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Why Are Banks Not Recapitalized During Crises?
Matteo CrosignaniNYU Stern
24 October 2014
Bocconi CarefinStructural Changes in the Banking Sector
Outline
1 INTRODUCTION
2 MODEL
3 EMPIRICAL EVIDENCE
INTRODUCTION MODEL EMPIRICAL EVIDENCE
FACT 1: RELIANCE ON DOMESTIC BANKSLevels Non-GIIPS
INTRODUCTION MODEL EMPIRICAL EVIDENCE
FACT 2: PRIVATE AND PUBLIC LENDINGNon-GIIPS
INTRODUCTION MODEL EMPIRICAL EVIDENCE
FACT 3: RELUCTANCE TO RECAPITALIZE EU BANKS
◮ EBA (Oct11): banks need $146 bn to meet new capitalrequirements
◮ Acharya, Engle, Pierret (2014): EBA underestimates capitalshortfall → reliance on risk-weight
◮ Asset Quality Review
◮ Basel III: delays in implementing CRD IV (Dec12 → Jan14)
INTRODUCTION MODEL EMPIRICAL EVIDENCE
THIS PAPER
◮ Fact 1. Highly levered banks in the periphery risk-shiftbuying domestic govt bonds
◮ Zero risk weight◮ High payoff in the good state◮ High correlation with other sources of revenues
→ LL binds in bad state
EAD
INTRODUCTION MODEL EMPIRICAL EVIDENCE
THIS PAPER
◮ Fact 1. Highly levered banks in the periphery risk-shiftbuying domestic govt bonds
◮ Zero risk weight◮ High payoff in the good state◮ High correlation with other sources of revenues
→ LL binds in bad state
◮ Fact 2. Govt bonds become more attractive relative tolending to private sector → crowding-out
EAD
INTRODUCTION MODEL EMPIRICAL EVIDENCE
THIS PAPER
◮ Fact 1. Highly levered banks in the periphery risk-shiftbuying domestic govt bonds
◮ Zero risk weight◮ High payoff in the good state◮ High correlation with other sources of revenues
→ LL binds in bad state
◮ Fact 2. Govt bonds become more attractive relative tolending to private sector → crowding-out
◮ Fact 3. Govt faces a trade-off when setting capitalrequirements
◮ ↓ private lending → ↓ tax collection◮ ↑ demand for dom bonds → ↑ debt capacity, ↓ govt yields
EAD
INTRODUCTION MODEL EMPIRICAL EVIDENCE
LITERATURE REVIEW
Theory: Acharya, Rajan (2013); Gennaioli, Martin, Rossi (2014);Acharya, Drechsler, Schnabl (2014); Bolton, Jeanne (2011);Broner, Erce, Martin, Ventura (2013); Broner, Martin, Ventura(2010).
Empirical: Acharya, Steffen (2013); Becker and Ivashina (2014);Arslanalp, Tsuda (2012); Brutti, Saure (2013); Acharya, Engle,Pierret (2013); Drechsel, Drechsler, Marques-Ibanez, Schnabl(2013).
INTRODUCTION MODEL EMPIRICAL EVIDENCE
WELL CAPITALIZED BANKS
Italy Spain
IT Firms Unicredit Santander ES Firms
INTRODUCTION MODEL EMPIRICAL EVIDENCE
F1: HOME BIAS AND CROWDING-OUT
Italy Spain
IT Firms Unicredit Santander ES Firms
INTRODUCTION MODEL EMPIRICAL EVIDENCE
F2: BANKS NOT RECAPITALIZED DURING CRISES
Italy Spain
IT Firms Unicredit Santander ES Firms
INTRODUCTION MODEL EMPIRICAL EVIDENCE
F3: RACE TO THE BOTTOM
Italy Spain
IT Firms Unicredit Santander ES Firms
Outline
1 INTRODUCTION
2 MODEL
3 EMPIRICAL EVIDENCE
INTRODUCTION MODEL EMPIRICAL EVIDENCE
ENVIRONMENT
