Bailing out the Banks: Reconciling Stability and Competition

CEPR: Thorsten Beck, Diane Coyle, Mathias Dewatripont, Xavier Freixas, Paul Seabright, 18-02-2010




An analysis of state-supported schemes for

financial institutions


Centre for Economic Policy Research (CEPR)


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ISBN: 978-1-907142-03-1

Bailing out the Banks:

Reconciling Stability and Competition

An analysis of state-supported schemes for

financial institutions

Thorsten Beck

(Tilburg University and CEPR)

Diane Coyle

(Enlightenment Economics, University of Manchester and CEPR)

Mathias Dewatripont

and CEPR)

(Universite Libre de Bruxelles, Solvay Brussels School, ECARES

Xavier Freixas

(Universitat Pompeu Fabra and CEPR)

Paul Seabright

(Toulouse School of Economics and CEPR)

Centre for Economic Policy Research (CEPR)

The Centre for Economic Policy Research is a network of over 700 Research Fellows and

Affiliates, based primarily in European universities. The Centre coordinates the research

activities of its Fellows and Affiliates and communicates the results to the public and private

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organization with uniquely wide-ranging scope and activities.

The Centre is pluralist and non-partisan, bringing economic research to bear on the analysis of

medium- and long-run policy questions. CEPR research may include views on policy, but the

Executive Committee of the Centre does not give prior review to its publications, and the

Centre takes no institutional policy positions. The opinions expressed in this report are those

of the authors and not those of the Centre for Economic Policy Research.

CEPR is a registered charity (No. 287287) and a company limited by guarantee and registered in

England (No. 1727026).

Chair of the Board Guillermo de la Dehesa

President Richard Portes

Chief Executive Officer Stephen Yeo

Research Director Mathias Dewatripont

Policy Director Richard Baldwin


About the authors vi

Acknowledgements viii

Glossary ix

Introduction 1

1. Why are banks special? 9

1.1 The high social cost of banks' bankruptcy 10

1.2 Contagion in times of financial instability 12

1.3 The regulatory safety net 13

1.4 The differences between banking and non-banking entities 14

2. Bank competition and financial stability 17

2.1. Bank competition and stability: what does theory predict? 17

2.2. Bank competition and stability: what do the data tell us? 19

2.3. Universal banking and stability

3. Origins and initial impact of the banking crisis 25


3.1 The systemic crisis 25

3.2 The channels of contagion 26

3.3 The subprime crisis 29

3.4 Bank bankruptcies 31

3.5 Impact of the crisis on bank activity 32

3.6 Experience of bank rescue packages in member states 35

4. Bank bailouts: their purpose, risks and implications for burden sharing 37

4.1 What problems are bailouts supposed to solve? 37

4.2 How can bailouts resolve these problems? 43

4.3 How bailouts can go wrong 46

4.4 'Good bank/bad bank' schemes 48

4.5 Desirable principles for rescue plans 49

5. Competition implications of bailouts 51

5.1 Behavioural solutions 52

5.2 Governance solutions 56

5.3 Principles for the competition policy evaluation of bank rescue plans 57

6. An evaluation of DG Competition's strategy 59

6.1 European Commission state aid communications 59

6.2 The European Commission's actions in individual bank rescues 63

7. Preventing future crises: reforming prudential regulation 67

7.1 Introduction 67

7.2 Globalisation and the new challenges in the current crisis 68

7.3 Requirements for effective harmonisation 71

7.4 Harmonisation in the European Union 71

7.5 The de Larosière report and its follow-up 74

7.6 Beyond the de Larosière report – the new financial supervision structure 74

8. Conclusions 85

References 86

About the authors

is Professor of Economics and Chairman of the European Banking

Center at Tilburg University. Before joining Tilburg University in 2008, he worked at

the Development Research Group of the World Bank. His research and policy work

has focused on international banking and corporate finance and has been published


Journal of Finance, Journal of Financial Economics, Journal of Monetary Economcis and

Journal of Economic Growth

Saharan Africa and Latin America. He is also Research Fellow in the Centre for

Economic Policy Research (CEPR) in London and a Fellow in the Center for Financial

