Deposit Insurance or Lender of Last Resort

Transcription

1 Deposit Insurance or Lender of Last Resort Cecchetti compares deposit insurance and lender of last resort as means to prevent banking crises Deposit Insurance could actually increase the probability of a banking crisis, because it fosters risk taking Protected depositers have no incentive to monitor their bankers behavior. Knowing this, bankers take on more risk than they would normally, since they get the benefits while the government assumes the costs (Cecchetti, 2007, p. 26)

2 Lender of Last Resort The lender of last resort facility works differently: In order to prevent the failure of solvent but illiquid financial institutions, the central bank should lend freely on good collateral at a penalty rate (Cecchetti, 2007, p.25). The basic problem of this facility is that the central bank needs enough information to assess a bank s solvency Cecchetti argues that it is very difficult to assess a bank s solvency in periods of crisis

3 Deposit Insurance or Lender of Last Resort Hence, Cecchetti argues that it is better to work with deposit insurance than lender of last resort facility The former can be seen as a rule, it is clear ex ante what the central bank will do to save a bank The latter is dependent upon arbitrary evaluations of controlling authorities and creates therefore much more uncertainty Cecchetti provides evidence by comparing a bank run in 2003 on Abacus with the bank run on Northern Rock in 2007

4 The Huge Impact of the Subprime Crisis Luigi Spaventa: the question is why a surge of subprime defaults should affect (though not disruptively for the moment) the banking system and.. general credit conditions. The losses in the subprime market are small relative to the size of aggregate financial assets Spaventa argues that the originate and distribute business model is to blame, together with the guarantees of banks on their off balance sheet investments

5 The Huge Impact of the Subprime Crisis In the originate and distribute model, banks provide loans, for example mortgages or student loans, securitize the loans and sell them in the market This should lead to a better spreading of risks A clear disadvantage not mentioned by Spaventa is that the risk sharing can also make loan providers less cautionary, taking excessive risks Spaventa focuses on how the mortgages were sold

6 The Huge Impact of the Subprime Crisis Conduits and structured investment vehicles (SIVs) are entities, off the banks balance sheets, that invest longterm, largely in high-yield asset backed securities and raise short-term finance by issuing correspondingly colletarized commercial paper, and/or by issuing CDOs, collateralized debt obligations So, officially the mortgage instruments are not on the balance sheet of the bank to escape capital requirements by regulators, but still the bank is the last-resort liquidity provider. Hence, when problems emerge the bank responsable needs enough liquidity.

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8 The Huge Impact of the Subprime Crisis Investors from all over the world invested in colletarized commercial paper and CDOs. Problems arose because it was unclear how risky these assets were, because the guarantees of the underlying banks were not clear A process of deleveraging sets in where funding liquidity and market liquidity affect each other and more and more investors can go bust (see exercise on this with related literature)

9 Spaventa: Causes of The Crisis Spaventa lists a number of reasons for the financial crisis: Low interest rates in making borrowing too easy and stimulating lenders to search for higher yield higher risk investments Loss of information and monitoring as risks are pooled Problems with credit rating agencies models and with their Value at Risk (VaR) models, that were based on too few observations and do not take into account feedback from the models use to the models outcomes Perverse incentive structures Among mortgage brokers Among credit rating agencies Among bank managers

10 Spaventa: Causes of The Crisis Too complex financial instruments lacking liquidity in the absence of a proper secondary market Lack of control to the shadow financial system, fostering excessive risk taking and too high leverage Information problems, because of the complexity of the investment products and the dependence of banks on their off balance sheet items Lack of regulation, both because of incompetence and because of ideology Effects? The first week I wrote

11 Effects Banks are reluctant to lend money to each other. Therefore, banks face direct payment problems, because they cannot finance their short-term liabilities Firms are starting to get problems to finance their activities, because the market for commercial paper dries up Bank customers are getting scared and threaten to withdraw their deposits. This would lead to a bank run

12 Effects Especially, the second effect is bothering us now. Firms have problems getting their liabilities financed and at the same time, we see a huge drop in consumer demand Last week we discussed that the central bank s official interest rate is near the zero lower bound. Deflation is threatening Advices vary from economists saying that the credit market has to be revived so as to close the gap between the official and the effective interest rates, to economists claiming that a huge fiscal stimulus is need in addition to complement the almost impotent monetary policy Next weeks we look at business cycle models, before going into these questions