Banks Are Special. And Elena Carletti Explains WhyA PROFESSOR OF FINANCE AT BOCCONI AND A MEMBER OF THE EUROPEAN SYSTEMIC RISK BOARD'S SCIENTIFIC COMMITTEE, CARLETTI HAS BEEN STUDYING ALL THE CRUCIAL ASPECTS OF THE CRISIS, FROM 2007 ONWARDS
When she was a child in La Spezia, Elena Carletti lived in a house in front of a Bank of Italy building. She could not imagine that one day central banks would become her main research interest. Her work stems from a question as simple as it is crucial: why are banks special? How can you regulate their uniqueness? The answers are explored through a series of papers on central banks, interbank markets, funding, asset pricing and regulatory reforms, of course, a subject that Carletti – Professor of Finance and member, among other things, of the advisory scientific committee of the European Systemic Risk Board – has examined very closely. “Research”, she says, “allows you to actively participate in the policy debate. Being close to policymaking enables you to pose relevant questions”.
Accounting in financial crisis
Mark-to-Market Accounting and Liquidity Pricing was written and published long before the subject made the news, after the 2007 global crisis. Carletti and Franklin Allen (Imperial College London) examine the role played by liquidity in asset pricing. There are two accounting systems for financial institutions: mark-to-market and historic cost. The difference is fundamental in the middle of a financial crisis. “The mark-to-market method is appropriate in a liquid market, where prices reflect the value of fundamentals. It can also be a warning sign to watch. When financial markets are illiquid, though, the prices do not reflect future payoffs. They rather reflect the amount of cash available in the market. This can lead to distortions in banks’ portfolio and exacerbate the crisis”. Liquidity is the core of another paper written for the 2008 economic symposium in Jackson Hole. It is an annual conference organized by the Federal Reserve Bank of Kansas City, attended by global central bank governors, chief economists at the main private banks and academics. “In 2007, when the market was illiquid, many banks’ assets were sold provoking a decline in prices and the occurrence of fire sales. If the economy is solid, this downward mechanism can be stopped by the central bank liquidity provision”, as Carletti, Allen and Douglas Gale (New York University) have proven to be true, also in the interbank market, in Interbank Market Liquidity and Central Bank Intervention.
Capital regulation is another strand of Carletti’s research. In a paper published in 2011, Carletti, Allen and Robert Marquez (University of California, Davis) refute the idea that banks have no incentive to hold capital because it is more costly than other sources of funds such as deposits. “We show that a competitive market induces banks to use positive capital because it makes them better lenders”. The next step was to verify if equity capital is actually a more expensive form of financing than deposits. “The existing literature had used partial equilibrium model. We have developed a general equilibrium model where the cost of equity and deposit finance for banks are endogenized. We have shown that, even though equity capital is costlier than deposits, it is a way to reduce bankruptcy costs. Being less subject to the risk of default, the bank benefits from the reduction of the cost of other sources of funds such as deposits and loans. Reducing the cost of capital would encourage banks to hold more capital, thus making the system more solid”.
The safety net
Deposit insurance is part of the banking safety net. It ensures depositors that they will obtain full repayments. But what is the best deposit insurance scheme? “If the insurance is not risk-adjusted it can entail moral hazard problems. The bigger the public intervention, the harder the problem: a manager can take huge risks if they are not fairly priced. An optimal deposit insurance scheme should be designed”. The insurance is designed to avoid panic-based runs, but how far can you go? In Ireland, at the peak of the financial crisis, the government gave a blanket guarantee to stop the runs. “It works as long as banks are solvent: the announcement stops the panic-based runs. But if the assets are troubled, as in Ireland, an extensive government intervention has a large fiscal cost”. A generalized guarantee can threaten sovereign solvency.
The global financial crisis has sparked a debate on the need for supranational integration of financial supervision. In November 2014, the Single Supervisory Mechanism, which resides within the European Central Bank, was launched. It supervises directly the largest 128 European banks and indirectly all the other banks. Local central banks, however, retain the task to collect information and to transmit it to Frankfurt. “If the central and the local supervisors have similar standards, the centralization has a positive effect. If the central supervisor is ‘tougher’ than the local one, the information collection may be inferior, especially if the local and the central supervisors view the costs of bank failure differently”. It is the case of banks that are systemic for a single country, but not for the whole Eurozone – something of particular relevance today.
Find out more
Mark-to-Market Accounting and Liquidity Pricing, Franklin Allen, Elena Carletti, Journal of Accounting and Economics, 2006
The Role of Liquidity in Financial Crises, Franklin Allen, Elena Carletti, da Maintaining Stability in a Changing Financial System, Jackson Hole Conference Proceedings, Federal Reserve Bank of Kansas City, 2008
Interbank Market Liquidity and Central Bank Intervention, Franklin Allen, Elena Carletti, Douglas Gale, Journal of Monetary Economics, 2009
Credit Market Competition and Capital Regulation, Franklin Allen, Elena Carletti, Robert Marquez, Review of Financial Studies, 2011
Deposits and Bank Capital Structure, Franklin Allen, Elena Carletti, Robert Marquez, Journal of Financial Economics, 2014
Deposit Insurance and Risk Taking, Franklin Allen, Elena Carletti, Agnese Leonello, Oxford Review of Economic Policy, 2011
Regulatory Reforms in the European Banking Sector, Elena Carletti, Agnese Leonello, in The Palgrave Handbook of European Banking, 2016
Supervisory Incentives in a Banking Union, Elena Carletti, Giovanni Dell’Ariccia, Robert Marquez, IMF Working Papers, 2016
by Claudio Todesco