TOO-MANY-TO-FAIL: A THEORETICAL APPROACH

JAUME MARTÍ

OUTLINE

• Important trends before the financial crisis• Why did it happened? • Modelling market failures• Could the financial crisis have been avoided?• Conclusions

OVERVIEW OF THE CRISIS

Important trends:

- Increase in leverage in the private sector- Supply of credit went up a lot- Concentration/real sector very reliant on banks - Banking system became very risky and

interconnected

WHY DID IT HAPPENED?

• Many factors contribute to explain the current financial crisis (e.g. lax regulatory supervision, financial innovation, off-balance-sheet items, easy monetary policy…)

• I will focus on incentives and market failures!

WHY DID IT HAPPENED?

• I will analyse two market failures to explain the current financial crisis:

- Moral hazard- Negative externalities

MARKET FAILURES

• Moral Hazard- Risk-taking view. Shareholders and

debtholders incentives are misaligned. Regulators knew that explicit and implicit guarantees to protect depositors

- Regulatory institutions, instead of creating a more stable financial system, distorted depositors and banks’ incentives Less market discipline and more appetite for risk

MARKET FAILURES

• George G. Kaufman suggests in “Bank Failures, Systemic risk, and Bank Regulation”:

“The prudential regulations imposed to prevent or mitigate the impact of such failures are frequently inefficient and counterproductive. […] Regulators have often increased the probability of failure and the costs of such failures”

MARKET FAILURES

• Two types of externalities:- Externalities related to fire sales. As banks do

not incorporate the negative consequences that their failure/distress may have to the whole system (systemic risk), they take excessive risk

- During the financial crisis, banks wanted to get rid-off their toxic assets, generating a spiral of losses

MARKET FAILURES

• Externalities related to strategic complementarities:- Strategic complementarities are defined as

strategies whose payoff increases with the amount of agents undertaking the same stratagem

- Banks invested in positively correlated assets (housing sector). If things went well, huge profits. If not, banks knew they would fail at the same time and they would be rescued. “Too-many-to-fail” problem

MODELLING MARKET FAILURES

• In the following slides I will offer a model in order to deal with these market failures from a theoretical standpoint

• It is important to mention that, in this model, risk systemic is not caused by a change in investors expectations or macroeconomic shocks. Systemic risk is created by banks’ appetite for risk Endogenous risk!

• This is why banks play the main role in this model. They decide the amount of risk they want

DESCRIPTION OF THE MODEL

• Players- Depositors. Risk-neutral investors. Can invest

their endowment in storage good or bank. Banks pay an interest rate “r” in case they don’t fail. Storage good pays no yield. Consumption occurs at t=1. Hence, they safe all their endowment at t=0

DESCRIPTION OF THE MODEL

- Banks. Two identical risk-neutral banks: Bank A and Bank B. They are funded with deposits from investors (D) plus equity from shareholders (E). They have full bargaining power with depositors

- They can invest in two lotteries: T (technology sector) or H (housing sector). Lottery H provides with higher payoff in case of success but has lower expected value.

- In case of unique failure, the surviving bank faces fire-sale losses (cost of C)

DESCRIPTION OF THE MODEL

Regulator. His aim is to maximize social welfare. His main role is to decide ex-ante the amount of bailout he provides whenever there is a joint failure (both banks fail at the same time)

TIMING OF THE MODEL

- Depositors decide whether to invest in the storage cost or in a bank

- Banks choose a lottery without knowing what the other bank has chosen. Simultaneous game

- Regulator decides amount of bailout in case of a joint failure

MODEL’S TREE

SOLVING THE MODEL

• Solving for depositorsBanks decide an amount of “r” that make depositors indifferent between investing in a bank or the storage cost. Satisfy participation constraint with equality!We obtain that the interest rate that satisfies the equality is:

SOLVING THE MODEL

• Solving for banksI assume that one bank chooses “first” and the other picks a lottery trying to anticipate its decision. NASH EQUILIBRIUMSSuppose that Bank A chooses lottery H:Bank B will choose lottery H if the expected utility of picking lottery H is higher than with choosing lottery T

SOLVING THE MODEL

• Mathematically:Bank B will be indifferent (given that Bank A has picked lottery H) between choosing H or T if the following equation is satisfied:

Same reasoning can be applied when Bank A chooses T

SOLVING THE MODEL

- Two different equilibriums in the model:

Depending on the amount of bailout the regulator chooses, banks will end up in one equilibrium or the other

ROLE OF VARIABLES

• Role of leverage in the model:Given the other variables constant, if banks are more leveraged, they have more incentives to pick lottery H, which is more risky. This is because they have less “skin in the game”! • Role of negative externalities:Given the other variables constant, a higher negative externality implies that banks have more incentives to choose lottery H, as banks get less in case of a unique failure

MARKET FAILURES IN THE MODEL

• Moral HazardDepositors do not observe which lottery banks choose after signing the contract. As they can only set a unique interest rate, this reduces market discipline. Banks are not penalized according to risk! Shareholders and debtholders incentives are misaligned. Banks have incentives to take more risk!

MARKET FAILURES IN THIS MODEL

• ExternalitiesEach bank does not incorporate in its maximizing function the losses generated to the other bank in case of a unique failureMoreover, the banking system does not incorporate as a whole the bailout costs in case of a joint failure

“TOO-MANY-TO-FAIL”

If bailout is high enough, banks coordinate and pick up lottery H; maximizing the probability of a joint failure. Hence, if things go well, high profits. However, if things go bad, they are going to be rescued! WIN-WIN strategy!

Gianni de Nicolò, Giovanni Favara and Lev Ratnovski suggest in “Externalities and Macroprudential Policy: “anticipating that simultaneous bank failures trigger bailout, banks may find it optimal to correlate risk, to maximize the probability that any failure is a joint failure”

WHAT SHOULD THE REGULATOR DO?

The regulator should provide an amount of bailout such that the banking system survives in case of a joint failure but it does not distort banks’ incentives. Very difficult…

In this model, his policy is time-consistent. However, in reality, very difficult to achieve!

CONCLUSIONS OF THE MODEL

- Bailout policies distort banks’ incentives. Instead of aligning incentives between shareholders and debtholders, it actually increases banks’ appetite for risk. Moreover, they diminish market discipline and exacerbate the “too-many-to-fail” problem

- More leveraged banks more prone to choose risky investments

- Banks should internalize the negative externalities that they generate to the banking system and the real economy

COULD THE FINANCIAL CRISIS HAVE BEEN AVOIDED?

• Microprudential versus macroprudential policiesMicroprudential regulation failed.Gianni de Nicolò, Giovanni Favara and Lev Ratnovski (2007) argue, “microprudential regulation is necessary but not sufficient to deal with systemic risk”. “Microprudential policies neglect risks that are systemic rather than individual, such as correlation risk”. Change of perspective on how to regulate banks: macroprudential policies try to mitigate market failures

COULD THE FINANCIAL CRISIS HAVE BEEN AVOIDED?

• Regulatory policiesEx-post measures- Reducing explicit/implicit guarantees (bailout policies and deposit insurance). However, social costs ex-post. Time-consistency problemEx-ante measures: their aim is to enhance stability and mitigate systemic risk- Increase capital requirements in order to diminish risk-taking incentives

CONCLUSIONS

- The financial crisis was not due to an exogenous shock. It was build up from inside the financial system

- Regulatory institutions provided more incentives to increase risk and leverage

- In order to guarantee a stable financial system, not enough with ex-post measures. Good ex-ante policies must be applied to provide good management behaviour