Studies in Frankfurt. He studied at Tübingen University, Universidad de Costa Rica,

University of Kansas and University of Virginia.

runs the consultancy Enlightenment Economics. She is a BBC Trustee

and member of the Migration Advisory Committee and of the independent Higher

Education Funding Review panel, and was for eight years a member of the

Competition Commission (until September 2009). She is also visiting professor at the

University of Manchester. She has a PhD from Harvard. She specialises in the

economics of new technologies, including extensive work on the impacts of mobile

telephony in developing countries. Recent projects include work for NESTA on the

wider conditions for innovation, and a study on the effects of mobiles in India. She

is the author of several books, has published numerous book chapters, reports and

articles, and was formerly a regular presenter on BBC Radio 4's

is to be published by Princeton University Press in 2010. Diane has acted as a member

of the advisory board of ING Direct UK and of the stakeholder advisory panel of EDF

Energy, and is a member of the advisory council of the think tank Demos. She was

previously Economics Editor of

and in the private sector as an economist. Diane was awarded the OBE in January


holds a Ph.D. in Economics from Harvard University, 1986. He

is professor of economics at ULB and currently the President of its Solvay Brussels

School of Economics and Management. He is laureate of the 1998 Francqui Prize and

of the 2003 Jahnsson Medal. He was Managing Editor of the

. His operational and policy work has focused on Sub-Analysis. Her next bookThe Independent, and earlier worked at the UK TreasuryReview of Economic Studies

(1990-94) and one of the three Programme co-chairs of the 2000 World Congress of

the Econometric Society (Seattle), of which he is Fellow and Council Member. In

2005, he was President of the European Economic Association. He has been Research

Director of CEPR as well as Annual Visiting Professor at MIT since 1998. He is a


member of European Commission DG-Competition's Economic Advisory Group on

Competition Policy and of European Commission President J.M. Barroso's Group of

Economic Policy Analysis. His general research area is the theory of incentives and

organizations, with applications to banking, corporate finance and the theory of

organizations. He has published many articles in international journals (including

Quarterly Journal of Economics, American Economic Review, Journal of Political Economy,

Review of Economic Studies,

Prudential Regulation of Banks

Banks: Global Lessons from the Financial Crisis

(Princeton University Press, due to appear in May 2010).

, (Ph D. Toulouse 1978) is Professor at the Universitat Pompeu Fabra in

Barcelona (Spain) and Research Fellow at CEPR. He is also Chairman of the Risk Based

Regulation Program of the Global Association of Risk Professionals (GARP). He is past

president of the European Finance Association and has previously been Deutsche

Bank Professor of European Financial Integration at Oxford University, Houblon

Norman Senior Fellow of the Bank of England and Joint Executive Director

Fundación de Estudios de Economía Aplicada FEDEA), 1989-1991, Professor at

Montpellier and Toulouse Universities. He has published a number of papers in the

main economic and finance journals (

Financial Studies, Econometrica, Journal of Political Economy

consultant for the European Investment Bank, the New York Fed, the European

Central Bank, the World Bank, the Interamerican Development Bank, MEFF and the

European Investment Bank. He is Associate Editor of

Intermediation, Review of Finance, Journal of Banking and Finance

Services Research

risk, contagion and the lender of last resort and the He is well known for his research

work in the banking area, that has been published in the main journals in the field,

as well as for his book Microeconomics of banking (MIT Press, 1997), co-authored

with Jean-Charles Rochet.

is Professor of Economics at the Toulouse School of Economics. He was

formerly a Fellow of All Souls College, Oxford and of Churchill College, Cambridge,

and Reader in Economics at the University of Cambridge. He has published research

in a wide range of areas of both theoretical and applied microeconomics, with a

particular focus on industrial organization and competition policy. He is the author

of several books, including The Company of Strangers: A Natural History of Economic

Life (Princeton 2004), which was shortlisted for the 2005 British Academy Book Prize

and will appear in a second edition in May 2010 with a new chapter on the financial

crisis. He is a member of European Commission DG-Competition's Economic

Advisory Group on Competition Policy and a Council Member of the European

Economic Association.

and Econometrica); moreover, his books include Thewith Jean Tirole (MIT Press, 1994) and Balancing thewith Jean-Charles Rochet and Jean TiroleJournal of Financial Economics, Review of,...). He has been aJournal of Financialand Journal of Financial. His research contributions deal with the issues of payment systems


We would like to thank Hans Degryse and Jean-Charles Rochet for their comments.

