Barth kaufman the first great financial crisis of the 21st century; a retrospective (2016)

The First Great Financial Crisis of the 21st Century A Retrospective 9469hc_9789814651240_tp.indd 7/9/15 12:05 pm World Scientific–Now Publishers Series in Business ISSN: 2251-3442 Published: Vol Games and Dynamic Games by Alain Haurie, Jacek B Krawczyk and Georges Zaccour Vol Dodd–Frank Wall Street Reform and Consumer Protection Act: Purpose, Critique, Implementation Status and Policy Issues edited by Douglas D Evanoff and William F Moeller Vol The History of Marketing Science edited by Russell S Winer and Scott A Neslin Vol The Analysis of Competition Policy and Sectoral Regulation edited by Martin Peitz and Yossi Spiegel Vol Contingent Convertibles [CoCos]: A Potent Instrument for Financial Reform by George M von Furstenberg Vol Superpower, China? 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Congress Cataloging-in-Publication Data The first great financial crisis of the 21st century : a retrospective / edited by James R Barth (Auburn University, USA & Milken Institute, USA), George G Kaufman (Loyola University Chicago, USA) pages cm (World Scientific-Now Publishers series in business ; vol 9) ISBN 978-9814651240 (alk paper) Financial crises I Barth, James R II Kaufman, George G HB3722.F57 2015 330.9'0511 dc23 2014046647 British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Copyright © 2016 by editors and authors All rights reserved In-house Editors: Dr Sree Meenakshi Sajani/Qi Xiao Typeset by Stallion Press Email: enquiries@stallionpress.com Printed in Singapore 9”x 6” b2028 The First Great Financial Crisis of the 21st Century: A Retrospective Contents Preface About the Authors vii xvii Chapter The Great Financial Crisis of 2007–2010: The Sinners and their Sins G.G Kaufman Chapter The Costs of the 2007–2009 Financial Crisis H Rosenblum Chapter The US Financial Crisis and the Great Recession: Counting the Costs Gillian G.H Garcia Chapter US Housing Policy and the Financial Crisis Peter J Wallison Chapter Playing for Time: The Fed’s Attempt to Manage the Crisis as a Liquidity Problem R.A Eisenbeis and R J Herring Chapter Japan’s Financial Regulatory Responses to the Global Financial Crisis K Harada, T Hoshi, M Imai, S Koibuchi and A Yasuda Chapter Regulatory Response to the Financial Crisis in Europe: Recent Developments (2010–2013) S Carbó-Valverde, H.A Benink, T Berglund and C Wihlborg 33 47 75 101 145 167 v b2028_FM.indd v 10/5/2015 2:01:12 PM b2028 The First Great Financial Crisis of the 21st Century: A Retrospective vi Chapter Chapter Contents Regulatory Change in Australia and New Zealand Following the Global Financial Crisis C.A Brown, K.T Davis and D.G Mayes 219 The Dodd-Frank Act: Systemic Risk, Enhanced Prudential Regulation, and Orderly Liquidation G.G Kaufman and R.W Nelson 249 Chapter 10 The Trade Execution and Central Clearing Requirements of Dodd-Frank Title VII — Transparency, Risk Management, and Financial Stability R.S Steigerwald Chapter 11 A Primer on Dodd-Frank’s Title VIII C Baker Chapter 12 9”x 6” Macroliquidity: Selected Topics Related to Title XI of the Dodd-Frank Act of 2010 W.F Todd 267 283 299 Chapter 13 The Dodd-Frank Act: Key Features, Implementation Progress, and, Financial System Impact J.R Barth, A (Penny) Prabha and C Wihlborg 337 Chapter 14 Hair of the Dog that Bit Us: The Insufficiency of New and Improved Capital Requirements E.J Kane 377 Chapter 15 Misdiagnosis: Incomplete Cures of Financial Regulatory Failures J.R Barth, G Caprio Jr and R Levine 399 Chapter 16 Path-Dependent Monetary Policy in the Post-Financial Crisis Era of Dodd-Frank H Rosenblum 433 Chapter 17 Bank Crisis Resolution and the Insufficiency of Fiscal Backstops: The Case of Spain S Carbó-Valverde and M.J Nieto 461 b2028_FM.indd vi 10/5/2015 1:50:05 PM 9”x 6” b2028 The First Great Financial Crisis of the 21st Century: A Retrospective Preface In recent years, the world has suffered the worst financial crisis since the Great Depression Most countries, if not all, were affected in one way or another, some far more severely than others As a result of this dire situation, there has been an ongoing assessment of what went wrong and what can be done to prevent a similar crisis in the future Already a number of affected countries have instituted major reforms in their financial regulatory regimes that are designed to ensure that “never again” will such a devastating episode occur Although there have been numerous studies of the causes and consequences of the crisis, many of these were undertaken before the financial and economic effects were fully realized and various governmental policy responses were decided upon and actually implemented This means that a more complete assessment is still needed of what led to havoc in so many countries and whether the reforms that have been implemented will accomplish their objective The purpose of the papers in this book is to provide a more thorough assessment now that the worst events and the regulatory reforms are sufficiently behind us and much more information about these developments is available All of the papers were originally