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Intervention in Financial Markets

This article from CEPR is definitely on the challenging side, but has some really useful insights into interventions to stabilise financial markets in Europe. I particularly like how it uses recent instability in Switzerland and the US alongside references to the financial crisis, which, although perhaps 'recent' to us, is outside the memory of our students.

Motivated students with an interest in finance could manage this as an extension task, but some students would struggle to access this independently. You could, however, use it in class, with quite a bit of teacher support, to practice reading challenging material. Another option would be to pick out a few smaller sections for students to read. I opted to put it through ChatGPT to summarise it and make it more accessible. In this case, it did a pretty good job, I've pasted this below in case you'd rather give students this version:

The article talks about a proposal by the European Commission called Crisis Management and Deposit Insurance (CMDI), which is aimed at improving how banks in the European Union (EU) are dealt with during financial crises. The authors, Mathias Dewatripont, Peter Praet, and André Sapir, believe that this proposal is a good step forward but suggest that it should be complemented by other measures.

Here's a simplified breakdown:

1.Background: Recently, several banks in the US and Switzerland collapsed or faced severe problems. This made people realize that there’s an urgent need to figure out better ways to handle such banking crises, especially in Europe. When a bank is in crisis, the authorities sometimes use public money to save it. This is often controversial as it's seen as using taxpayers’ money to bail out big banks.

2. EU’s Current System: The EU has a rule called the Banking Recovery and Resolution Directive (BRRD). This rule makes it hard to use public money to save a troubled bank unless 8% of the bank’s total assets have been ‘bailed-in’, meaning losses have been absorbed by the bank’s shareholders or creditors. However, this rule can put the deposits (people’s savings) in danger, which can be bad for financial stability. As a result, this rule has often been avoided and hasn't been very effective.

3. The New Proposal (CMDI): The European Commission has come up with the CMDI proposal to address these issues. The CMDI makes it easier to use money from deposit guarantee schemes (which are funds designed to protect people’s deposits in banks) to save a troubled bank without having to use people’s savings. However, the proposal doesn't go for a Europe-wide scheme yet and relies on national schemes.

4. Why This is Good: The authors think this is a smart move because it can help stabilize the financial system and protect people’s savings. This is essential for the economy and ultimately beneficial for everyone.

5. But, There are Concerns: Even though using deposit guarantee schemes sounds good, it's still, in a way, using public money. The authors are concerned that this can be unpopular with the public and that banks might take more risks if they know they can be bailed out (this is called moral hazard).

6. Additional Recommendations: The authors believe that to really address these issues, the CMDI proposal should be accompanied by:

- Increasing loss-absorbency: Making sure banks have enough of their own funds to absorb losses so they don’t have to rely on public money.

- Better supervision: Keeping a closer watch on banks, especially with new banking methods and technologies that might be riskier.

- Holding management accountable: If a bank gets into trouble because of bad decisions, the people who made those decisions should face consequences. This can deter reckless behaviour.

- Flexibility in dealing with troubled banks: Authorities should have more options in how they handle a troubled bank. For example, sometimes it might be better for the government to temporarily take over a troubled bank, instead of rushing to sell it.

7. Conclusion: The CMDI proposal is a good step, but it needs to be part of a larger set of measures that make banks safer, hold people accountable, and protect both the economy and the public's money.

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