We are grateful to many individuals within the European Commission who gave us

valuable advice and information, and in particular Damien Neven and his team

members, Georges Siotis and Stan Maes. More generally, we thank Damien Neven for

encouraging our work and Philip Lowe for his support and his readiness to allow us

to publish this study. This report draws on research the authors carried out for DG

Competition during the first months of 2009, but it reflects the views of the authors

and not of DG Competition or of CEPR.


ABS Asset Backed Security

AMC Asset Management Corporation

BCM Bank Crisis Management

BIS Bank for International Settlements

CDO Collateralised Debt Obligation

CDS Credit Default Swap

EBA European Banking Authority

EDIC European Deposit Insurance Corporation

ECB European Central Bank

EFC Economic and Financial Committee

ESA European Supervisory Authorities

ESFS European System of Financial Supervisors

ESRB European Systemic Risk Board

ESRC European Systemic Risk Council

FDIC Federal Deposit Insurance Corporation

FDICIA Federal Deposit Insurance Corporation Improvement Act

LCFI Large Complex Financial Institution

MoU Memorandum of Understanding

OTC Over the Counter

OFT Office of Fair Trading

PCA Prompt Corrective Action

RBS Royal Bank of Scotland

SIV Special Investment Vehicle / Structured Investment Vehicle




The continuing crisis has been exceptional in its intensity and global reach. It began

as a financial crisis and it became an all-out economic crisis, requiring a wide range

of globally-coordinated policy responses: monetary and fiscal as well as regulatory

responses, not to mention steps to avoid the trap of protectionism.

Much has already been written on the subject,

address the current crisis in its entirety. Since its main focus is on bank bailout plans,

we will not discuss trade and macroeconomic aspects (except to emphasise that

bailout plans should not threaten the sustainability of public finances).

This report will concentrate on two specific aspects of policy: financial regulation

and competition policy. These are inevitably intertwined. Since the Great Depression

policymakers have struggled to define the right mix of competition rules and

regulations specific to the banking sector. The Great Depression led to the

discontinuation of most standard competition policies in banking in order to foster

financial stability. This objective was clearly achieved, but at the cost, over succeeding

decades, of stifling innovation and imposing a high burden on consumers. This led

in turn, from the 1970s, to a swing of the pendulum towards deregulation, with more

competition and innovation but also with many banking crises (e.g. in the US in the

1980s and in Scandinavia and Japan in the 1990s, in addition to the many emergingmarket

crises). Each time, regulation did try and adapt, in a global fashion, leading in

particular to the Basel I and II regulatory frameworks.

Obviously, this has not prevented the massive crisis that exploded in 2008, leading

to the two unavoidable questions that accompany every such episode: (1) how to deal

with the current crisis; and (2) what lessons the experience offers for reducing the

likelihood of another crisis and mitigating its impact? This report will address these

two questions, with special emphasis on competition policy, and in particular on

state aid control. It is important, furthermore, to put these policy responses in the

context of the overarching architecture of regulatory policies, because the question of

the link between competition and stability in the banking industry depends on the

ability of the various levers of prudential regulation to prevent excessively risky

behaviour by bank managers and shareholders.

The crisis has provoked two common but quite different reactions concerning the

role of competition policy in the banking sector. One reaction has been to consider

1 and this report will not try to


1 Just to focus on CEPR/VoxEU outputs, see for example the recent ebooks edited by Baldwin

(2009), Dewatripont et al. (2009) and by Baldwin and Evenett (2009), as well as the two

ebooks collecting Vox columns on the crisis edited by Felton and Reinhart (2008, 2009).