◮ Two-periods
◮ No discounting
◮ Risk neutrality
◮ Two countries with a banking sector and a government
◮ Countries only differ in domestic banks’ initial capital
◮ Shock hits w.p. 1 − θ ∈ (0, 1) at t = 1.5
INTRODUCTION MODEL EMPIRICAL EVIDENCE
INVESTMENT OPPORTUNITY SET
Italy Spain
IT Firms BankI(1−
α)(1−
k)
α(1
−k)
k
◮ Invest k in lending
◮ → α home bias in govt bond market
INTRODUCTION MODEL EMPIRICAL EVIDENCE
PRIVATE LENDING
◮ Invest k at t = 0. Revenues f (k) at t = 1 and t = 2◮ Shock destroys t = 2 revenues◮ Govt levies tax τ in both periods
t=0 t=1 t=2
θ
1 − θ
−k (1 − τ)f (k)
0
(1 − τ)f (k)
INTRODUCTION MODEL EMPIRICAL EVIDENCE
DOMESTIC GOVERNMENT BONDS
◮ Banks invest qD = α(1 − k) in domestic govt bonds◮ Govt repays debt with proceeds from tax collection
→ default in bad state
t=0 t=1 t=2
θ
1 − θ
−qD
0
qD(1 + r)
INTRODUCTION MODEL EMPIRICAL EVIDENCE
FOREIGN GOVERNMENT BONDS
◮ qF = (1 − α)(1 − k) invested in foreign govt bonds
◮ Foreign govt defaults w.p. 1 − θ
t=0 t=1 t=2
θ
1 − θ
−qF
θqF(1 + r∗)
θqF(1 + r∗)
INTRODUCTION MODEL EMPIRICAL EVIDENCE
GOVERNMENT DEBT CAPACITY
◮ Govt maximizes spending using debt◮ τ is exogenous◮ Issues debt D at t = 1.◮ Chooses whether to default on D at t = 2◮ Cost of default (1 + r)C(α, k) > 0 where C1 > 0 and C2 > 0
INTRODUCTION MODEL EMPIRICAL EVIDENCE
GOVERNMENT DEBT CAPACITY
◮ Govt maximizes spending using debt◮ τ is exogenous◮ Issues debt D at t = 1.◮ Chooses whether to default on D at t = 2◮ Cost of default (1 + r)C(α, k) > 0 where C1 > 0 and C2 > 0
◮ Govt defaults if not able and/or not willing to pay◮ Not able if τf (k) < D(1+ r) (AP)◮ Not willing if C(α, k) < D (WP)
INTRODUCTION MODEL EMPIRICAL EVIDENCE
GOVERNMENT DEBT CAPACITY
◮ Govt maximizes spending using debt◮ τ is exogenous◮ Issues debt D at t = 1.◮ Chooses whether to default on D at t = 2◮ Cost of default (1 + r)C(α, k) > 0 where C1 > 0 and C2 > 0
◮ Govt defaults if not able and/or not willing to pay◮ Not able if τf (k) < D(1+ r) (AP)◮ Not willing if C(α, k) < D (WP)
⇒ investors are willing to buy govt bonds if
D ≤ min
{
C(α, k),τθf (k)
1 + r
}
INTRODUCTION MODEL EMPIRICAL EVIDENCE
GOVERNMENT SPENDING
τf (k∗) + τβθf (k∗)︸ ︷︷ ︸
tax collection
+D − βθ(1 + r)D︸ ︷︷ ︸
govt debt
INTRODUCTION MODEL EMPIRICAL EVIDENCE
GOVERNMENT SPENDING
τf (k∗) + τβθf (k∗)︸ ︷︷ ︸
tax collection
+D − βθ(1 + r)D︸ ︷︷ ︸
govt debt
where
D = min
{
C(α, k),τθf (k)
1 + r
}
INTRODUCTION MODEL EMPIRICAL EVIDENCE
BANKS’ PROBLEM
t=1
θ
1 − θ
2(1 − τ)f (k)
(1 − τ)f (k)
Good state: lending (t = 1, 2)Bad state: lending (t = 1)
INTRODUCTION MODEL EMPIRICAL EVIDENCE
BANKS’ PROBLEM
t=1
θ
1 − θ
2(1 − τ)f (k) +qD(1 + r)
(1 − τ)f (k)
Good state: lending (t = 1, 2) + dom. bondsBad state: lending (t = 1)
INTRODUCTION MODEL EMPIRICAL EVIDENCE
BANKS’ PROBLEM
t=1
θ
1 − θ
2(1 − τ)f (k) +qD(1 + r) +qFθ(1 + r∗)
(1 − τ)f (k) +qFθ(1 + r∗)
Good state: lending (t = 1, 2) + dom. bonds + for. bondsBad state: lending (t = 1) + for. bonds