presented at the Western Economic Association International Conference in Denver, Colorado, on June 28, 2014 They cover events related to the global crisis that have occurred in a number of countries between 2007 and 2010, including the causes of the crisis, the costs of the crisis, and the regulatory responses to the crisis We now briefly point out the contribution made by each of the papers in the book Importantly, George Kaufman argues that the crisis may be viewed as the product of a perfect storm He identifies the major culprits or sinners of the US crisis and enumerates their more important sins According to him, the culprits include central bankers, commercial and investment vii b2028_FM.indd vii 10/5/2015 10:09:24 AM b2028 The First Great Financial Crisis of the 21st Century: A Retrospective viii 9”x 6” Preface bankers, credit rating agencies, financial engineers, the government, investors, mortgage borrowers, mortgage brokers, and prudential bank regulators Among the numerous sins committed by these sinners, George emphasizes the role of the government in encouraging and subsidizing risky home mortgages and, in particular, the poor performance of the prudential regulators in adequately enforcing the in-place rules He considers the regulators to have been poor agents for the healthy banks and taxpayer principals He concludes that the prevention of a future crisis requires, among other things, the development of better incentives to motivate the regulators to be more faithful to both the letter and the spirit of the legislative intent of Congress In his paper, Harvey Rosenblum reviews the costs to the US economy resulting from the financial crisis and its aftermath The estimates of the costs, according to him, depend to a large extent on how long it will take the US to return to a more normal path of growth in economic activity If growth returns to pre-crisis trends in 2015, the cost of the crisis in terms of lost output could be as little as $6 trillion, about 40% of annual US output If the return to pre-crisis trends takes considerably longer, the cost of lost output could total $30 trillion, almost two years of human effort down the drain Harvey argues that including estimates of the reduced opportunities and economic trauma faced by the generation of those impacted by the crisis, as well as the costs of monetary and fiscal policy extremes that were used to address the crisis, adds significantly to the burdens stemming from the crisis Given the enormity of these costs, he believes it is critically important that the policy errors that led to the financial crisis not be repeated Gillian Garcia also focuses on the cost of the crisis, pointing out that the its costs in the US range from lost GDP, depleted wealth, outlays and subsidies expended to rescue troubled financial and commercial firms, increased post-crisis regulation and supervision, and damage done to the social fabric by higher unemployment, escalating bankruptcies and foreclosures, greater income and wealth inequality, reduced access to medical services, lower fertility, skyrocketing student debt, and growing political alienation However, she notes, there is no comprehensive discussion of the full panoply of the costs that the United States has endured Gillian therefore seeks to fill this gap by surveying and critiquing b2028_FM.indd viii 10/5/2015 10:09:25 AM 9”x 6” b2028 The First Great Financial Crisis of the 21st Century: A Retrospective Preface ix estimates of many individual components of the crisis’s costs In doing so, she argues that, on the one hand, estimates of lost GDP exaggerate the cost when they compare recession values to pre-crisis trend GDP Precrisis trends have been seriously overstated by failing to notice that growth in labor and capital services and productivity were already declining before the crisis hit On the other hand, Gillian argues, official estimates of the cost of assisting troubled firms with equity capital, loans, and guarantees seriously underestimate the true costs of this particular response to the crisis According to Peter J Wallison, although the conventional explanation for the financial crisis is that it was caused by insufficient or inadequate government regulation of private-sector risk-taking, there is compelling evidence that the underlying cause of the crisis was US government’s housing policies, implemented primarily through the governmentsponsored enterprises Fannie Mae and Freddie Mac According to him, these policies, principally the affordable-housing goals administered by the Department of Housing and Urban Development, forced the loosening of traditional mortgage underwriting standards in order to make mortgage credit more available to low-income borrowers However, Peter emphasizes that the loosened standards spread to the wider market and helped to build a massive housing price bubble between 1997 and 2007 By 2008, he states that most of the mortgages in the US were subprime or otherwise weak Peter concludes that when the housing bubble deflated, these mortgages failed in unprecedented numbers, weakening the largest financial institutions and causing a financial