VoxEU.org has published two other relevant ebooks, both edited by Baldwin and Eichengreen

(2008a, b).

that financial stability should take priority over all other concerns, including those of

traditional competition policy; and therefore, that the ‘business as usual’

preoccupations of competition regulators should be put on hold, and the normal

rules suspended for the duration. Another reaction has been to fear that intervention

to restore financial stability will lead to massive distortions of competition in the

banking sector, and therefore to conclude that competition rules should be applied

even more vigorously than usual, with the receipt of state aid being considered

presumptive grounds for suspecting the bank in question of anti-competitive

behaviour. As will be seen, in this report we endorse neither of these points of view.

We reject the idea that the crisis requires the suspension of normal competition

policy rules; in times of crisis they are more important than ever. However, we also

believe that the competition rules appropriate to the banking sector are not the same

as those that should apply to most other sectors. The reasons are set out in detail

below, and result from the fact that bailing out one bank in an episode of crisis helps

its competitors. State-aided banks have a different relation to the rest of the economy

than state-aided firms in other sectors, and the rules of state aid policy should reflect

these differences. However, this is not equivalent to saying that competition policy in

banking does not matter in a crisis. On the contrary, there should be a thorough

competitive assessment of the banking sector following the bailouts.

This report focuses on general economic principles that should be kept in mind

when facing crisis-induced bank bailouts. It then discusses the reaction by

competition authorities to the current crisis. It is fair to say in this respect that they

tried to strike a balance between the insistence on competition concerns and the need

for urgent action to respond to the financial crisis. Nevertheless, the specific

characteristics of banking need to be acknowledged more explicitly, in particular

because the crisis has had sector-wide competition implications which measures

targeting the individual recipients of aid are not well suited to address.

Main conclusions of the report

The various methods of helping banks, such as purchasing toxic assets (perhaps to be

put in a bad bank), recapitalisation or providing guarantees, should have three

objectives in mind: (i) the need to stabilise the financial system; (ii) the need to restart

lending; and (iii) the need to avoid distortions of competition. Although in some

respects there is a balance to be struck between these objectives, there is no

fundamental trade-off between the aims of financial stability and competition: in our

view, reformed prudential regulation should take care of potentially excessive risktaking,

which means competition policy rules can then apply in banking as in other

sectors of the economy, once the crisis has subsided.

Our conclusions on

general economic principles fall under three main headings.

Bank bailouts can help competitors

It is important to recognise that in the banking industry, in times of crisis, the fact

that one firm is being helped could well imply a positive externality for its

Bailing out the Banks: Reconciling Stability and Competition


competitors, either because it prevents systemic problems, or because these

competitors are themselves its creditors, and so are indirectly also bailout recipients.

This means that bank bailouts do not necessarily require 'compensation' for

competitors, in contrast to the normal assessment of state assistance in other

industries. This does not detract from the fact that in the medium- to long-term, the

survival of less efficient banks can hurt their competitors and the whole banking


New lending needs to be supported

In periods of generalised bailouts, remedies that will tend to contract new lending

must be avoided, although the economic crisis means the desired amount of lending

will decline and the credit-worthiness of some borrowers will have declined.

Standard competition policy should apply to banks

There is no case for applying weaker competition policy criteria to banks, because

competition and stability are not incompatible. The data show that the share of

profits of financial institutions, in GDP, had been growing steadily over time until

2008. Even if some of this was an unsustainable bubble, it was not a situation in

which trouble would have been unavoidable whatever the design of regulation. The

problem was clearly not one of competition leading inevitably to banking fragility.

