Economia Finanziaria e Monetaria Lezione 11 Ruolo degli intermediari: aspetti micro delle crisi finanziarie (asimmetrie informative e modelli di business bancari/ finanziari) 1
0. Outline Scaletta della lezione 11 1. Adverse selection and moral hazard 2. The role of the banking system 3. Capital markets & endogenous credit rationing 4. Bank runs 5. The importance of the bank business model 6. Asymmetric information and financial crises 2
1. Adverse selection and moral hazard 1 The main function of capital markets is to direct I towards the most productive uses. The presence of asymmetric information may hamper this objective. Asy. Info.: people have more accurate information than others. This may S C for SME (small-medium enterprises). Usually banks can be a good solution for this friction. H/e, during FC the of available information on the quality of borrowers significantly complicates banking activity. 3
1. Adverse selection and moral hazard 2 4
1. Adverse selection and moral hazard 3 Asy. Info. in financial markets cause 2 different problems: - adverse selection (Adv. Sel). - moral hazard (MH). Adverse selection: a situation in which potentially - desirable borrowers are also those who will have + chances to be selected to obtain a L. If the risk of Adv. Sel. becomes particularly high, creditors may decide not to grant loans even if there are good-quality businesses on the market. If creditors cannot observe the specific quality of each borrowers, they offer funds at i = the average quality borrowers. H/e, good-quality businesses consider this rate too high and decide to leave the market. Creditors realize that lending rate of quality of the borrowers Creditors will choose to keep i stable and S C. 5
1. Adverse selection and moral hazard 4 Example: Market for lemons Low Quality Cars (lemons) High Quality Cars Sellers Value $1000 $2000 Buyers Value $1200 $2400 6
1. Adverse selection and moral hazard 5 HP: sellers know the quality of the cars. but buyers do not know the quality of the cars. If all cars are put on the market, buyers would be willing to pay up to $1,800. That is: (1200*0.5 + 2400*0.5) At that price, only lemons are offered for sale, b/c high quality car sellers consider the price too low. With only low quality car on the market, the equilibrium price can not be $1,800. This is a typical example of market failure. 7
1. Adverse selection and moral hazard 6 Moral hazard: a situation in which creditors are exposed to the risk that borrowers undertake bad (or opportunistic) behavior, jeopardizing loan payback. When moral hazard risks are particularly high, creditors may the S C. See Moral hazard example below. 8
2. The role of the banking system 1 The intermediaries can effectively reduce the problems of information asymmetries, through the collection of private information. In fact, selecting and monitoring firms, banks can collect information on the specific quality of enterprises which allows them to grant private and customized loans. Considering that this loan cannot be negotiated on the markets, unless securitization operations are performed, other agents cannot free-ride on information collected by banks. 9
3. Capital markets & endogenous credit rationing 1 The main function of capital markets is to direct investments towards the most productive uses. One of the chief obstacles in achieving this objective, which is essential for a solid and long-lasting economic growth, is the presence of information asymmetries. The more penalized firms by these problem are usually smallersized enterprises. Although banks can be a good solution for this friction, but during a financial crises their activities are more complicate. Thus, let s see in which case the supply of loans is lower than the demand. 10
3. Capital markets & endogenous credit rationing 2 The key point of this approach is that, in some specific situation, the banks can not be compensated for an increase in risk by an increase in the rate of interest. Beyond some specific loan exposure, the risk will always outweigh the rate of interest and the expected profit would decline. It is useful distinguish two type of rationing: Type 1 when a borrower cannot borrow all of what he wants. Type 2 when out of a pool of identical borrowers some individuals have their credit demands unsatisfied. 11
3. Capital markets & endogenous credit rationing 3 The development of imperfect information, endogenous rationing models include elements of: 1. Asymmetric information. This refers to the possibility that both sides to the transaction do not possess the same amount or quality of information. For example, the borrower may have more information about the possible success of the project financed by a loan than the bank. 2. Adverse selection. When the bank may select the wrong candidate: e.g.: the person more likely to default. 3. Adverse incentives. When the contracted interest rate creates an incentive for the borrower to take on greater risk than they otherwise would, so that the higher interest rate can be paid. 4. Moral hazard. A situation when one of the parties to an agreement has an incentive to behave in a way that brings benefit to them but at the expense of the counterparty. 12
3. Capital markets & endogenous credit rationing 4 Let s see a model of type 1 rationing in the framework of asymmetric information with adverse selection and moral hazard. The bank faces 2 types of borrowers, honest & dishonest. Honest borrowers will not borrow if they cannot repay; whereas dishonest borrowers borrow knowing they wouldn t repay The bank knows that a certain proportion of borrowers are dishonest but cannot tell between the 2 types (due to asymmetric information). The use of interest rate to separate the two types of borrowers could result in instability and a breakdown in the market. The reasoning is that if the bank attempts to price the risk of dishonest borrowers into the loan rate, the proportion of dishonest borrowers increases as honest borrowers drop out of the loan market. i dishonest & honest The solution is to offer a common contract to both types of borrowers (i.e. a pooling contract) with a smaller loan size than loan demand 13
3. Capital markets & endogenous credit rationing 5 Let s see a model of type 2 rationing in the framework of asymmetric information with adverse incentive and adverse selection (Stiglitz and Weiss; 1981). The interest rate produces not only positive effect on the bank s return but also two negative effect: 1. The interest rate charged affects the riskiness of the loan, (adverse selection effect). 2. the higher the rate of interest charged, the greater the incentive to take on riskier projects (which is the adverse incentive effect). 14