INTRODUCTION MODEL EMPIRICAL EVIDENCE
BANKS’ PROBLEM
t=1
θ
1 − θ
[ 2(1 − τ)f (k) +qD(1 + r) +qFθ(1 + r∗) −L ]+
[ (1 − τ)f (k) +qFθ(1 + r∗) −L ]+
Good state: lending (t = 1, 2) + dom. bonds + for. bonds - debtBad state: lending (t = 1) + for. bonds - debt
INTRODUCTION MODEL EMPIRICAL EVIDENCE
BANKS’ PROBLEM
t=1
θ
1 − θ
2(1 − τ)f (k) +qD(1 + r) +qFθ(1 + r∗) −L
(1 − τ)f (k) +qFθ(1 + r∗) −L
Suppose L is “low enough” (W)
◮ LL does not bind
◮ Invest in domestic bonds iff θ(1 + r) ≥ θ(1 + r∗)
INTRODUCTION MODEL EMPIRICAL EVIDENCE
BANKS’ PROBLEM
t=1
θ
1 − θ
2(1 − τ)f (k) +qD(1 + r) +qFθ(1 + r∗) −L
0
Suppose L is “high enough” (U)
◮ LL binds in the bad state of the world
◮ Invest in domestic bonds iff (1 + r) ≥ θ(1 + r∗)
EAD
INTRODUCTION MODEL EMPIRICAL EVIDENCE
BENCHMARK CASE: WELL CAPITALIZED BANKS
◮ Assume both banks are “well capitalized”
→ identical: k∗, D∗, r∗
α(z)
INTRODUCTION MODEL EMPIRICAL EVIDENCE
BENCHMARK CASE: WELL CAPITALIZED BANKS
◮ Assume both banks are “well capitalized”
→ identical: k∗, D∗, r∗
Italy Spain
BankI BankS
α(z)
INTRODUCTION MODEL EMPIRICAL EVIDENCE
HOME BIAS AND CROWDING-OUT
◮ Assume Italian banks are W and Spanish banks are U
INTRODUCTION MODEL EMPIRICAL EVIDENCE
HOME BIAS AND CROWDING-OUT
◮ Assume Italian banks are W and Spanish banks are U
◮ Assume f (k) = ǫ√
k and C(α, k) = z − (1 − α)(1 − k)
INTRODUCTION MODEL EMPIRICAL EVIDENCE
HOME BIAS AND CROWDING-OUT
◮ Assume Italian banks are W and Spanish banks are U
◮ Assume f (k) = ǫ√
k and C(α, k) = z − (1 − α)(1 − k)◮ Crowding out in Spain: kS < kI◮ → Home Bias in Spain → rS < rI◮ → Home bias in Italy: αI = αS = 1◮ Higher debt capacity DS > DI
Italy Spain
BankI BankS
α(z)
INTRODUCTION MODEL EMPIRICAL EVIDENCE
BANKS’ CAPITALIZATION AND MULTIPLE EQM
In eqm, in the bad state of the world, banks’ revenues are
[ǫ(1 − τ)√
k − L]+
LI LI0
W
INTRODUCTION MODEL EMPIRICAL EVIDENCE
BANKS’ CAPITALIZATION AND MULTIPLE EQM
In eqm, in the bad state of the world, banks’ revenues are
[ǫ(1 − τ)√
k − L]+
LILI LI0
W U
INTRODUCTION MODEL EMPIRICAL EVIDENCE
BANKS’ CAPITALIZATION AND MULTIPLE EQM
In eqm, in the bad state of the world, banks’ revenues are
[ǫ(1 − τ)√
k − L]+
LS
LS
LS
LILI LI0
Multiple Equilibria
WW
WU
UW
UU
INTRODUCTION MODEL EMPIRICAL EVIDENCE
GOVERNMENT CAPITALIZATION CHOICE
Government re-capitalizes domestic banks iff
τǫ(1 + θ)(√
kW −√
kU)︸ ︷︷ ︸
increased taxcollection
≥ (DU − DW)︸ ︷︷ ︸
lower debtissuance
+ θ((1+ rW)DW − (1+ rU)DU)︸ ︷︷ ︸
higher payments tobondholders
INTRODUCTION MODEL EMPIRICAL EVIDENCE
WELFARE
Recapitalization is always efficient
((1− kW)(1+ rW)− (1 − kU)(1+ rU))︸ ︷︷ ︸
higher profits fromholding govt bonds
+ ǫ(1 − τ)((1+ θ)√
kW − 2θ√
kU)︸ ︷︷ ︸
no crowding-out
≥ 0
INTRODUCTION MODEL EMPIRICAL EVIDENCE
WELFARE
Recapitalization is always efficient
((1− kW)(1+ rW)− (1 − kU)(1+ rU))︸ ︷︷ ︸
higher profits fromholding govt bonds
