The Seeds of a Crisis

Transcription

1 The Seeds of a Crisis A theory of bank liquidity and risk-taking over the business cycle Viral V Acharya and Hassan Naqvi NYU Stern, CEPR and NBER, and NUS June 2010

2 Motivation For too long, the debate has got sidetracked. Into whether we can rely on monetary policy mopping up after bubbles burst. Or into whether monetary policy could be used to control asset prices as well as doing its orthodox job of steering nominal trends in the economy... - Paul Tucker, Executive Director for Markets and Monetary Policy Committee (MPC) member at the Bank of England. We need a new philosophical approach...which recognises that market liquidity is bene cial up to a point but not beyond that point... - Lord Turner, Chairman of the Financial Services Authority.

3 Motivation I Does the banking system contribute to the formation of asset price bubbles?

4 Motivation I Does the banking system contribute to the formation of asset price bubbles? I What is the role of bank liquidity in inducing bank managers to take risk?

5 Motivation I Does the banking system contribute to the formation of asset price bubbles? I What is the role of bank liquidity in inducing bank managers to take risk? I When are bubbles most likely to occur?

6 Motivation I Does the banking system contribute to the formation of asset price bubbles? I What is the role of bank liquidity in inducing bank managers to take risk? I When are bubbles most likely to occur? I What are the implications of our theory for optimal monetary policy?

7 Motivation I Finland had an expansionary budget in 1987

8 Motivation I Finland had an expansionary budget in 1987 I ratio of bank loans to nominal GDP increased from 55% in 1984 to 90% in 1990.

9 Motivation I Finland had an expansionary budget in 1987 I ratio of bank loans to nominal GDP increased from 55% in 1984 to 90% in I House prices rose by 68% between 1987 and 1988.

10 Motivation I Finland had an expansionary budget in 1987 I ratio of bank loans to nominal GDP increased from 55% in 1984 to 90% in I House prices rose by 68% between 1987 and I Sweden credit expansion in 1980s! property boom

11 Motivation I Finland had an expansionary budget in 1987 I ratio of bank loans to nominal GDP increased from 55% in 1984 to 90% in I House prices rose by 68% between 1987 and I Sweden credit expansion in 1980s! property boom I Japan lowered discount rate 5 times between Jan 86 and Feb 87 down to 2.5%

12 Motivation I Finland had an expansionary budget in 1987 I ratio of bank loans to nominal GDP increased from 55% in 1984 to 90% in I House prices rose by 68% between 1987 and I Sweden credit expansion in 1980s! property boom I Japan lowered discount rate 5 times between Jan 86 and Feb 87 down to 2.5% I asset price bubble

13 Motivation I Finland had an expansionary budget in 1987 I ratio of bank loans to nominal GDP increased from 55% in 1984 to 90% in I House prices rose by 68% between 1987 and I Sweden credit expansion in 1980s! property boom I Japan lowered discount rate 5 times between Jan 86 and Feb 87 down to 2.5% I asset price bubble I Federal Reserve lowered rates to 1% in lowest since 1958

14 Motivation I Finland had an expansionary budget in 1987 I ratio of bank loans to nominal GDP increased from 55% in 1984 to 90% in I House prices rose by 68% between 1987 and I Sweden credit expansion in 1980s! property boom I Japan lowered discount rate 5 times between Jan 86 and Feb 87 down to 2.5% I asset price bubble I Federal Reserve lowered rates to 1% in lowest since 1958 I subprime crisis.

15 Motivation I Finland had an expansionary budget in 1987 I ratio of bank loans to nominal GDP increased from 55% in 1984 to 90% in I House prices rose by 68% between 1987 and I Sweden credit expansion in 1980s! property boom I Japan lowered discount rate 5 times between Jan 86 and Feb 87 down to 2.5% I asset price bubble I Federal Reserve lowered rates to 1% in lowest since 1958 I subprime crisis. I Chinese banks issued a record Rmb9,600bn in new loans in 2009

16 Motivation I Finland had an expansionary budget in 1987 I ratio of bank loans to nominal GDP increased from 55% in 1984 to 90% in I House prices rose by 68% between 1987 and I Sweden credit expansion in 1980s! property boom I Japan lowered discount rate 5 times between Jan 86 and Feb 87 down to 2.5% I asset price bubble I Federal Reserve lowered rates to 1% in lowest since 1958 I subprime crisis. I Chinese banks issued a record Rmb9,600bn in new loans in 2009 I House prices increased by 7.8% in the year to Dec 2009

17 Motivation

18 Results We develop a theory which gives us the following results: I Risk-taking over the business cycle is the consequence of an agency problem.

