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Motivation
• Observations linked to the crisis٧ Rise of securitization – financial innovation٧ Banks were holding such assets٧ Banks were seen as “well capitalized”٧ Basel II
− Risk-weights− Internal-Rating-Based (IRB) Approach
• Tax-payer exposure• Volcker Rule, Vickers, and Liikanen Reports
٧ Ring-fencing− Limit exposure− Ensures continuation of essential services
• A Representative bank٧ Initial capital , maximize value of equity٧ Takes insured deposits٧ CRS investment opportunity
− −
• Measure 1 of risk averse households٧ Endowed with 1 unit of consumption good٧ Storage technology٧ Utility from end-of-period consumption
A single period model
Financial innovation (1/2)
• Imagine a second (symmetric) economy• Investment opportunity
٧ ٧
• Imperfect correlation• Risk sharing “trade”
٧ Assume they swap 50% of their portfolio
• Effect on portfolio return distribution٧ Interpretation
− Securitization− Buying CDS
Bottom line
• Financial sophistication has value• But incentives are very strong to
٧ Overestimate diversification٧ Make side bets
• Can we trust internal models?٧ Information asymmetry
• Mechanism design٧ In a static world…٧ In reality…
− Full joint distribution matters− Supervisor’s human capital
• “Ring fencing” may make sense
A possible logic
• Deposit insurance distorts incentives٧ But is necessary to preserve confidence٧ Continuation of essential services
• Financial innovation is useful٧ By nature, its impact is hard to assess
• If cannot confidently supervise٧ Separate entities
• If other gains from conglomerate٧ “Ring-fencing”
• Deposit taking are insured and do safe stuff• Others can innovate but are not insured
٧ If no-bailout clause credible => internalize cost of risk٧ If fails, deposit institutions are preserved
In practice
• Volcker Rule: prevent side bets• Vickers and Liikanen propose to restrict bank
“activities”• Remarks
٧ Deposit insurance Vs taking deposits٧ I assume main goals are
− Preserving deposit institutions− Allowing for financial innovation
٧ Prevent adverse alteration of joint distribution
Where to put up the fence?
Commercial Bank
A L
Debt
Equity
Investment bank
Funny business
These links are problematic
These links seem fine
Loans & Bonds
Stocks
A L
Deposits & Debt
Equity
Commercial bank
Beware of credibility !
Some questions and caveats
• Inside the fence٧ Assets
− Regulator should be able to assess joint distributions− Restrictions on assets, validation?− Interbank positions within the fence?
٧ Liabilities− Collateralized borrowing?− Hybrid liabilities?− Full guarantee?
• Outside the fence٧ Credibility (TBTF?)٧ No restriction at all?
− Externalities (among IB and/or towards the fenced institutions)
• Crisis?٧ Contingent rules?٧ Repatriate business within the fence?٧ Reward the survivors?