One of the interesting features of the 2008 financial crisis is the wide range of relationships between changes in a country’s output and changes in unemployment. Spain and Ireland had very large increases in unemployment despite quite different falls in output. This is perhaps not very surprising because both had significant construction industries that were devastated by the bursting of the property bubbles in both countries. More surprising is the fact that countries like Germany and Japan had much larger drops in output than the US but the effect on their unemployment rates was small.

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The recent financial crisis has generated fundamental reforms in the financial regulatory system in the U.S. and internationally. In our paper, Enhancing Prudential Standards in Financial Regulations, which was recently made publicly available on SSRN, we discuss academic research and expert opinions on this vital subject of financial stability and regulatory reforms.

Despite the extensive regulation and supervision of U.S. banking organizations, the U.S. and the world financial systems were shaken by the largest financial crisis since the Great Depression, largely precipitated by events within the U.S. financial system. The new “macroprudential” approach to financial regulations focuses on both the risks arising in financial markets broadly and those risks arising from financial distress at individual financial institutions.

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Academic literature has typically analyzed corporate governance from an agency perspective, sometimes referred to as separation of ownership and control between investors and managers. This reflects the view in the US, UK and many other Anglo-Saxon countries, where the law clearly specifies that shareholders are the owners of the firm and managers have a fiduciary duty to act in their interests. However, firms’ objectives vary across other countries, and often deviate significantly from the paradigm of shareholder value maximization. A salient example is Germany, where the system of co-determination requires large firms to have an equal number of seats for employees and shareholders in the supervisory board in order to pursue the interests of all parties (see Rieckers and Spindler, 2004, and Schmidt, 2004). Similarly, stakeholders’ interests are pursued through direct or indirect representation of employees in companies’ boards in countries like Austria, the Netherlands, Denmark, Sweden, Luxembourg and France (Wymeersch, 1998, and Ginglinger, Megginson, and Waxin, 2009), or through other arrangements and social norms in countries like China and Japan (Wang and Huang, 2006, Dore, 2000, Jackson and Miyajima, 2007, and Milhaupt 2001).

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In our paper, Credit Market Competition and Capital Regulation, which was recently accepted for publication in the Review of Financial Studies, we present a theory that demonstrates that inducements for banks to hold capital can also come from the asset side. We show that when credit markets are competitive, market discipline coming from the asset side induces banks to hold positive levels of capital as a way to commit to monitor and attract borrowers.

We develop a simple one-period model of bank lending, where firms need external financing to make productive investments. Banks grant loans to firms and monitor them, which helps improve firms’ expected payoff. Given that monitoring is costly and banks have limited liability, banks are subject to a moral hazard problem in the choice of monitoring effort. One way of providing them with greater incentives for monitoring is through the use of equity capital. This forces banks to internalize the costs of their default, thus ameliorating the limited liability problem banks face due to their extensive reliance on deposit-based financing. A second instrument to improve banks’ incentives is embodied in the loan rate. A marginal increase in the loan rate gives banks a greater incentive to monitor in order to receive the higher payoff if the project succeeds and the loan is repaid. Thus, capital and loan rates are alternative ways to improve banks’ monitoring incentives, but entail different costs. Holding capital implies a direct private cost for the banks, whereas increasing the loan rate has a negative impact only for borrowers in terms of a lower return from the investment. We consider both the case where there is and isn’t deposit insurance.

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