19 Results We develop a theory which gives us the following results: I Risk-taking over the business cycle is the consequence of an agency problem. I The agency problem a ects risk-takers (traders, loan o cers, etc.) who are compensated on volume. (Bureau of Labor Statistics reports that Most loan o cers are compensated based on the number of loans originated. )

20 Results We develop a theory which gives us the following results: I Risk-taking over the business cycle is the consequence of an agency problem. I The agency problem a ects risk-takers (traders, loan o cers, etc.) who are compensated on volume. (Bureau of Labor Statistics reports that Most loan o cers are compensated based on the number of loans originated. ) I As liquidity increases compensation becomes more sensitive to volume ) excessive lending

21 Results We develop a theory which gives us the following results: I Risk-taking over the business cycle is the consequence of an agency problem. I The agency problem a ects risk-takers (traders, loan o cers, etc.) who are compensated on volume. (Bureau of Labor Statistics reports that Most loan o cers are compensated based on the number of loans originated. ) I As liquidity increases compensation becomes more sensitive to volume ) excessive lending I Asset price bubbles are formed for high enough bank liquidity;

22 Results We develop a theory which gives us the following results: I Risk-taking over the business cycle is the consequence of an agency problem. I The agency problem a ects risk-takers (traders, loan o cers, etc.) who are compensated on volume. (Bureau of Labor Statistics reports that Most loan o cers are compensated based on the number of loans originated. ) I As liquidity increases compensation becomes more sensitive to volume ) excessive lending I Asset price bubbles are formed for high enough bank liquidity; I Bubbles are more likely to be formed when the underlying macroeconomic risk is high;

23 Results We develop a theory which gives us the following results: I Risk-taking over the business cycle is the consequence of an agency problem. I The agency problem a ects risk-takers (traders, loan o cers, etc.) who are compensated on volume. (Bureau of Labor Statistics reports that Most loan o cers are compensated based on the number of loans originated. ) I As liquidity increases compensation becomes more sensitive to volume ) excessive lending I Asset price bubbles are formed for high enough bank liquidity; I Bubbles are more likely to be formed when the underlying macroeconomic risk is high; I Bubbles are more likely to be formed following loose monetary policies;

24 Results We develop a theory which gives us the following results: I Risk-taking over the business cycle is the consequence of an agency problem. I The agency problem a ects risk-takers (traders, loan o cers, etc.) who are compensated on volume. (Bureau of Labor Statistics reports that Most loan o cers are compensated based on the number of loans originated. ) I As liquidity increases compensation becomes more sensitive to volume ) excessive lending I Asset price bubbles are formed for high enough bank liquidity; I Bubbles are more likely to be formed when the underlying macroeconomic risk is high; I Bubbles are more likely to be formed following loose monetary policies; I Monetary policy should lean against liquidity.

25 Related literature I Myers and Rajan (1998) show that access to liquidity allows nancial rms to engage in risk-shifting, but the anticipation of this behavior renders them illiquid ex ante.

26 Related literature I Myers and Rajan (1998) show that access to liquidity allows nancial rms to engage in risk-shifting, but the anticipation of this behavior renders them illiquid ex ante. I Allen and Gale (2000) show that monetary policy uncertainty exacerbates risk-taking incentives and fuels a bubble.

27 Related literature I Myers and Rajan (1998) show that access to liquidity allows nancial rms to engage in risk-shifting, but the anticipation of this behavior renders them illiquid ex ante. I Allen and Gale (2000) show that monetary policy uncertainty exacerbates risk-taking incentives and fuels a bubble. I Diamond and Rajan (2008) show that lowering interest rates ex post may be desirable but this induces moral hazard and encourages banks to hold more illiquid assets.

28 Related literature I Myers and Rajan (1998) show that access to liquidity allows nancial rms to engage in risk-shifting, but the anticipation of this behavior renders them illiquid ex ante. I Allen and Gale (2000) show that monetary policy uncertainty exacerbates risk-taking incentives and fuels a bubble. I Diamond and Rajan (2008) show that lowering interest rates ex post may be desirable but this induces moral hazard and encourages banks to hold more illiquid assets. I Farhi and Tirole (2009) argue that banks have incentives to correlate their risk exposures so that authorities ex post are forced to facilitate re nancing.

