Issues in Too Big to Fail

Transcription

1 Issues in Too Big to Fail Franklin Allen Imperial College London and University of Pennsylvania Financial Regulation - Are We Reaching an Efficient Outcome? NIESR Annual Finance Conference 18 March 2016

2 What went wrong with banking regulation? The focus of regulators was on microprudential regulation that involves ensuring no individual bank takes large risks This failed to prevent a financial crisis because it ignored systemic risk What are the sources of systemic risk? 2

3 Some sources of systemic risk 1. Panics banking crises due to multiple equilibria 2. Banking crises due to asset price falls 3. Contagion 4. Financial architecture 5. Foreign exchange mismatches in the banking system 3

4 Too Big to Fail (TBTF) and systemic risk The reason TBTF is so important for systemic risk is contagion. As Barth and Wihlborg (2016) point out policies to counter TBTF can be divided into four categories: 1. Restricting size of banks 2. Restricting scope of banks 3. Higher capital levels for large banks 4. Orderly resolution framework for banks both domestically and internationally 4

5 3. Contagion A very important systemic risk At least three different types: 1. Domino effects through the payments system or interbank markets 2. Common asset exposure 3. Uncertainty about how events will play out because of a lack of precedent 5

6 1. Domino effects The role of networks: small shocks, that initially affect only a few institutions, propagate through the entire system, e.g. Allen and Gale (2000) Standard three-date banking model with short- and long-term assets, liquidity shocks and liquidation costs at the intermediate date The Interbank Deposit Market allows liquidity to be transferred from regions with excess liquidity to those with a shortage of liquidity and so shares the risk of idiosyncratic liquidity shocks 6

7 There are complete markets when each region s bank can make deposits in every other region s bank A B D C 7

8 There are incomplete markets when links are limited, e.g. A B D C A small aggregate shock can lead the whole financial system to collapse even though with complete markets there would be no contagion 8

9 Modeling issues What network structures are resilient to contagion? Theory: Allen and Gale (2000), Eisenberg and Noe (2001), Leitner (2005), Gai and Kapadia (2010). Simulations/empirical: Upper and Worms (2004), Upper (2011) How do financial institutions form connections? Babus (2015), Castiglionesi and Navarro (2011), Farboodi (2014). 9

10 Recent extensions Elliott, Golub and Jackson (2014) consider the role of integration and diversification. The former is concerned with how much banks rely on other banks while the latter is the number of banks a particular bank's liabilities are spread over. They analyse the trade-off between them. Acemoglu, Ozdaglar, and Tahbaz-Salehi (2015) show that connected networks where all banks are connected to each other, at least indirectly, are more robust to shocks because of risk sharing than networks where they are not all connected. However, large shock are more likely to make all institutions fail in in connected networks. 10

11 Policy issues Too-big-to-fail and too-interconnected-to-fail policies are aimed at preventing contagion but are they optimal? Role of capital regulation in preventing this type of contagion Very different perspective than the standard skin-in-thegame moral hazard rationale Fiscal versus monetary interventions 11

12 2. Common asset exposure Diversification and systemic risk Shaffer (1994), Wagner (2010), Jaffee, Ibragivmov and Walden (2011) The recent crisis has shown the importance of Interconnections among financial institutions due to common assets and greater diversification Funding risk: short versus long term maturity The interaction of the two in determining systemic risk 12

13 Allen, Babus and Carletti (2012) develop a model of common asset exposure and consider the role of financial architecture (clustered versus unclustered or equivalently domestic versus global financial systems) in determining breakdown of liquidity in markets and premature liquidation Welfare depends on the asset structure Unclustered structure is more stable and typically welfare superior, but not always Welfare comparison depends on bankruptcy costs and investors opportunity cost (measure of early liquidation efficiency) The policy implication is that globalization is not always optimal 13

14 3. Uncertainty due to lack of a precedent After the Lehman Brothers default macroeconomic time series were very heavily affected Why did GDP fall so much in many countries? This seems to be a third type of contagion where there is a massive flight to quality that is not well understood 14

15 Quarterly data, domestic currency, real terms (OECD National Accounts standard data) 15

16 Annual data, domestic currency, real terms (OECD National Accounts standard data) Change Japan Finland US UK Germany France Korea GDP -5.53% -8.23% -2.78% -4.31% -5.64% -2.94% 0.71% Private Consumption -0.38% -1.36% -1.08% -2.00% 0.02% 0.11% 0.08% Government Consumption 0.41% 0.35% 0.59% 0.24% 0.54% 0.55% 0.74% Gross Capital Formation -3.59% -5.30% -3.38% -3.28% -3.58% -3.23% -3.03% Trade Balance -1.96% -1.92% 1.09% 0.73% -2.61% -0.37% 2.91% Trade Balance Breakdown Japan Finland US UK Germany France Korea GDP -5.53% -8.23% -2.78% -4.31% -5.64% -2.94% 0.71% Private Consumption -0.38% -1.36% -1.08% -2.00% 0.02% 0.11% 0.08% Government Consumption 0.41% 0.35% 0.59% 0.24% 0.54% 0.55% 0.74% Gross Capital Formation -3.59% -5.30% -3.38% -3.28% -3.58% -3.23% -3.03% Exports -4.08% -8.64% -1.03% -2.44% -6.04% -3.00% -0.15% Less Imports -2.12% -6.72% -2.13% -3.17% -3.43% -2.63% -3.06% 16

