one
supplier to the other
network effects the existence of network externalities can lead to lock-in effects
and make it hard for potential competitors to successfully enter the market

Abusive conduct has two categories;

1) exploiting customers or suppliers (high prices)
2) exclusionary behavior; weakens competition

Merger control
The 2004 EC Merger Regulation prohibits every merger which significantly impede
effective competition ban is not confined to dominant firms

Assessment of dominant positions;

Step 1: Identify the relevant market
product market comprise all those products and/or services which are regarded
as interchangeable/substitutable
geographical market comprises the area in which the undertakings concerned are
involved in the supply and demand of products or services
= SSNIP-test > used to examine whether some good produced within a specific area
constitute their own relevant geographical market
Can monopolist earn a profit by increasing 5-10 per cent (small but significant) for a
period of more than 12 months (non-transitory)

Calculate the market share of individual or combined firms by Cx and HHI

Problem = data

Despite having a high market share, a firm may not be dominant if:
> very low barriers to relevant market
> intense competition even with very few players
> buyers have significant countervailing power against firm with high market share

Concentration may be remedied:

> carving out of parts of the company (reduce joint market share)
> remedies are imposed by authority
> they have deadline, market sensitive information!
Step 2: Abuse of dominance?
Step 3: Issue decision (a fine might be imposed, see framework)
Joint ventures
Who has control?
Tool for collusion? I.e. pricing behavior, marketing campaigns
In practice; consult a competition lawyer (in time)

State aid
State support hampers internal market (Article 107 TFEU; objective of state aid
control is to ensure government interventions do not distort competition and trade
inside the EU)
> firms receiving support from their government are likely to obtain an unfair
advantage over their competitors
therefore forbidden by Treaty,
UNLESS justified by reasons of general economic development

During financial crisis

European Commission tried to ensure that distortions of competition were limited to
minimum despite large amount of state aid and that beneficiary banks were
evidence showed that banks with state aid downsized (ING), while EU banking
system grew

Principle for restructuring financial institution that received state aid:

> restructuring plan to return to long-term viability
> burden sharing between bank, its stakeholders and the state
> limitation of competitive distortions by;
1) Structural divestures (downsizing)
> remedies
> implications may be welfare destroying (Dutch banking sector)
2) Behavioral measures (no aggressive commercial behavior)
> implications may be adverse (Dutch banking sector)

State support allowed (TFEU 107) inter alia if;

> disturbance at national level (economy of Member State)
> with effect to Internal Market

If a SIFI (systemically important financial institution) is at stake, state aid is worth the
while > not saving an individual bank, but the Dutch banking system as a whole

College 12: Financial Stability

Financial cycle is procyclical
link to why all financial panics involve debt (financial cycle captures dynamics of
credit and asset prices / value of collateral

Systemic risk: the risk that an event will trigger a loss of economic value or
confidence in a substantial part of the financial system that is serious enough to have
significant adverse effects on the real economy
cyclical perspective
structural perspective

Features of financial systems that make them prone to systemic risk:

1) negative externalities from risk taking by financial intermediaries
2) transactions in financial markets are subject to asymmetric information (adverse
selection and moral hazard)
3) financial system is characterized by powerful feedback and amplification
mechanisms (reinforce shocks)

Global debt at all time high

Conceptual framework of macroprudential supervision;

Four intermediate objectives, which aim at mitigating systemic risks to financial
stability that follow from:
> excessive credit growth and leverage (key driver of asset price bubbles)
> excessive maturity mismatch and market illiquidity
> direct and indirect exposure concentrations
> misaligned incentives and moral hazard
Two pillar
cyclical macroprudential policy mitigating the build-up of financial
imbalances at an early stage
herding behavior = the tendency for individuals to mimic the actions of a larger
group, can lead to financial imbalances at the macro level (dotcom bubble)
structural policies change the institutions of the economy, through discrete
policy reforms, and ultimately aim to improve long-term growth potential
Instrument = Basel Accords
(zie collegeblok voor two pillar strategy en intermediate target en indicators schema)

SIFI systemically important financial institutions = financial institutions, whose

disorderly failure, because of their size, complexity, and systemic
interconnectedness, may cause significant disruption to the wider financial system
and economic activity
- G-SIBs: Global systematically important banks
- G-SIIs: Global systematically important insurers
- OFIs: Global shadow banks under discussion
SIB systematically important bank
TB(I)TF too big (important) to fail
Indicators of SIFI:
1) cross-border activity
2) size
3) interconnectedness
4) substitutability
5) complexity