29 Related literature I Myers and Rajan (1998) show that access to liquidity allows nancial rms to engage in risk-shifting, but the anticipation of this behavior renders them illiquid ex ante. I Allen and Gale (2000) show that monetary policy uncertainty exacerbates risk-taking incentives and fuels a bubble. I Diamond and Rajan (2008) show that lowering interest rates ex post may be desirable but this induces moral hazard and encourages banks to hold more illiquid assets. I Farhi and Tirole (2009) argue that banks have incentives to correlate their risk exposures so that authorities ex post are forced to facilitate re nancing. I Acharya and Yorulmazer (2007) show that banks have incentives to reduce their risk-correlations given the possibility that one bank may acquire the other unless the bene ts of a systemic bailout are high enough.

30 Related literature I Myers and Rajan (1998) show that access to liquidity allows nancial rms to engage in risk-shifting, but the anticipation of this behavior renders them illiquid ex ante. I Allen and Gale (2000) show that monetary policy uncertainty exacerbates risk-taking incentives and fuels a bubble. I Diamond and Rajan (2008) show that lowering interest rates ex post may be desirable but this induces moral hazard and encourages banks to hold more illiquid assets. I Farhi and Tirole (2009) argue that banks have incentives to correlate their risk exposures so that authorities ex post are forced to facilitate re nancing. I Acharya and Yorulmazer (2007) show that banks have incentives to reduce their risk-correlations given the possibility that one bank may acquire the other unless the bene ts of a systemic bailout are high enough. I Thakor (2005) argues that banks over-lend by not invoking the MAC clause in booms given reputational concerns.

31 Benchmark model I Risk neutral bank and depositors

32 Benchmark model I Risk neutral bank and depositors I At t = 0 bank receives deposits D from depositors and gives out loans L

33 Benchmark model I Risk neutral bank and depositors I At t = 0 bank receives deposits D from depositors and gives out loans L I Reservation utility of depositors: ū

34 Benchmark model I Risk neutral bank and depositors I At t = 0 bank receives deposits D from depositors and gives out loans L I Reservation utility of depositors: ū I Deposit rate: r D

35 Benchmark model I Risk neutral bank and depositors I At t = 0 bank receives deposits D from depositors and gives out loans L I Reservation utility of depositors: ū I Deposit rate: r D I Rate of return on loans: r L

36 Benchmark model I Risk neutral bank and depositors I At t = 0 bank receives deposits D from depositors and gives out loans L I Reservation utility of depositors: ū I Deposit rate: r D I Rate of return on loans: r L I Probability of success of bank investments: θ

37 Benchmark model I Demand function for loans: L (r L ) where L 0 (r L ) < 0.

38 Benchmark model I Demand function for loans: L (r L ) where L 0 (r L ) < 0. I Reserves: R = D L (r L )

39 Benchmark model I Demand function for loans: L (r L ) where L 0 (r L ) < 0. I Reserves: R = D L (r L ) I At t = 1 a fraction x of the depositors experience liquidity shocks and withdraw early.

40 Benchmark model I Demand function for loans: L (r L ) where L 0 (r L ) < 0. I Reserves: R = D L (r L ) I At t = 1 a fraction x of the depositors experience liquidity shocks and withdraw early. I Each investor who withdraws early receives 1 unit of his endowment back.

41 Benchmark model I Demand function for loans: L (r L ) where L 0 (r L ) < 0. I Reserves: R = D L (r L ) I At t = 1 a fraction x of the depositors experience liquidity shocks and withdraw early. I Each investor who withdraws early receives 1 unit of his endowment back. I If xd > R, i.e. liquidity shortfall, then bank needs to pay a penalty proportional to the shortage: r p (xd R)

42 Benchmark model I Demand function for loans: L (r L ) where L 0 (r L ) < 0. I Reserves: R = D L (r L ) I At t = 1 a fraction x of the depositors experience liquidity shocks and withdraw early. I Each investor who withdraws early receives 1 unit of his endowment back. I If xd > R, i.e. liquidity shortfall, then bank needs to pay a penalty proportional to the shortage: r p (xd R) I At t = 2 the proceeds from bank investments, if any, are divided among depositors and equityholders.