Proper prudential regulation should therefore be sufficient to allow standard

competition policy principles (Articles 81 and 82 and merger regulations) to be

applied: there is no need to weaken standard competition policy for banks. Nor

should competition policy be applied more strictly in a crisis; it should be applied

with sensitivity to the circumstances that distinguish banks from other kinds of stateaided


Behavioural restrictions may distort competition

Standard competition policy imposes both structural and behavioural restrictions on

firms, and there are no grounds for applying these less vigorously to banks in a crisis:

leniency in merger approval or greater tolerance of predatory behaviour are no more

justified for weak banks than for any other financial or non-financial firm. However,

the opposite tendency also needs to be avoided: in particular, there is no case for

specific behavioural restrictions following bailouts that would put the rescued bank

at a competitive disadvantage with respect to competitors, such as caps on the

compensation of new hires (when banks need fresh talent to clean up the mess

created by previous executives), or limitations on their pricing strategies relative to


Moreover, in periods where many banks have received bailouts, there are good

reasons to avoid imposing conditions on the receipt of state aid that require

generalised balance sheet reductions. These are sometimes justified by analogy with

other sectors (such as manufacturing), where the crisis conditions that lead to

bailouts are often an indicator of structural overcapacity in the sector. In banking, by

contrast, bailouts have been provided due to the fear of a credit crunch – that is, of



inadequate activity in the sector due to the efforts of weak banks to recapitalise.

Imposing balance sheet reductions as an automatic condition of state aid therefore

does not have the rationale that it often has in other sectors of the economy.

This does not imply that concerns about balance sheet growth are unjustified: on

the contrary, limiting growth through acquisitions does make sense as a way to

prevent the recipients of a bailout gaining an unfair advantage. And, in fact, there is

a case for requiring balance sheet reduction in the case of banks whose prior

overexpansion was the reason for their needing a bailout. This being said, a lot of

restructuring in the sector will be desirable following the crisis, and there is no reason

to prevent acquisitions which are compensated by divestitures and therefore avoid

net growth of balance sheets. This should, however, be accompanied by an

assessment of the competitive situation in the sector taken as a whole.

Bailouts should not favour banks' domestic assets

Bailouts should not be permitted to lead to any move away from the single market,

either through national governments directing their own banks towards domestic

lending, or through the imposition of remedies that would lead banks to spin off

foreign rather than domestic activities.


Accounting changes are dangerous

In cases of bank insolvency, such as those we are experiencing in current conditions,

'real' bailouts are needed. Changing accounting rules in order to pretend things are

fine is inappropriate: this just means allowing insolvent banks to go on rather than

cleaning them up, which would result in inefficient lending – ie, leading either to a

credit crunch (as in Japan in the 1990s), or to 'zombie lending' (as in the US Savings

and Loans Crisis in the 1980s).

The amount of the bailout should be the minimum necessary

While 'real' bailouts are needed, Governments must avoid being 'overly generous' in

bank rescues; they should avoid plans that give such banks extra funds that would,

for example as discussed above, allow them to start buying other financial

institutions that are in trouble.

Equity holders must bear as much of the bailout burden as possible

Minimising aid means in particular that, to the extent possible, bailout plans should

wipe out initial equity holders, in order to reduce potential moral hazard. However,

this can be overstated, as the regulatory environment will clearly change after the

crisis, and as there is a danger of negative externalities (including between member

states) if a government treats shareholders too harshly. The key criterion for European

authorities should be to insist that the sustainability of public finances is not


More of the burden should be placed on 'junior creditors'

Moral hazard and fiscal considerations also point to imposing losses on junior

creditors, something which has been too much overlooked in the 2008-2009

Bailing out the Banks: Reconciling Stability and Competition



fear is overrated: separating out the claims of junior creditors from those of senior

ones may well encourage the latter to lend more, rather than less freely. Of course,

one should be careful about second-round effects: if junior creditors are financial

institutions too, such liability re-evaluations may simply transfer the problem; and

European authorities may want to give careful attention to this argument in the case

of foreign junior creditors, whose interests would naturally be neglected by member


2 This may be because of the fear of causing panic among creditors – but this

Sunset clauses/exit strategies are needed

The difficulty of monitoring and enforcing behavioural restrictions on the assisted

banks, and of designing restrictions which do not distort competition, make it

imperative to include an end date or exit strategy in bailout plans.

Governance of banks needs strengthening

For the same reason, certainly for the duration of the state aid and in many cases



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