panic when Lehman Brothers was allowed to fail Robert A Eisenbeis and Richard J Herring examine the events leading up to the Great Recession, the US Federal Reserve’s response to what it perceived to be a short-term liquidity problem, and the programs it put in place to address liquidity needs from 2007 through the third quarter of 2008 They point out that these programs were designed to channel liquidity to some of the largest institutions, most of which were primary dealers Bob and Dick describe these programs, examine available evidence regarding their effectiveness, and detail which institutions received the largest amounts under each program They then argue that increasing financial fragility and potential insolvencies in several major institutions b2028_FM.indd ix 10/5/2015 10:09:25 AM 9”x 6” b2028 The First Great Financial Crisis of the 21st Century: A Retrospective Bank Crisis Resolution and the Insufficiency of Fiscal Backstops: The Case of Spain 473 Public Interventions in the Banking Sector in the EU in the Context of the Crisis: The Case of Spanish Banks This section focuses on the policy tools, some of an extraordinary nature, that have been used at the different stages during the recent financial crisis in the EU.4 Against this background, we will refer to the liquidity and solvency support tools used by the Spanish authorities.5 The initial response to the crisis was led by central banks and deposit guarantee schemes (DGSs), which both contributed to reassure the confidence of depositors and to limit the adverse impact on banks’ liquidity and, ultimately, financial stability In light of the insufficiency of both forms of emergency liquidity provision to stanch the banking crisis, national governments decided to provide direct financial support to their national banking systems Central banks had to respond to the challenge of restoring normal money market functionality To that end, for example, they had to provide both ample liquidity extending the maturity of the refinancing operations and foreign currency liquidity through local operational frameworks at harmonized market prices; they also had to accept less liquid collateral in their operations In addition to the central banks’ support to the money markets, there was also support to individual credit institutions in the central banks’ traditional role of lenders of last resort In this regard, it should be highlighted that the lender-of-last-resort function is a national responsibility in the euro area, where the provision of emergency liquidity assistance (ELA) is the responsibility and liability of national central banks This means that any costs and risks arising from the provision of ELA should be incurred by the national central bank concerned (or by a third party acting as a guarantor) This is a unique feature of the Eurosystem (European Central Bank) Deposit insurance, the other element of the safety net aimed at restoring depositors’ confidence and helping to maintain financial stability, proved This section draws from Nieto and Garcia (2012) For key dates of the financial crisis (i.e., relevant policy decisions), see www.ecb.europa eu/ecb/html/crisis.en.html (accessed June 2014) b2028_Ch-17.indd 473 10/5/2015 10:09:42 AM b2028 The First Great Financial Crisis of the 21st Century: A Retrospective 474 9”x 6” The First Great Financial Crisis of the 21st Century: A Retrospective to be insufficient At the time of the financial crisis, Europe had made little progress in the harmonization of national deposit insurance schemes, which in most Member States have very limited roles in bank crisis resolution, serving mainly as pay boxes to ferry compensation to insured depositors of the failed bank The Spanish DGS before the 2012 reform had a limited role in bank resolution (i.e., debt guarantees, impaired asset purchase, and subscription of subordinated debt) The existing DGSs Directive imposed minimal conformity, and Member States chose a diverse set of responses in implementing it The dramatic events that followed the collapse of Lehman Brothers fostered further harmonization (levels of coverage were increased, as well as speed of repayment, coinsurance was ended, the payout periods shortened, and ex ante financing arrangements were introduced) The 2014 DGSs Directive has further harmonized relevant aspects, such as eligibility of deposits, determinants of payable amounts, as well as target level, and use of deposit insurance funds, including their role in financing bank resolution (EUR-Lex) Coordination among national DGSs has been strengthened via both stronger harmonization and the possibility to borrow between DGS, however, on a voluntary basis In light of the insufficiency of the traditional safety net liquidity provision to stall the financial crisis, national governments went ahead with providing guarantees to their financial institutions’ long-term debts, and acquiring both their good and impaired assets Moreover, the government support often encompassed direct recapitalizations of financial institutions All these forms of government support were initially granted within the EU without coordination