43 Benchmark model t = 0 t = 1 t = 2 Bank raises deposits Bank observes success probabilit L Investments made and bank sets aside reserves R Bank suffers early withdrawals, xd Bank incurs a penal ty cost if xd>r Bank projects either succeed or fail Payoffs divided among parties

44 Benchmark model Bank s maximization problem: max r L,r D,R Π = π r pe [max ( xd R, 0)] (1) subject to E ( x) + (1 E ( x)) θr D + (1 θ) E [max (R xd, 0)] (1 E ( x)) D ū (2) where π = θfr L L (r L ) r D D (1 E ( x)) + E [max (R xd, 0)]

45 Benchmark model Proposition 1. (Risk e ect) r L θ < 0, i.e. an increase in risk (1 θ), ceteris paribus, will increase the equilibrium lending rate. 2. (Liquidity e ect) r L D < 0, i.e. an increase in bank liquidity, ceteris paribus, will decrease the equilibrium lending rate.

46 Agency problem I OCC (1998) found that 73% of failed banks had indulged in over-lending and that agency problems is a key reason for bank failures, whereby managers tend to behave over aggressively.

47 Agency problem I OCC (1998) found that 73% of failed banks had indulged in over-lending and that agency problems is a key reason for bank failures, whereby managers tend to behave over aggressively. I In the period preceding the crisis, traders and large pro t/risk centers in many nancial institutions were paying themselves bonuses based on the size of their risky positions.

48 Agency problem I Risk averse bank manager

49 Agency problem I Risk averse bank manager I e 2 fe L, e H g denotes e ort level of manager

50 Agency problem I Risk averse bank manager I e 2 fe L, e H g denotes e ort level of manager I E [L (r L ) je H ] > E [L (r L ) je L ]

51 Agency problem I Risk averse bank manager I e 2 fe L, e H g denotes e ort level of manager I E [L (r L ) je H ] > E [L (r L ) je L ] I Principal can impose a penalty, ψ, on the manager if it is inferred after an audit that the manager had acted over-aggressively.

52 Agency problem I Risk averse bank manager I e 2 fe L, e H g denotes e ort level of manager I E [L (r L ) je H ] > E [L (r L ) je L ] I Principal can impose a penalty, ψ, on the manager if it is inferred after an audit that the manager had acted over-aggressively. I Audit cost given by z ˆΠ, where z 0 ˆΠ > 0.

53 Agency problem I Risk averse bank manager I e 2 fe L, e H g denotes e ort level of manager I E [L (r L ) je H ] > E [L (r L ) je L ] I Principal can impose a penalty, ψ, on the manager if it is inferred after an audit that the manager had acted over-aggressively. I Audit cost given by z ˆΠ, where z 0 ˆΠ > 0. I Probability of conducting audit given by φ.

54 Agency problem I Risk averse bank manager I e 2 fe L, e H g denotes e ort level of manager I E [L (r L ) je H ] > E [L (r L ) je L ] I Principal can impose a penalty, ψ, on the manager if it is inferred after an audit that the manager had acted over-aggressively. I Audit cost given by z ˆΠ, where z 0 ˆΠ > 0. I Probability of conducting audit given by φ. I Probability that manager will be penalized following an audit given by ζ.

55 Agency problem I Risk averse bank manager I e 2 fe L, e H g denotes e ort level of manager I E [L (r L ) je H ] > E [L (r L ) je L ] I Principal can impose a penalty, ψ, on the manager if it is inferred after an audit that the manager had acted over-aggressively. I Audit cost given by z ˆΠ, where z 0 ˆΠ > 0. I Probability of conducting audit given by φ. I Probability that manager will be penalized following an audit given by ζ. I Audit technology imperfect but correlated to manager s choice of r L : ζ > 0.5 if r L < r f L but ζ < 0.5 if r L = r f L.

56 Agency problem I Manager s utility: u (w, ψ, e) = v (w) c (ψ) e, where v 0 (w) > 0, v 00 (w) < 0, c 0 (ψ) > 0 and c 00 (ψ) > 0. i.e. manager prefers more wealth to less, is risk averse, and dislikes high e ort.

