Yves Nosbusch

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In defence of better regulation
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By awarding the 2014 Nobel Prize in Economic Sciences to Jean Tirole from the University of Toulouse, Sweden's Royal Academy of Sciences has acknowledged the vast body of work of a researcher who has made fundamental contributions in a number of areas. The scientific community had long expected Jean Tirole to win the award. The real question was not if he would receive the Nobel Prize but rather which part of his work the selection committee would focus on : his work with Jean-Jacques Laffont on the regulation of oligopolies, i.e. markets dominated by a small number of companies (the area highlighted by the committee), his analysis of industrial organisation more generally, his characterisation of conditions under which rational speculative bubbles may form, his work on liquidity with Bengt Holmström, or his analysis of the banking sector and various aspects of its regulation with Jean-Charles Rochet, Mathias Dewatripont and, more recently, Emmanuel Farhi.

 

A modern theory of the financial sector
Much has been said in the last few days about his collaborations with Jean-Jacques Laffont. The present article will focus on a more recent part of Jean Tirole's research programme on the banking sector and bank regulation, and in particular on a 2012 article co-authored with Emmanuel Farhi from Harvard University and published in the American Economic Review.

 

In this article, the authors develop a theoretical model based on developments in the banking sector before the recent crisis. The key idea is that market forces may lead banks to take on similar risks. In other words, the market may give an individual bank an incentive to adopt a given risky strategy if a sufficient number of rival banks adopt the same strategy. Not taking on those risks would mean lower returns which could place the bank in a difficult, perhaps unsustainable, competitive situation. In addition, the authorities would be forced to intervene in case of problems provided that the number of financial institutions exposed to the strategy in question is sufficient to constitute a systemic risk.

Macro-prudential regulation, liquidity requirements and “too big to fail”
The model provides a theoretical foundation for several recent changes in bank regulation. First of all, it stresses the importance of macro-prudential regulation: rather than examining banking risks on a case-by-case basis, it is critical to supervise the global exposure of the sector, and in particular the potential build-up of certain risks stemming from the adoption of similar strategies. This is one of the main lessons learned from the recent crisis, one that led to the creation of a single supervisory mechanism, which constitutes the first pillar of Europe's nascent banking union and for which the European Central Bank will be responsible.

The model also gives a theoretical justification for the new regulatory requirements on liquidity that form a significant part of the Basel III rules. The idea here is to avoid an excessive maturity transformation or, in other words, too great a maturity mismatch between the assets and liabilities held by banks.

 

Another interesting implication of the model is that the problem does not lie in the large size of some banking institutions (i.e., the idea of “too big to fail”) but instead in the similarities of the risks taken by different institutions. This research is typical of Jean Tirole's approach, consisting of an elegant theoretical model motivated by real-world problems and with major practical implications.

 

 

In addition to these fundamental scientific advances, Jean Tirole has contributed immensely to the field by bringing a unified and rigorous approach to previously disparate fields. Perfect examples of this are his 1988 book on industrial organisation, still a reference in the field, and his 2006 book on the theory of corporate finance, which provides a unified approach to a particularly complex field while at the same adding new insights. His students and readers admire him for this ability to explain a multitude of complex problems in a unified framework, which can be of great benefit to anyone embarking on the journey of discovery of these research fields.


 

Yves Nosbusch

Chief Economist

BGL BNP Paribas

 

 

Published in the Luxemburger Wort (in French) on 23 October 2014.
 

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