Systemic Risk and Optimal Regulatory Architecture
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1 Systemic Risk and Optimal Regulatory Architecture Marco Espinosa-Vega IMF Rafael Matta University of Amsterdam Charles Kahn University of Illinois Juan Solé FSB ECB Workshop Banking Supervision and Central Banks: Insights from Research Frankfurt, Germany June 26, 2013 (Espinosa-Vega & Kahn & Matta & Solé ) Systemic Risk and Optimal Regulatory Architecture 1 / 17
2 Motivation The financial crisis highlighted the need to take systemic externalities seriously Current financial reform legislation worldwide reflects this intent New Systemic Risk Authorities European Systemic Risk Board (EU) Financial Stability Oversight Council (US) Increased Attention to Systemic Risk by Existing Authorities (Espinosa-Vega & Kahn & Matta & Solé ) Systemic Risk and Optimal Regulatory Architecture 2 / 17
3 Our Point Regulatory architecture should take into account the regulatory incentives In particular, bias towards excessive forbearance Incentives for information gathering and sharing among regulators Examine some consequences of alternative designs when these incentives are taken into account and systemic risk is a factor (Espinosa-Vega & Kahn & Matta & Solé ) Systemic Risk and Optimal Regulatory Architecture 3 / 17
4 Related Literature Most of the literature on bank regulation has not considered strategic interaction among regulators Repullo (2000) is one of the first papers to consider strategic interaction Looks at the interaction between different institutions who might be taking on the role of lender of last resort Assume regulatory bias against forbearance (Espinosa-Vega & Kahn & Matta & Solé ) Systemic Risk and Optimal Regulatory Architecture 4 / 17
5 Related Literature Kahn and Santos (2005) and Kahn and Santos (2006) look at this question in the presence of the dilemma of insolvency versus illiquidity Regulatory bias towards forbearance (Kane (1992)) Examine incentives to gather and share private information Just one bank and look at the case of a regulator and a lender of last resort and the relative merits of joint versus separate regulatory powers We consider the consequences of systemic risk linkages across multiple regulated banks (Espinosa-Vega & Kahn & Matta & Solé ) Systemic Risk and Optimal Regulatory Architecture 5 / 17
6 Elements of the Model Two banks, one of which is systemic The insolvency or closure of the systemic bank increases the probability that the non-systemic banks fails; the reverse is not true Both banks are subject to two sources of shocks Liquidity shocks, represented by a sudden drop in deposits Solvency shocks, represented by a signal about the probability of success of the bank s investment project (Espinosa-Vega & Kahn & Matta & Solé ) Systemic Risk and Optimal Regulatory Architecture 6 / 17
7 Elements of the Model Two regulators A lender of last resort (LoLR), charged with the provision of emergency liquidity to banks A deposit insurer (DI), responsible for guaranteeing bank deposits and that has early intervention powers All regulators have private objective functions; that is, regulators do not maximize social welfare Instead, regulators care about their financial shortfall Face a trade-off between the political cost of closing a bank in distress and the expected financial cost of forbearance Unified regulator Holds powers and responsibilities associated with both LoLR and DI (Espinosa-Vega & Kahn & Matta & Solé ) Systemic Risk and Optimal Regulatory Architecture 7 / 17
8 Elements of the Model (Espinosa-Vega & Kahn & Matta & Solé ) Systemic Risk and Optimal Regulatory Architecture 8 / 17
9 Results (Espinosa-Vega & Kahn & Matta & Solé ) Systemic Risk and Optimal Regulatory Architecture 9 / 17
10 Results (Espinosa-Vega & Kahn & Matta & Solé ) Systemic Risk and Optimal Regulatory Architecture 10 / 17
11 Results (Espinosa-Vega & Kahn & Matta & Solé ) Systemic Risk and Optimal Regulatory Architecture 11 / 17
12 Results In the presence of systemic risk Regulators become more forbearing towards systemic institutions Regulators become less forbearing towards non-systemic institutions (Espinosa-Vega & Kahn & Matta & Solé ) Systemic Risk and Optimal Regulatory Architecture 12 / 17
13 Results (Espinosa-Vega & Kahn & Matta & Solé ) Systemic Risk and Optimal Regulatory Architecture 13 / 17
14 Results (Espinosa-Vega & Kahn & Matta & Solé ) Systemic Risk and Optimal Regulatory Architecture 14 / 17
15 Results Unified regulator is generally less forbearing than separate regulators Exception: At high levels of liquidity shock, unified regulator is more forbearing than a separate lender of last resort At high levels of liquidity shock, unified regulator becomes relatively less forbearing with increases in degree of systemic risk bankruptcy costs liquidation value (Espinosa-Vega & Kahn & Matta & Solé ) Systemic Risk and Optimal Regulatory Architecture 15 / 17
16 Results Private information on degree of systemic importance Generalizes result: informed regulator will not pass on useful information voluntarily New result: if information once gathered must be passed on, separate institutions have less incentive to gather information than do unified institutions (Espinosa-Vega & Kahn & Matta & Solé ) Systemic Risk and Optimal Regulatory Architecture 16 / 17
17 Conclusion Current quest for improved regulatory architecture for bank supervision and regulation of systemic risk Important to understand and account for objectives of regulators in creating design Simply announcing responsibility for systemic risk is unlikely to be effective without providing instruments and incentives (Espinosa-Vega & Kahn & Matta & Solé ) Systemic Risk and Optimal Regulatory Architecture 17 / 17
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