57 Agency problem I Manager s utility: u (w, ψ, e) = v (w) c (ψ) e, where v 0 (w) > 0, v 00 (w) < 0, c 0 (ψ) > 0 and c 00 (ψ) > 0. i.e. manager prefers more wealth to less, is risk averse, and dislikes high e ort. I Manager s reservation utility: u o

58 Agency problem I Manager s utility: u (w, ψ, e) = v (w) c (ψ) e, where v 0 (w) > 0, v 00 (w) < 0, c 0 (ψ) > 0 and c 00 (ψ) > 0. i.e. manager prefers more wealth to less, is risk averse, and dislikes high e ort. I Manager s reservation utility: u o I Bank liquidity non-veri able and principal observes distribution of bank liquidity.

59 Timeline I At t = 0 principal o ers contract to manager, manager then receives deposits, chooses e ort and manager sets r L. t = 0 t = 0.5 t = 1 t = 2 Principal offerscontract to manager Depositsreceived Manager sets r L Manager chooses e L(r L ) realized A f raction x of depositors withdraw early Payoffsrealized and divided among parties

60 Timeline I At t = 0 principal o ers contract to manager, manager then receives deposits, chooses e ort and manager sets r L. I At t = 0.5, L (r L ) is realized; at t = 1 early withdrawals and at t = 2 payo s consumed. t = 0 t = 0.5 t = 1 t = 2 Principal offerscontract to manager Depositsreceived Manager sets r L Manager chooses e L(r L ) realized A f raction x of depositors withdraw early Payoffsrealized and divided among parties

61 Agency problem Symmetric information problem: max Π = π r p E [max ( xd R, 0) je = e H ] (3) s.t. E ( x) + (1 E ( x)) θr D + (1 θ) E [max (R xd, 0) je = e H ] (1 E ( x)) D ū (4) where π = θfr L E [L (r L ) je H ] r D D (1 E ( x)) +E [max (R xd, 0) je = e H ]g (5)

62 Agency problem Contractual problem under asymmetric information: subject to max Π (E [w (L)] E [ψ (S)]) E (z) (6) w (L),ψ(S ),φ(s ) E [v (w(l))] E [c (ψ (S))] e u o (7) E [v (w(l)je H )] e H E [v (w(l)je L )] e L (8) h i h i E c ψ (S) jr L = rl f E c ψ (S) jr L < rl f (9) where S = max (xd bank, if any. R, 0) represents the liquidity shortfall of the

63 Agency problem Proposition Managerial wages, w, are increasing in loan volume, L. However, if an audit is conducted and it is inferred that the manager had acted over-aggressively then he is penalized where the managerial penalty, ψ, is such that it is increasing in the bank s liquidity shortfall, S.

64 Agency problem Proposition The principal will conduct an audit if and only if the liquidity shortfall su ered by the bank exceeds some threshold S. Thus the optimal audit timing as de ned by the audit probability, φ, is given by φ = 1 0 if S > S otherwise. (10)

65 Agency problem Summary of results: I Managerial wages increasing in loan volume. I An audit is triggered if liquidity shortfall exceeds a threshold. I If it is inferred that manager had acted over-aggressively he is penalized a fraction of the bank s penalty cost. Proposition The manager will engage in overly-aggressive behavior if and only if bank liquidity is su ciently high. Intuition: The manager is penalized a proportion of the penalty costs but in the presence of substantial liquidity the probability of experiencing liquidity shortages is low and hence audit probability is low. This encourages excessive lending.

66 Asset pricing I Suppose there exists a continuum, n, of bank borrowers (household and/or corporate borrowers) with zero wealth.

67 Asset pricing I Suppose there exists a continuum, n, of bank borrowers (household and/or corporate borrowers) with zero wealth. I X d : number of units of the asset demanded by a representative borrower.

68 Asset pricing I Suppose there exists a continuum, n, of bank borrowers (household and/or corporate borrowers) with zero wealth. I X d : number of units of the asset demanded by a representative borrower. I X s : supply of risky asset

69 Asset pricing I Suppose there exists a continuum, n, of bank borrowers (household and/or corporate borrowers) with zero wealth. I X d : number of units of the asset demanded by a representative borrower. I X s : supply of risky asset I Asset returns a cash ow of C if succeeds.

70 Asset pricing I Suppose there exists a continuum, n, of bank borrowers (household and/or corporate borrowers) with zero wealth. I X d : number of units of the asset demanded by a representative borrower. I X s : supply of risky asset I Asset returns a cash ow of C if succeeds. I Let P be the asset price.