between Member States Immediately after the onset of the crisis, national governments’ support was initially targeted to individual solvent institutions, and Spanish authorities were no exception As the crisis intensified after the fall of Lehman Brothers in October 2008, it became obvious that interventions had to be extended to a larger number of banks, and even to the financial system as a whole encompassing virtually all bank liabilities — including retail, corporate, and interbank deposits in some countries (e.g., Irish and Danish blanket guarantee schemes) The European Commission coordinated ex post national government support in the context of its State aid policy, which aimed to preserve an b2028_Ch-17.indd 474 10/5/2015 10:09:42 AM 9”x 6” b2028 The First Great Financial Crisis of the 21st Century: A Retrospective Bank Crisis Resolution and the Insufficiency of Fiscal Backstops: The Case of Spain 475 integrated financial market in the EU.6 The commission’s coordinating role materialized in several other areas, including guidance on government guarantees on bank debt issuance, the recapitalization of financial institutions, treatment of banks’ impaired assets and return to viability, and the assessment of the restructuring measures in the financial sector under the State aid rules Also, the European Central Bank played a coordinating role by drawing up recommendations on the appropriate framework for the pricing of such forms of government support.7 Figure shows government support to the banking sector as of 2013 Contingent Liabilities Liabilities Total EU Total EMU 70 65 60 55 50 45 40 35 30 25 20 15 10 HU SK SE LT DK FR SI IT AT LV UK NL DE LU ES BE CY PT GR IE Figure Government support to the banking sector in the EU (Public sector liabilities and contingent liabilities) as percent GDP (2013) Source: Eursotat The advantage of the explicit schemes, as compared to the ad hoc measures, resides in the transparency regarding the institutions eligible, the volume of support available, the pricing, and the duration For further details on the role of the ECB, see www.ecb.int/pub/pdf/other/recommendations_ on_pricing_for_recapitalisationsen.pdf; www.ecb.int/pub/pdf/other/recommendations_ on_guaranteesen.pdf and www.ecb.int/pub/pdf/other/guidingprinciplesbankassetsupport schemesen.pdf b2028_Ch-17.indd 475 10/5/2015 10:09:42 AM b2028 The First Great Financial Crisis of the 21st Century: A Retrospective 476 9”x 6” The First Great Financial Crisis of the 21st Century: A Retrospective Government guarantees of new issuance of bank senior debt were also introduced with the objective of further easing the solvent banks’ liquidity problems Such guarantees excluded subordinated debt (Tier capital) or blanket guarantees (indiscriminate coverage of all liabilities) In most countries, contingent liabilities stemming from government guaranteed bonds have decreased from the peak of 2009, when such forms of support amounted to €930 billion (€720 billion in the euro area); but it has increased in some countries that, like Spain, were affected by the negative loop between sovereign and banking crisis, where the rise in government spreads mirrored that of the government guaranteed bonds In Spain, the accumulative balances of government guarantees were €103.4 billion until year-end 2012 (total balance outstanding of €53.8 billion) (IMF, 2013) In the EU, government capital injections aimed to respond to the market’s perception that banks’ reported capital ratios did not reflect the true risks on their balance sheets Although initially capital support came in the form of Tier capital and non-core Tier (e.g., preferred shares) in order to avoid any minority voting rights, it was only a matter of time before the governments’ financial support materialized into acquisitions of banks’ ordinary shares and even full nationalizations (e.g., Hypo Real Estate; Anglo Irish, Bankia, etc.) In some instances, capitalization involved support by several governments simultaneously (i.e., Dexia and Fortis) Recapitalization is the second most used instrument to support the financial sector, after the guarantees on liabilities In the period 2008–2012, Member States have granted an overall amount of €413.2 billion in recapitalization measures Spain (€60 billion) was one of the four countries that supported their banks most with capital measures during these years, along with the UK (€82 billion), Germany (€64 billion), and Ireland (€63 billion) In 2009, Spain launched a special fund to provide solvency support to crisis banks, the Fondo de Restructuración Ordenada Bancaria, or FROB.8 FROB is almost entirely public and, at its inception, had limited tools to resolve failing banks The largest part of public recapitalization of Spanish banks took place in the context of the For more information on the fund, known in English as the Fund for the Orderly Restructuring of the Banking Sector, see www.frob.es/general/creacion_en.html FROB’s charter was revised in the context of the MoU b2028_Ch-17.indd 476 10/5/2015 10:09:42 AM 9”x 6” b2028 The First Great Financial Crisis of the 21st Century: A Retrospective Bank Crisis