+ ǫ(1 − τ)((1+ θ)√
kW − 2θ√
kU)︸ ︷︷ ︸
no crowding-out
≥ 0
...but high levered banks want to recapitalize iff
((1− kW)(1+ rW)− (1 − kU)(1 + rU))︸ ︷︷ ︸
higher profits fromholding govt bonds
+ ǫ(1− τ)((1+ θ)√
kW − 2θ√
kU)︸ ︷︷ ︸
no crowding-out
≥ L(1 − θ)
Outline
1 INTRODUCTION
2 MODEL
3 EMPIRICAL EVIDENCE
INTRODUCTION MODEL EMPIRICAL EVIDENCE
SUPPORTING EMPIRICAL EVIDENCE
Model prediction: highly levered and “local” banks drive thepurchases of domestic bonds in crisis
INTRODUCTION MODEL EMPIRICAL EVIDENCE
SUPPORTING EMPIRICAL EVIDENCE
Model prediction: highly levered and “local” banks drive thepurchases of domestic bonds in crisis
Data: EBA stress tests and Bankscope
INTRODUCTION MODEL EMPIRICAL EVIDENCE
GIIPS HIGH VS. LOW LEVERAGE BANKS
INTRODUCTION MODEL EMPIRICAL EVIDENCE
GIIPS LOCAL VS. INTERNATIONAL BANKS
Core Banks
INTRODUCTION MODEL EMPIRICAL EVIDENCE
ALTERNATIVE CHANNELS
◮ Moral suasion◮ Consistent as long as what we observe is an equilibrium
outcome
◮ Regulatory arbitrage◮ Inconsistent with lower holdings of GIIPS non-domestic
bonds
◮ Information advantage◮ Capitalization should not matter
INTRODUCTION MODEL EMPIRICAL EVIDENCE
CONCLUSION
◮ Shown that during crises◮ govts rely on domestic bond buyers◮ banks increase holdings of domestic govt bonds◮ policy makers are reluctant to recapitalize domestic banks
◮ Developed a tractable GE model that rationalizes thesefacts and yields additional empirical implications
◮ Shown that stress test data support the proposed channel
Outline
4 Appendix
Appendix
FACT 1: INCREASING HOME BIAS (LEVELS)Back
Appendix
FACT 1: HOME BIAS (NON-GIIPS)Back
Appendix
FACT 1: HOME BIAS (NON-GIIPS)Back
Appendix
FACT 2: PRIVATE AND PUBLIC LENDING
(NON-GIIPS) Back
Appendix
FACT 2: PRIVATE AND PUBLIC LENDING
(NON-GIIPS) Back
Appendix
GIIPS LOCAL & HIGH LEV. VS. INTERN. & LOW LEV.Back
Appendix
CORE HIGH VS. LOW LEVERAGE BANKSBack
Appendix
EXPOSURES AT DEFAULT Introduction
Banks’ Problem
Bank Country GIIPS Bank Name Exposure to EAD (em) EAD/E
GR EFG Eurobank Ergasias GR 53,005 47.0GR Alpha Bank GR 46,171 18.1IT Banca Monte Paschi Siena IT 205,347 15.6ES Banco Popular Espanol ES 120,981 11.2IT Banco Popolare IT 122,583 10.0ES Caixa ES 259,731 8.7IE Irish Life and Permanent IE 36,487 8.0ES BBVA ES 378,707 7.3IT Intesa Sanpaolo IT 418,126 6.8IT Unicredit IT 382,176 5.4IE Bank of Ireland IE 68,883 5.2GR EFG Eurobank Ergasias PL 5,707 5.1IE Bank of Ireland GB 64,743 4.9IE Allied Irish Banks IE 85,923 4.6GR EFG Eurobank Ergasias RO 4,552 4.0ES Banco Santander ES 355,523 3.3GR EFG Eurobank Ergasias BG 3,607 3.2ES Banco Santander GB 292,735 2.7GR EFG Eurobank Ergasias DE 2,801 2.5IT Unicredit DE 151,948 2.1GR Alpha Bank CY 4,848 1.9IE Irish Life and Permanent GB 8,466 1.9IE Allied Irish Banks GB 32,117 1.7GR Alpha Bank RO 4,261 1.7GR Alpha Bank GB 3,059 1.2IT Unicredit AT 74,355 1.0
Appendix
HHB AND LHB REGIONSBack
α
z z
1
0
LHB
HHB
α