71 Asset pricing I Suppose there exists a continuum, n, of bank borrowers (household and/or corporate borrowers) with zero wealth. I X d : number of units of the asset demanded by a representative borrower. I X s : supply of risky asset I Asset returns a cash ow of C if succeeds. I Let P be the asset price. I Let b (X d ) represent a non-pecuniary investment cost such that: b (0) = b 0 (0), b 0 (X d ) > 0 and b 00 (X d ) > 0 for all X d > 0.

72 Asset pricing Problem faced by representative borrower: s.t. max X d θ [CX d r L PX d ] b (X d ). nx d = X s. Solution: P = θc b0 (X d ) θr L, where r L is the loan rate set by bank manager. But P f = θc b0 (X d ), where r f θrl f L is the loan rate in the absence of agency problems. Corollary An asset price bubble is formed for high enough bank liquidity. Intuition: Bank managers set the loan rate. For high enough liquidity, the loan rate is underpriced due to agency problems. This increases the asset price for the same level of risk.

73 Mechanics of the formation of asset price bubbles Y III Price, P Z 1 IV Z Y Z Z 1 Expe cted Invest ment, E[L e H ] N A A 1 Risk A 1 II N I A Loan rate, r L

74 Mechanics of the formation of asset price bubbles I Quadrant I depicts the inverse relationship between risk and loan rate.

75 Mechanics of the formation of asset price bubbles I Quadrant I depicts the inverse relationship between risk and loan rate. I Quadrant II shows that as the loan rate decreases the demand for bank loan increases and thus investment increases.

76 Mechanics of the formation of asset price bubbles I Quadrant I depicts the inverse relationship between risk and loan rate. I Quadrant II shows that as the loan rate decreases the demand for bank loan increases and thus investment increases. I Quadrant III shows that asset prices increase as demand for assets increase.

77 Mechanics of the formation of asset price bubbles I Quadrant I depicts the inverse relationship between risk and loan rate. I Quadrant II shows that as the loan rate decreases the demand for bank loan increases and thus investment increases. I Quadrant III shows that asset prices increase as demand for assets increase. I Quadrant IV depicts the inverse relationship between asset prices and risk.

78 Mechanics of the formation of asset price bubbles I Quadrant I depicts the inverse relationship between risk and loan rate. I Quadrant II shows that as the loan rate decreases the demand for bank loan increases and thus investment increases. I Quadrant III shows that asset prices increase as demand for assets increase. I Quadrant IV depicts the inverse relationship between asset prices and risk. I A bubble is formed if an increase in liquidity induces managers to underprice risk thereby shifting the AA curve in quadrant I to the right.

79 When are bubbles likely to be formed? I High macroeconomic risk

80 When are bubbles likely to be formed? I High macroeconomic risk I Risk"=)Bank liquidity"=)bubbles likely

81 When are bubbles likely to be formed? I High macroeconomic risk I Risk"=)Bank liquidity"=)bubbles likely I Gatev and Strahan (2006)

82 When are bubbles likely to be formed? I High macroeconomic risk I Risk"=)Bank liquidity"=)bubbles likely I Gatev and Strahan (2006) I Loose monetary policy

83 When are bubbles likely to be formed? I High macroeconomic risk I Risk"=)Bank liquidity"=)bubbles likely I Gatev and Strahan (2006) I Loose monetary policy I Loose MP=) increase in money supply=)bubbles likely

84 When are bubbles likely to be formed? I High macroeconomic risk I Risk"=)Bank liquidity"=)bubbles likely I Gatev and Strahan (2006) I Loose monetary policy I I Loose MP=) increase in money supply=)bubbles likely BOJ lowered rates to 2.5% between 1986 and 1987 following the Plaza accord

85 When are bubbles likely to be formed? I High macroeconomic risk I Risk"=)Bank liquidity"=)bubbles likely I Gatev and Strahan (2006) I Loose monetary policy I I I Loose MP=) increase in money supply=)bubbles likely BOJ lowered rates to 2.5% between 1986 and 1987 following the Plaza accord Fed lowered rates to 1% in 2003, lowest since In fact, Fed Funds rate was even below the target in the period preceding the crisis.