Resolution and the Insufficiency of Fiscal Backstops: The Case of Spain 477 ESM-supported financial-sector program (€41.3 billion) (European Union Commission (EUC), 2013).9 Initially, the acquisition of impaired assets was part of the governments’ strategy to clean up banks’ balance sheets in a context of high refinancing costs due to the uncertainty on banks’ asset quality in the EU Government asset support took two forms: asset insurance schemes, which maintained the assets in the banks’ balance sheets (often in the context of the distressed bank acquisition by a healthy bank); and asset removal schemes, which transferred the assets to a separate institution (bad banks, such as in Germany, Ireland, and Spain) Only in Spain, good-quality assets received government support before the ESM-supported financial-sector program In Spain the cumulative balance of the maximum amount of losses covered by asset protection schemes on certain asset classes was €28.7 billion until May 2013 Such protection schemes were provided in the context of acquisitions of distressed banks (IMF, 2013) In 2012, restructuring banks in the context of the ESM-supported financial sector program transferred real estate assets of approximately €55 billion (real estate loans; stakes in real estate companies, and foreclosed assets) to an asset management vehicle (SAREB) at a discount that ranged from 47.5% (loans) to 65.3% (foreclosed assets) Distressed banks that have received State aid in the form of recapitalization and/or impaired asset support, which altogether exceeds 2% of the bank’s total risk-weighted assets, are obliged to present a restructuring plan to the European Commission In July 2013, the Commission adapted State Aid rules for crisis banks to make sure that State support should be granted on terms that represent an adequate burden-sharing by those who invested in the bank before resorting to public money (EU) Before granting any kind of restructuring aid to a bank, be it a recapitalization or impaired asset measure, all Both the EU Commission and the ECB provided guidance on the methodology to calculate the remuneration policy of government capitalizations based on market prices and specific bank risk, taking into consideration the level of subordination and corresponding risk of the specific instrument (credit default swap (CDS) spreads, equity risk premiums) and the country risk (government bond yield) Most important, pricing has to incentivize the temporary nature of the government’s involvement, using add-on fees, call options, or conditional payment of dividends b2028_Ch-17.indd 477 10/5/2015 10:09:42 AM b2028 The First Great Financial Crisis of the 21st Century: A Retrospective 478 9”x 6” The First Great Financial Crisis of the 21st Century: A Retrospective capital-generating measures, including the conversion of junior debt, should be exhausted, provided that fundamental rights are respected and financial stability is not put at risk.10 As a final reflection, the EU faced the international financial crisis with a decentralized system for bank prudential regulation, supervision, emergency liquidity assistance, and bank failure reorganization and resolution, all of which had been the responsibility of each Member State National authorities focused on preserving their national banking systems with little regard for the potential negative spillovers In 2008 the dramatic events that followed the collapse of Lehman Bros catalyzed political agreement for further implicit and explicit coordination not only across country regulators but also among different safety net regulators Nieto and Schinasi (2007) characterized this process as an iterative process in which EU countries gradually and selectively internalized some of the negative externalities associated with cross-border financial problems and instability In the euro area, it took politicians the twin banking and sovereign crises to progress in the process of internalization of the existing nationaloriented arrangements to deal with bank crisis resolution, including the development of a (partial) credit transfer among sovereigns: the ESM, and the centralization of bank supervision and resolution Spanish Bank Restructuring and Resolution in the Context of the MoU The reversal of imbalances in the Spanish real estate sector and the euroarea debt crisis together fueled a vicious cycle of failing banks, unsustainable fiscal deficits, rising borrowing costs, contracting output, and severe financial market turmoil (IMF, 2012) On June 25, 2012, in face of the difficulties of the Kingdom of Spain to obtain financing in the markets, or at least it at a reasonable price, the Spanish authorities requested financial assistance from the European Financial Stability Facility (EFSF), the precursor of the ESM, to support the ongoing restructuring and recapitalization of its financial sector It was 10 “When a public recapitalization is urgently necessary to avert risks to financial stability, it can still be temporarily approved before the full restructuring plan is ready, provided that the competent supervisor confirms that an immediate intervention is