Almost every country in the world has sophisticated systems to prevent banking crises. Yet such crises--and the massive financial and social damage they can cause--remain common throughout the world. Does deposit insurance encourage depositors and bankers to take excessive risks? Are banking regulations poorly designed? Or are banking regulators incompetent? Jean-Charles Rochet, one of the world's leading authorities on banking regulation, argues that the answer in each case is no. In Why Are There So Many Banking Crises?, he makes the case that, although many banking crises are precipitated by financial deregulation and globalization, political interference often causes--and almost always exacerbates--banking crises. If, for example, political authorities are allowed to pressure banking regulators into bailing out banks that should be allowed to fail, then regulation will lack credibility and market discipline won't work. Only by insuring the independence of banking regulators, Rochet says, can market forces work and banking crises be prevented and minimized. In this important collection of essays, Rochet examines the causes of banking crises around the world in recent decades, focusing on the lender of last resort; prudential regulation and the management of risk; and solvency regulations. His proposals for reforms that could limit the frequency and severity of banking crises should interest a wide range of academic economists and those working for central and private banks and financial services authorities.

Jean-Charles Rochet is one of the dedicated 'audacious pioneers' who have attempted to dissect with rigor, precision, and creativity some of the most elusive issues of financial (in)stability. It is pleasing to see his work presented in a unified, clear, and well-written form. A testament to his formidable contributions and remarkable insights, this book will guide researchers and students, as well as practitioners, into the future.

Why there so many banking crises? One answer is that so few economists of Jean-Charles Rochet's caliber have worked on the problem. Combining analytical and technical abilities, institutional knowledge, clear writing, and common sense to an outstanding degree, Rochet has produced a book that will benefit everyone who reads it.

This collection of important papers by Jean-Charles Rochet, one of the leading theoreticians of banking, should generate great interest.

Among economists' explanations are moral hazard, ill-judged capital adequacy rules and the incompetence of supervisors. Jean-Charles Rochet, a leading authority on banking, argues the real problem lies with politicians who too often insist on rescuing insolvent banks for short-term reasons of their own. [W]hatever the verdict on the policy proposals, the book makes interesting reading in current circumstances.

Jean-Charles Rochet is professor of mathematics and economics at the University of Toulouse and a visiting professor at the London School of Economics and Political Science. His books include (with Xavier Freixas) "Microeconomics of Banking" and (with Guillaume Plantin) "When Insurers Go Bust" (Princeton).

Preface and Acknowledgments ix

General Introduction and Outline of the Book 1

References 14

PART 1. WHY ARE THERE SO MANY BANKING CRISES? 19

Chapter 1: Why Are There So Many Banking Crises? by Jean-Charles Rochet 21

1.1 Introduction 21

1.2 The Sources of Banking Fragility 23

1.3 The Lender of Last Resort 24

1.4 Deposit Insurance and Solvency Regulations 27

1.5 Lessons from Recent Crises 28

1.6 The Future of Banking Supervision 30

References 33

PART 2. THE LENDER OF LAST RESORT 35

Chapter 2: Coordination Failures and the Lender of Last Resort: Was Bagehot Right After All? by Jean-Charles Rochet and Xavier Vives 37

2.1 Introduction 37

2.2 The Model 41

2.3 Runs and Solvency 44

2.4 Equilibrium of the Investors' Game 47

2.5 Coordination Failure and Prudential Regulation 53

2.6 Coordination Failure and LLR Policy 55

2.7 Endogenizing the Liability Structure and Crisis Resolution 58

2.8 An International LLR 63

2.9 Concluding Remarks 66

References 67

Chapter 3: The Lender of Last Resort: A Twenty-First-Century Approach by Xavier Freixas, Bruno M. Parigi, and Jean-Charles Rochet 71