86 When are bubbles likely to be formed? I High macroeconomic risk I Risk"=)Bank liquidity"=)bubbles likely I Gatev and Strahan (2006) I Loose monetary policy I I I I Loose MP=) increase in money supply=)bubbles likely BOJ lowered rates to 2.5% between 1986 and 1987 following the Plaza accord Fed lowered rates to 1% in 2003, lowest since In fact, Fed Funds rate was even below the target in the period preceding the crisis. Loose monetary policy adopted by People s Bank of China in 2009 ) Bank deposits are now 150% of GDP and house prices are increasing.

87 When are bubbles likely to be formed? Liquidity, D D + D 1 D D * D _ D + D D _ c 1 1 Risk

88 When are bubbles likely to be formed? I The gure depicts the relationship between bank liquidity and macro risk: As risk increases bank liquidity increases due to ight to quality but for very high risk bank liquidity starts getting adversely a ected.

89 When are bubbles likely to be formed? I The gure depicts the relationship between bank liquidity and macro risk: As risk increases bank liquidity increases due to ight to quality but for very high risk bank liquidity starts getting adversely a ected. I Agency problems actuate and hence bubbles are formed when liquidity crosses the threshold D.

90 When are bubbles likely to be formed? I The gure depicts the relationship between bank liquidity and macro risk: As risk increases bank liquidity increases due to ight to quality but for very high risk bank liquidity starts getting adversely a ected. I Agency problems actuate and hence bubbles are formed when liquidity crosses the threshold D. I The gure shows that during times of excess liquidity the central bank can avoid bubbles by adopting a contractionary monetary policy. (The liquidity-risk curve shifts downwards)

91 When are bubbles likely to be formed? I The gure depicts the relationship between bank liquidity and macro risk: As risk increases bank liquidity increases due to ight to quality but for very high risk bank liquidity starts getting adversely a ected. I Agency problems actuate and hence bubbles are formed when liquidity crosses the threshold D. I The gure shows that during times of excess liquidity the central bank can avoid bubbles by adopting a contractionary monetary policy. (The liquidity-risk curve shifts downwards) I However, if during these times an expansionary monetary policy is adopted this will further fuel asset prices. (The liquidity-risk curve shifts upwards)

92 Optimal Monetary policy I Aggressive behavior of managers results in a worsening of the quality of bank loans ) Bubbles are costly. I Trade-o faced by central bank: Money supply (M) " ) D " ) Investment " (Greenspan put) However, M " ) D " ) Bubbles more likely Proposition The optimal monetary policy implies a leaning against liquidity approach, i.e., tightening monetary policy in times of excessive bank liquidity and loosening monetary policy in times of falling bank liquidity. More formally, dm dd < 0 8θ. I Intuition: In times of excessive bank liquidity, central banks can avoid the formation of bubbles by a contractionary monetary policy. But in times of falling bank liquidity, investment is low as banks raise loan rates. Central banks can o set this e ect via an expansionary monetary policy.

93 Endogenizing the bubble cost I Bank borrowers are heterogenous in the sense that some borrowers have a higher probability of success.

94 Endogenizing the bubble cost I Bank borrowers are heterogenous in the sense that some borrowers have a higher probability of success. I If they do not borrow from banks they can consume their outside option ū B.

95 Endogenizing the bubble cost I Bank borrowers are heterogenous in the sense that some borrowers have a higher probability of success. I If they do not borrow from banks they can consume their outside option ū B. I An entrepreneur borrows from the bank if and only if his expected return exceeds the outside option.

96 Endogenizing the bubble cost I Bank borrowers are heterogenous in the sense that some borrowers have a higher probability of success. I If they do not borrow from banks they can consume their outside option ū B. I An entrepreneur borrows from the bank if and only if his expected return exceeds the outside option. I Given this setup as the lending rate decreases, more and more entrepreneurs forgo their outside option and thus the quality of loans worsens ) default risk increases ) expected cost of default increases.

97 Endogenizing the bubble cost I Bank borrowers are heterogenous in the sense that some borrowers have a higher probability of success. I If they do not borrow from banks they can consume their outside option ū B. I An entrepreneur borrows from the bank if and only if his expected return exceeds the outside option. I Given this setup as the lending rate decreases, more and more entrepreneurs forgo their outside option and thus the quality of loans worsens ) default risk increases ) expected cost of default increases. I Cost of default can take several forms: Cost su ered by banks, cost su ered by taxpayers, (political) cost su ered by regulators, etc.