Stress testing to enhance the authorities understanding of possible vulnerabilities

within individual institutions as well as the overall system (system-wide stress tests)
Zie collegeblok voor cyclical macroprudential instruments en structural instruments

New resolution after crisis

address the moral hazard & too big to fail problem
1) Limit the probability of a failure by capital surcharges
2) In case of failure, and no private solutions, limit the impact
> shareholders/creditors should bear losses instead of tax payer
> ensure continuity of critical financial and economic functions
> minimize impact of failure on financial system and economy

Macroprudential architecture
European Systemic Risk Board (ESRB) responsible for the macroprudential
oversight of the EUs financial system

The Capital Requirements Regulation (CRR) and Directive (CRDIV) introduce new
macroprudential tools and require Member States to set up a designated authority.
Can be conducted by:
> ministry of finance/economics
> the central bank
> the financial authority
> an ad hoc committee

Financial Stability Board (FSB) (April, 2009) = coordinate work of national authorities
and international standard setting bodies and develop/promote implementation of
effective regulation and supervision

When institutions is about to fail;

> resolve as going concern: bail-in & restructure
> transfer systematically important functions to bridge bank & wind down residual of
institution (non systemic)

Key elements of the Bank Recovery and Resolution Directive (BRRD) (new crisis
management framework for banks in Europe):
> preparation and prevention (planning)
> early intervention
> resolution (by instruments such as bail-in)
> resolution fund (loss absorbing capacity)
> cooperation and coordination (cross-border resolution)
financial trilemma (stable financial system, international banking and national
financial polies for supervision cannot be combined)

Requirements for resolution:

1) institution is failing/likely to fail (FOLTF)
2) no alternative private solutions
3) resolution is necessary in the publics interest

Resolution tools
1) private-sector acquisition parts of bank can be sold (without influence
2) transfer part of the bank to a temporary structure (bridge bank). Make sure
essential banking functions can continue
3) separate assets split bank in distress into:
> good bank which retains performing assets
> bad bank which receives toxic assets
4) bail-in enables authorities to recapitalize a failing bank through the write down
of liabilities and/or their conversion to equity, so that the bank can continue as a
going concern

objective is to stabilize a failing bank in order for it to continue its critical functions,
with minimal or no use of public funds
the write-down will follow ordinary allocation of losses and ranking in insolvency
> equity has to absorb losses before any debt claim is written down
> after equity, it will impose losses on holder of subordinated debt and when
necessary, senior debt-holders (deposits from SMEs and natural persons will be
preferred over senior creditors; deposit guarantee scheme)

BRRD protects the interest of creditors by stating that no creditor should be worse off
under resolution than normal insolvency proceedings

injection of public funds may still be needed when systematic threat (Goodhart &
Avgouleas 2014)

Does bail-in work?

Advantages protect taxpayer, better creditor monitoring, lower levels of moral
Disadvantages more contagious and pro-cyclical, more litigious, higher (funding)
Other relevant instruments:
> Emergency liquidity assistance (ELA)
> Deposit Guarantee Schemes (DGS) up to 100.000 euro

FSB: Total Loss Absorbing Capacity (TLAC)

designed for failing G-SIBs so they will have sufficient loss-absorbing and
recapitalization capacity available in resolution for authorities to implement an orderly
resolution that minimizes impacts on financial stability, maintains the continuity of
critical functions, and avoids exposing public funds to loss
TLAC consists of:
> required minimum amount or regulatory capital (excluding buffers)
> bail-in debt (maturity > one year)

Banking Union: Single Resolution Mechanism (SRM)

Centralized resolution fund, rather than decentralized approach based on BRRD
Components are Single Resolution Board (SRB) and Single Resolution Fund (SRF)
Two sessions:
> executive session SRB takes key preparatory and operational decisions for
resolving individual banks (use of SRF as well)
> plenary session SRB takes all decisions of general and budgetary nature

GFB has showed that there is need for:
> ex ante macroprudential supervision focus on financial system
> ex post crisis management

Two pillar macroprudential framework to monitor and analyze how:

> risk is distributed across system: cross-sectional dimension (structural)
> aggregate risk evolves over time: time dimension (cyclical)

BBRD provides resolution authorities with bail-in tool to write down or convert into
equity claims of shareholders and creditors of troubled banks

Single Resolution Mechanism allows for supranational resolution of banks in the

Banking Union