3.1 Introduction 71

3.2 The Model 75

3.3 Efficient Supervision: Detection and Closure of Insolvent Banks 81

3.4 Efficient Closure 85

3.5 Central Bank Lending 89

3.6 Efficient Allocation in the Presence of Gambling for Resurrection 95

3.7 Policy Implications and Conclusions 97

3.8 Appendix 98

References 101

PART 3. PRUDENTIAL REGULATION AND THE MANAGEMENT OF SYSTEMIC RISK 103

Chapter 4: Macroeconomic Shocks and Banking Supervision by Jean-Charles Rochet 105

4.1 Introduction 105

4.2 A Brief Survey of the Literature 106

4.3 A Simple Model of Prudential Regulation without Macroeconomic Shocks 108

4.4 How to Deal with Macroeconomic Shocks? 112

4.5 Is Market Discipline Useful? 118

4.6 Policy Recommendations for Macroprudential Regulation 121

References 123

Chapter 5: Interbank Lending and Systemic Risk by Jean-Charles Rochet and Jean Tirole 126

5.1 Benchmark: No Interbank Lending 132

5.2 Date-0 Monitoring and Optimal Interbank Loans 139

5.3 Date-1 Monitoring, Too Big to Fail, and Bank Failure Propagations 148

5.4 Conclusion 153

5.5 Appendix: Solution of Program (P) 155

References 157

Chapter 6: Controlling Risk in Payment Systems by Jean-Charles Rochet and Jean Tirole 159

6.1 Taxonomy of Payment Systems 161

6.2 Three Illustrations 166

6.3 An Economic Approach to Payment Systems 173

6.4 Centralization versus Decentralization 181

6.5 An Analytical Framework 184

6.6 Conclusion 191

References 192

Chapter 7: Systemic Risk, Interbank Relations, and the Central Bank by Xavier Freixas, Bruno M. Parigi, and Jean-Charles Rochet 195

7.1 The Model 199

7.2 Pure Coordination Problems 205

7.3 Resiliency and Market Discipline in the Interbank System 207

7.4 Closure-Triggered Contagion Risk 210

7.5 Too-Big-to-Fail and Money Center Banks 213

7.6 Discussions and Conclusions 215

7.7 Appendix: Proof of Proposition 7.1 217

References 222

PART 4. SOLVENCY REGULATIONS 225

Chapter 8: Capital Requirements and the Behavior of Commercial Banks by Jean-Charles Rochet 227

8.1 Introduction 227

8.2 The Model 230

8.3 The Behavior of Banks in the Complete Markets Setup 231

8.4 The Portfolio Model 238

8.5 The Behavior of Banks in the Portfolio Model without Capital Requirements 240

8.6 Introducing Capital Requirements into the Portfolio Model 244

8.7 Introducing Limited Liability into the Portfolio Model 246

8.8 Conclusion 249

8.9 Appendix 250

8.10 An Example of an Increase in the Default Probability Consecutive to the Adoption of the Capital Requirement 256

References 257

Chapter 9: Rebalancing the Three Pillars of Basel II by Jean-Charles Rochet 258

9.1 Introduction 258

9.2 The Three Pillars in the Academic Literature 259

9.3 A Formal Model 260

9.4 Justifying the Minimum Capital Ratio 266

9.5 Market Discipline and Subordinated Debt 268

9.6 Market Discipline and Supervisory Action 269

9.7 Conclusion 272

9.8 Mathematical Appendix 274

References 277

Chapter 10: The Three Pillars of Basel II: Optimizing the Mix by Jean-Paul Décamps, Jean-Charles Rochet, and Benoît Roger 281

10.1 Introduction 281

10.2 Related Literature 284

10.3 The Model 287

10.4 The Justification of Solvency Requirements 292

10.5 Market Discipline 294

10.6 Supervisory Action 298

10.7 Concluding Remarks 302

10.8 Appendix: Proof of Proposition 9.2 303

10.9 Appendix: Optimal Recapitalization by Public Funds Is Infinitesimal (Liquidity Assistance) 303

10.10 Appendix: Proof of Proposition 9.3 304

References 305