98 Revisiting monetary policy I We are never certain where we are in the cycle

99 Revisiting monetary policy I We are never certain where we are in the cycle I Alan Greenspan, Financial Times, 27 May 08

100 Revisiting monetary policy I We are never certain where we are in the cycle I Alan Greenspan, Financial Times, 27 May 08 I Given the events of the last eight months, it would be foolish not to reconsider the Greenspan doctrine.

101 Revisiting monetary policy I We are never certain where we are in the cycle I Alan Greenspan, Financial Times, 27 May 08 I Given the events of the last eight months, it would be foolish not to reconsider the Greenspan doctrine. I Kenneth Rogo, Financial Times, 16 May 08

102 Revisiting monetary policy I We are never certain where we are in the cycle I Alan Greenspan, Financial Times, 27 May 08 I Given the events of the last eight months, it would be foolish not to reconsider the Greenspan doctrine. I Kenneth Rogo, Financial Times, 16 May 08 I I think I am still with the orthodoxy but I have to admit that recent events are sowing seeds of doubt.

103 Revisiting monetary policy I We are never certain where we are in the cycle I Alan Greenspan, Financial Times, 27 May 08 I Given the events of the last eight months, it would be foolish not to reconsider the Greenspan doctrine. I Kenneth Rogo, Financial Times, 16 May 08 I I think I am still with the orthodoxy but I have to admit that recent events are sowing seeds of doubt. I Alan Blinder, Financial Times, 16 May 08

104 Revisiting monetary policy I We are never certain where we are in the cycle I Alan Greenspan, Financial Times, 27 May 08 I Given the events of the last eight months, it would be foolish not to reconsider the Greenspan doctrine. I Kenneth Rogo, Financial Times, 16 May 08 I I think I am still with the orthodoxy but I have to admit that recent events are sowing seeds of doubt. I Alan Blinder, Financial Times, 16 May 08 I A Central Bank should bear in mind those long-run consequences of asset price bubbles and nancial imbalances in the setting of current interest rates.

105 Revisiting monetary policy I We are never certain where we are in the cycle I Alan Greenspan, Financial Times, 27 May 08 I Given the events of the last eight months, it would be foolish not to reconsider the Greenspan doctrine. I Kenneth Rogo, Financial Times, 16 May 08 I I think I am still with the orthodoxy but I have to admit that recent events are sowing seeds of doubt. I Alan Blinder, Financial Times, 16 May 08 I A Central Bank should bear in mind those long-run consequences of asset price bubbles and nancial imbalances in the setting of current interest rates. I Charles Bean, Financial Times, 16 May 08

106 Conclusion We develop a theory of banking which gives us the following results: I bank managers will behave in an overly-aggressive manner by mispricing risk when bank liquidity is su ciently high;

107 Conclusion We develop a theory of banking which gives us the following results: I bank managers will behave in an overly-aggressive manner by mispricing risk when bank liquidity is su ciently high; I asset price bubbles are formed for high enough bank liquidity;

108 Conclusion We develop a theory of banking which gives us the following results: I bank managers will behave in an overly-aggressive manner by mispricing risk when bank liquidity is su ciently high; I asset price bubbles are formed for high enough bank liquidity; I bubbles are more likely to be formed when the underlying macroeconomic risk is high;

109 Conclusion We develop a theory of banking which gives us the following results: I bank managers will behave in an overly-aggressive manner by mispricing risk when bank liquidity is su ciently high; I asset price bubbles are formed for high enough bank liquidity; I bubbles are more likely to be formed when the underlying macroeconomic risk is high; I bubbles are more likely to be formed following loose monetary policies;

110 Conclusion We develop a theory of banking which gives us the following results: I bank managers will behave in an overly-aggressive manner by mispricing risk when bank liquidity is su ciently high; I asset price bubbles are formed for high enough bank liquidity; I bubbles are more likely to be formed when the underlying macroeconomic risk is high; I bubbles are more likely to be formed following loose monetary policies; I monetary policy should lean against liquidity.

111 Conclusion We develop a theory of banking which gives us the following results: I bank managers will behave in an overly-aggressive manner by mispricing risk when bank liquidity is su ciently high; I asset price bubbles are formed for high enough bank liquidity; I bubbles are more likely to be formed when the underlying macroeconomic risk is high; I bubbles are more likely to be formed following loose monetary policies; I monetary policy should lean against liquidity. I Other measures that can complement the leaning against liquidity policy: Minimum Liquidity requirements, Bank Supervision (especially in times when banks are ush with liquidity).