Background and Key Themes

Since the collapse of Lehman Brothers, central banks and regulatory authorities in general have been confronted with difficult questions. The global financial crisis made apparent that the analytical models of the Great Moderation period failed to capture the changing nature of financial intermediation and the complex business models of transnational banks operating across different jurisdictions. In turn, despite few theoretical certainties with which to draw upon, central banks have played key roles in responding to the crisis and in trying to devise more adequate modes of regulation and intervention. First, in the immediate aftermath of the crisis, it was the central bank governors of Basel Committee member countries that amended the existing Basel II rules and methodologies for capital adequacy. Second, it was the Financial Stability Board, with much the same country membership as the Basel Committee and with central bank governors gathered around the negotiating table, which identified principles and guidelines for the resolution of distressed banks. And last but not least, it was the central banks that replaced conventional tools with new instruments and practices that extend their mandate and blur the traditional separation from private financial markets. For the past five years, central banks have intervened in both public and private debt markets, taking on functions of market makers or dealers of last resort. In this book, we propose to explore these developments and set them in the context of the European crisis.

The most comprehensive national regulatory response to the crisis came from the USA, where the Dodd–Frank Act specifically aimed at regulating the business models of banks by removing the risky proprietary trading from the investment banking activities in bank conglomerates and moving over-the-counter derivatives trading to the exchanges. The Vickers Report in the UK, too, aimed at separating investment banking from the retail banking activities of universal banks, but in a less clear way, by proposing the ring fencing of retail from investment banking. Such ring fencing would involve different capital-adequacy rules for retail and investment banking activities within the same bank holding company.

Introduction

Prior to the recent financial crisis, the failure of a bank would in most countries be treated under the standard law of bankruptcy applicable to all institutions. Standard bankruptcy law is, however, best suited to those instances where the bulk of the assets are fixed, real assets, property, land and buildings, or equipment, such as railroad lines, steel furnaces, or airplanes—assets whose nature and value are not affected by the process of bankruptcy itself. Then the bankruptcy can, and does, involve a process of finding a (highest bidding) buyer for the unchanged real assets who can take them over and use them again productively. The more a business is built on such real assets, with a relatively assured and stable secondhand resale price, the more appropriate is debt finance, limited liability equity finance, and a continuing market, via takeovers, for ownership in that equity market.

Bankruptcy procedures and governance structures may need to become more complicated when the institution is primarily based on intangible capital—intellectual know-how—rather than on real tangible assets. Examples are legal and accountancy firms, advertising agencies, medical practices, universities, etc. In such cases, with no or little ability to constrain and to pre-commit the staff, who possess the human capital, by indenture or by slavery, the gone-concern value of such an institution is often a tiny fraction of its potential going-concern value. In such a condition, debt is, in general, not such an appropriate financing vehicle (on what would it be based?), a market for ownership of the institution is more problematical, and partnerships, of some form, are more suitable than a (limited liability) equity base. Normally, however, the failure of one such service provider strengthens its competitors in the market. Not only is competition for their output reduced, but they may also be able to pick up displaced and unemployed skilled staff more easily from the failing firm(s). As a generality, the failure of a service provider does not lead to contagion in that sector, whereby the failure of one firm drags others down with it.

This book has its origin in a conference held in the Axelborg Hall in Copenhagen last year. Axelborg Hall, built in 1920, was the second largest secular building in Copenhagen at the time, surpassed only by Parliament. The Danish Cooperative Bank, for which Axelborg was originally built, went bankrupt in 1925, only five years later. But the building itself survived and now boasts a colorful history of nearly one hundred years of different owners and tenants, with banking by far the dominant theme. It seemed the perfect venue for a conference on central banking at a crossroads.

However, as esteemed speakers and eager participants arrived to the venue on the morning of 29 January last year, Axelborg Hall lay shrouded in darkness, as did indeed the entire building and a few blocks around it. Helped only by the dim light of a few candles, Professor Charles Goodhart delivered his opening talk masterfully to an audience of several hundred, most of whom could perhaps hear but not see much. Halfway through Goodhart's talk, the lights came back on. And from there, it was smooth sailing.

A generous reading of post-crisis central banking would say that an exceptionally difficult situation was handled just as masterfully. Out of a dark and dangerous event, came a stronger mode of central banking, reinvented and with new resilience. Others will say that in the world of central banking, darkness is still the order of the day, as we chase systemic risk and try to tame phenomena of which we still have only insufficient understanding.

The contributions in this book fall between these two poles, perhaps with a slight bias towards a worried take on the trajectory of central banking in recent years. While a certain measure of concern may be shared by all contributors, the approaches taken and conclusions reached by different authors vary considerably. This was a defining feature of the talks given at the conference too, in which many (but not all) of the chapters originate.