17 Quarterly data, domestic currency, real terms (OECD National Accounts standard data) 17

18 Capital regulation Capital helps offset moral hazard from deposit insurance and prevent contagion Capital is costly and banks minimize it: why? Tax subsidy to debt in the form of interest deductibility Implicit subsidy to debt through government guarantees Reform corporate tax system: Remove debt deductibility (or even corporate income tax?) Revenue neutral change: remove debt deductibility and decrease corporate income tax Remove public subsidy to debt Create proper enforcement mechanism, i.e. resolution procedures 18

19 Resolution mechanisms Large institutions are saved to avoid contagion at the cost of moral hazard Large institutions hold less capital and are riskier as they internalize that they are TBTF Much effort has been devoted to try to create resolution mechanisms that eliminate TBTF by among other things bailing in non-deposit insured bank liabilities How credible is this? 19

20 Liabilities: 10-year average ( ) 100% 90% 80% 70% Other liabilities Bonds 60% 50% 40% Customer deposits Interbank deposits 30% 20% 10% Borrowing from Central bank Capital and reserves 0% US Japan France Germany UK 20

21 Assets: 10-year average ( ) 100% 90% Other assets 80% 70% Securities 60% 50% Loans 40% 30% 20% 10% Interbank deposits Cash and balance with Central bank 0% US Japan France Germany UK 21

22 Household versus Corporate Lending ( ) Enterprise credit to GDP Household credit to GDP US Japan France Germany UK 22

23 Resolution mechanism In a number of countries bail-ins are likely to be very problematic Problem of resolving large cross-border banks little progress has been made TBTF is not Too Big to Liquidate Government should orderly resolve failing institutions Guarantee short term commitments to avoid contagion The top 5 executives should be removed immediately All employee pension claims should be eliminated Over the next few years the bank should be liquidated 23

24 Concluding remarks Systemic risk is a complex phenomenon with many different causes Contagion is a very important example of systemic risk that is not well understood Too Big to Fail is likely to be implemented going forward despite regulatory changes and politicians assurances it won t happen Much work remains to be done to understand contagion and the effect of eliminating Too Big to Fail 24

25 References Acemoglu, D., A. Ozdaglar, and A. Tahbaz-Salehi (2015). Systemic Risk and Stability in Financial Networks, American Economic Review 105(2), Allen, F., A. Babus and E. Carletti (2012). Asset Commonality, Debt Maturity and Systemic Risk, Journal of Financial Economics,104, Allen, F., and D. Gale (2000). Financial Contagion, Journal of Political Economy, 108(1), Babus, A. (2015): The Formation of Financial Networks, RAND Journal of Economics, forthcoming. Barth, J. R. and C. Wihlborg (2016). Too Big to Fail and Too Big to Save: Dilemmas For Banking, National Institute Economic Review February 2016, R27-R39. Castiglionesi, F., and N. Navarro (2011): Fragile Financial Networks, working paper, Tilburg University, Center for Economic Research. Eisenberg, L., and T. N (2001): Systemic Risk in Financial Systems, Management Science, 47(2), Elliott, M., B. Golub, and M. Jackson, (2014). Financial Networks and Contagion, American Economic Review 104, Farboodi, M. (2014). Intermediation and Voluntary Exposure to Counterparty Risk, working paper, Princeton University. Gai, P., and S. Kapadia, (2010). Contagion in Financial Networks, Proceedings of the Royal Society of London, A, 466 (2120), Ibragimov, R., D. Jaffee, J. Walden, (2011). Diversification disasters, Journal of Financial Economics 99, Leitner, Y. (2005): Financial Networks: Contagion, Commitment, and Private Sector Bailouts, Journal of Finance, 60(6), Shaffer, S., (1994). Pooling Intensifies Joint Failure Risk, Research in Financial Services 6, Upper, C. (2011) "Simulation Methods to Assess the Danger of Contagion in Interbank Markets", Journal of Financial Stability, 7(3): Upper, C., and A. Worms (2004): Estimating Bilateral Exposures in the German Interbank Market: Is There a Danger of Contagion?, European Economic Review, 48(4), Wagner, W., (2010). Diversification at Financial Institutions and Systemic Crises, Journal of Financial Intermediation 19,