necessary” (European Commission) b2028_Ch-17.indd 478 10/5/2015 10:09:42 AM 9”x 6” b2028 The First Great Financial Crisis of the 21st Century: A Retrospective Bank Crisis Resolution and the Insufficiency of Fiscal Backstops: The Case of Spain 479 the first time the instrument of recapitalization of banks through loans granted to a government was used There were no contributions from other lenders In July 2012, the Ministers of Finance of the euro-area countries (Eurogroup) approved an envelope of financial assistance for Spain of up to €100 billion It was designed to cover a capital shortfall identified in a number of Spanish banks, with an additional safety margin However, the Spanish government did not request the full amount The program concluded as scheduled in January 2014, and the total financial assistance required was €41.3 billion The difference between the initial request and the effective disbursement highlights the uncertainty about the real need for Spanish bank recapitalizations at the time of the program negotiation The ESM-supported program for Spain built on reforms that the authorities had already undertaken during the crisis, such as demands for additional loan loss provisioning (€130.000 billion, including writeoffs)11 and capital requirements, including regulatory changes as a result of the implementation of the Capital Requirement Directive The program consisted of 32 measures, which included institutional and regulatory changes that had to be completed in 18 months However, two elements of the program were most relevant to change the course of the events, First, was the establishment of a rigorous process to identify and address undercapitalized banks, which consisted of two differentiated parts: (1) identifying and addressing undercapitalized banks via a stress test cum asset quality review and (2) performing a burden-sharing of capital shortfalls identified in the stress test A better-capitalized Spanish banking system diminished uncertainty regarding the strength of its balance sheets, thereby improving Spanish banks’ access to funding markets The capitalization of weak banks also aimed to protect taxpayers by requiring those banks to undertake private capital-raising efforts before undercapitalization problems became aggravated The second change was reform of the institutional framework for financial-sector regulation, supervision, and resolution, aimed at enhancing its credibility before the market participants — hence, making it credible that supervisors and resolution authorities would take swift action to deal with banks under resolution or liquidation In particular, the Law on the orderly restructuring and resolution of credit institutions (1) provided the authorities 11 Authors’ estimate b2028_Ch-17.indd 479 10/5/2015 10:09:42 AM b2028 The First Great Financial Crisis of the 21st Century: A Retrospective 480 9”x 6” The First Great Financial Crisis of the 21st Century: A Retrospective with sufficient powers to recapitalize, restructure, and resolve troubled banks in a way that minimizes private and public costs and (2) invested such powers in the agency (i.e., FROB) best placed to exercise them The rest of this section will present the methodology and results of the stress test cum asset quality review, as well as the burden-sharing of capital shortfalls identified in the stress test; and the key improvements of the Law on bank restructuring and resolution, many of which also incorporate emerging international best practices 5.1 Identification of capital shortfall of Spanish banks The identification of banks’ capital needs covered 17 banking groups, which represented approximately 90% of the system’s domestic credit The identification of capital needs took place through a comprehensive asset quality review carried out by four major international audit firms and a bank-by-bank bottom-up stress test conducted by an external consultant Spanish banks’ capital needs were evaluated on a consolidated basis against a post-stress Core Tier ratio (CET1 European Banking Authority (EBA)-definition) of 9% and 6% in a baseline and adverse macroeconomic scenario, respectively To ensure the high quality of the bank data used in the stress test, the four major international audit firms carried out an asset quality review of each bank’s loan portfolio to adjust for potential misclassification of loans, while five external appraisal companies assessed the value of foreclosed assets.12 A total of 10 of the 17 banking groups, representing 35% of the sample’s assets, were identified as needing additional capital under the adverse scenario, with a total capital need of €55.9 billion The triage of the ten banks with capital shortfalls resulted in three separated categories (1) Group constituted by four banks, which already had public ownership via the Fund for Orderly Bank Restructuring, or FROB.13 These banks constituted 78% of the identified capital shortfall 12 Details of the asset quality review and bottom up stress test exercise of the Spanish banks performed by Wyman are available were published in September 28, 2014 (Wyman, 2014) 13 These banks were BFA-Bankia Group, Catalunya