After the crisis: improving incentives in the financial sector
Jean-Pierre Danthine, Member of the Governing Board
Founding event of the School of Finance, University of St. Gallen, 20.05.2011
Excessive risk-taking, plausibly resulting from the deficient incentives facing the various stakeholders of financial institutions, is likely to have been a determinant of the latest financial crisis. The incentive problem is particularly apparent in the case of the institutions that are deemed too big to fail (TBTF). In order to restore incentives for balanced risk decisions and mitigate the implicit subsidy granted to TBTF institutions, several measures have been proposed. Important among these are higher capital requirements, including a capital surcharge for systemically relevant institutions, a fraction of this capital taking the form of contingent convertible bonds. Also of importance are organisational measures facilitating 'partial' bankruptcy and mitigating the externality imposed by systemically relevant institutions. The analysis shows that sound theoretical principles underlie these measures, which are part of the TBTF package currently submitted to the Swiss Parliament. It is argued that, beyond the intended reduction in risk-taking and the mitigation of the implicit state subsidy, these measures are likely to have few side-effects, either for lending practices or on the cost of capital. Return on equity will decrease in proportion to the decrease in the risks assumed by shareholders.