Caixa, NCG Banco, and Banco de Valencia b2028_Ch-17.indd 480 10/5/2015 10:09:42 AM 9”x 6” b2028 The First Great Financial Crisis of the 21st Century: A Retrospective Bank Crisis Resolution and the Insufficiency of Fiscal Backstops: The Case of Spain 481 (2) Group constituted by those banks that were not owned by FROB and that were in need of state aid to address their capital shortfalls.14 Four banks that constituted 16% of the identified capital shortfall fall into this group (3) Group constituted by those banks for whom their plans to meet their capital shortfall privately without recourse to state aid are deemed credible.15 Two banks included in the stress test and 6% of the identified capital shortfalls were placed in this category Banks in Groups and were all considered viable after being restructured in the context of the new Law on bank restructuring and resolution passed during 2012 The Principles of bank restructuring and resolution contained in the Law required that the shareholders (stakeholders or partners) and subordinate creditors bear first losses caused by the restructuring or resolution in accordance with the order of priority established in insolvency legislation The Spanish approach to bank restructuring in the context of the ESM program was inspirational for the European Commission when it adapted State Aid rules for crisis banks in July 2013 Groups and banks’ restructuring plans, which in some instances involved important divestments of business lines, were subject to the scrutiny of the Commission as competition authority None of the banks in Groups and were liquidated at a later stage 5.2 Key improvements of the Law on bank restructuring and resolution Among the 32 measures agreed in the ESM-supported program for Spain, the 2012 Law on orderly restructuring and resolution of credit institutions played a key role in giving credibility to the recapitalization process The Law was essential to create the right structure of incentives including changes in the institutional framework and providing a broad toolkit of resolution tools to meet the challenges in the 14 15 BMN, Caja3, CEISS, and Libercaja Ibercaja and Popular b2028_Ch-17.indd 481 10/5/2015 10:09:42 AM b2028 The First Great Financial Crisis of the 21st Century: A Retrospective 482 9”x 6” The First Great Financial Crisis of the 21st Century: A Retrospective operational phase particularly the burden-sharing arrangements The 2012 Law is broadly well in line with the new European Directive establishing a framework for the recovery and resolution of credit institutions and investment firms regarding the objectives, principles and tools of the resolution authority (European Union, 2014) However, there is an important difference, which is that the Spanish 2012 Law envisages that FROB can provide public capital injections to crisis banks in the context of an effective formal reorganization and resolution process By contrast, the Directive only envisages the private funding of national resolution funds, which cannot be used for the recapitalization of weak banks Three main features of the institutional reform brought about by the 2012 Law represented a clear improvement from the situation existing before the ESM-supported program The first feature is the concise definition of the objective of FROB, which is to manage the restructuring and resolution processes of banks As it was the case before the ESM program, FROB is funded by the General State Budget; in addition, it may raise funds by issuing fixed-income securities, receiving loans, applying for credits, and engaging in any other borrowing operations.16 Also, FROB has been instrumental for channeling the ESM loans for recapitalization of banks in Groups and The second main feature is the clearer separation of FROB and Bank of Spain functional responsibilities on bank restructuring and resolution The Law strengthens the powers and tools of FROB as resolution authority Finally, the third feature is the distinction between viable and nonviable institutions: while FROB is responsible for crisis resolution of viable banks and its financing, the costs of resolving non-viable entities should ultimately be paid by the banking sector, and thus by the FGD (Fondo de Garantía de Depósitos) In spite of the important progress, some challenges remain In particular, there is the need of close cooperation between Bank of Spain and 16 The Directive establishes that funding of resolution funds comes from banks via riskadjusted fees b2028_Ch-17.indd 482 10/5/2015 10:09:42 AM ... in the financial system, and may have exacerbated the crisis According to Kimie Harada, Takeo Hoshi, Masami Imai, Satoshi Koibuchi, and Ayako Yasuda, Japan’s financial regulatory responses to the. .. b2028 The First Great Financial Crisis of the 21st Century: A Retrospective vi Chapter Chapter Contents Regulatory Change in Australia and New Zealand Following the Global Financial Crisis C .A Brown,... in Abacus, Journal of Banking and Finance, Journal of Financial Research, Australian Journal of Management, Journal of Futures Markets, International Review of Finance, and Accounting & Finance,