3. Capital markets & endogenous credit rationing 6 Figure: Type II rationing 15
3. Capital markets & endogenous credit rationing 7 The LHS of the figure shows the profit-interest rate combination implied by the fact that profits fall after a particular rate of interest due to the negative effect of interest rates on banks profits and the profit- The maximum profit point is shown by π bm maximizing rate of interest is shown as r M. The right-hand side of the figure shows the demand and supply of bank loans. The supply curve reflect the profit function shown on the left-hand side of the Figure and slopes backwards after the interest rate r M. The demand for loans intersects the supply at an interest rate above the profit-maximizing rate r M. For example, if the demand curve intersected the supply curve above r M there would be no credit rationing. This is a stable equilibrium but is not a profit-maximizing equilibrium because the bank can increase profits by reducing the interest rate to r M. 16
3. Capital markets & endogenous credit rationing 8 The maximum loan supply is shown by L M, which is greater than the loan demanded at the higher rate of interest but less than the loan quantity demanded. There is an excess demand for loans, shown by the range E, so the bank must ration credit between the prospective borrowers. The weakness of the type 1 and 2 models of rationing is the reliance on the relative ignorance of the bank; i.e., the presence of asymmetric information. However, we know that the theory of banking is based on the notion that banks have a comparative advantage in information gathering. Eventually, the bank and, ultimately, the banking industry will become aware of the characteristics of the risky borrowers and devise means of differentiating between the risky and safe borrowers ex ante based on past experience. How can banks do that? Screening & relationship banking 17
3. Capital markets & endogenous credit rationing 9 Requiring a collateral is one method of screening borrower type. In fact, in case of default, the bank can sell the collateral (for example the house) and use the cash to pay-off the loan. Let s assume that the bank cannot distinguish between the 2 types of borrowers but it can offer alternative combinations of collateral and interest rates that ensure the same expected profit to the bank. Assume that safe borrowers have a preference for a high collateral - low interest rate combination. The risky borrowers, knowing the riskiness of their projects, would be unwilling to commit their own assets as collateral and would prefer a low collateral-high interest rate combination By learning their preferences the bank can appropriately price the loan as a mix of collateral/int. rate for different types of borrower. In the extreme case the risky borrower would accept a contract that has zero collateral and high interest and the safe borrower would accept a contract with low interest rate and high collateral 18
4. Bank runs 1 Consider the Bank run as in Diamond Dybvig s model. We have: N agents and T={0,1,2} At T=0 the agents do not know their consumption needs. At T=1 a fraction q of agents (impatient) need to consume, whereas a fraction (1-q) of agents (patient) can wait until T=2. C I impatient agents consumption level C p patient agent consumption level U(C I ) utility function of imp. agents U(C P ) utility function of pat. Agents U(C) is increasing and concave 19
4. Bank runs 2 Period 0 1 2 Initial Endowment Illiquid Investment liquid Investment 1 0 0-1 1-m R -1 1 1 In T=2, illiquid investment has an higher return than liquid one: R > 1 However, T=1, to liquidate the illiquid investment the agent needs to pay a cost = m. On the contrary, liquid investment does not have liquidation cost in T=1 20
4. Bank runs 3 CASE 1= NO BANK t = fraction of resources invested in illiquid instrument. The optimal value of t is given by the solution of this problem: Max t q U(C I ) + (1-q) U(C P ) [1] s.t.: C I = 1-mt [2] C P = tr + (1-t) [3] If the agent choice t=0: C I =1 C P =1 If the agent choice t=1 C I =1-m C p =R 21
4. Bank Runs runs 4 C P R/(1-q) C R A 1 B AB Autarky Solution CD Bank Solution D 1-m 1 1-q C I 22
4. Bank runs 5 CASE 2= THE PRESENCE OF BANK Here, two possible situation may arise at the equilibrium: 1. An efficient allocation, when patient agents trust the bank and withdraw only at t = 2. 2. An inefficient bank run, when all depositors withdraw at t = 1. In the efficient allocation, the problem of the bank is: Max t q U(C I ) + (1-q) U(C P ) [4] s.t.: qc I = 1-t [5] (1-q)C P = tr [6] [5] the bank invest an amount of resources in illiquid investment such that the need of impatient agent are satisfied. [6] with the presence of the bank, the patient agents do not need to invest a fraction of reserve in liquid instrument. 23
4. Bank runs 6 If t=0, C I =1/q and C P =0 If t=1, C I =0 and C P = R/(1-q) The line CD gives an higher level of cosumption and utiliy. But, another equilibrium exists, leading to an inefficient allocat n Suppose the patient agents anticipates that all other patient consumers want to withdraw at t = 1. In this case the bank will have not enough liquid funds to pay back the depositors: Supply of funds: qc I =1-t Demand of funds: q C I =1-t If q >q then Demand > Supply Thus, Bank goes default and patient agents take 0 in T=2 Anticipating this, the optimal strategy for a patient agents is to withdraw at t = 1. 24
4. Bank runs 7 Thus the initial expectations of the consumer are self-fulfilling. Change in expectations was supposed to be the main channel of contagion in the nineteenth century and the beginning of the twentieth century. This channel seems also important today in countries that are vulnerable to currency crises. This type of crisis closely resembles bank runs because they occur as self-fulfilling prophecies. 25
5. The importance of the bank business model 1 Securitizations drastically change the banking model: from originate to hold (OTH) to originate to distribute (OTD) model OTH: the loan is a simple operation between bank & borrower. OTD: loan origination is a complex operation (productive process) involving various subjects (screening & monitoring are lost). 26
5. The importance of the bank business model 2 Ø The evolutionary view postulated that financial markets be more efficient than banks at managing risks, so that banks should move from the old model (lend & keep the loans, OTH) to the new model (lend & sell the loans, via securitization, OTD). Ø Banks role as certifiers of loan quality was neglected but that role was there only with OTH not with OTD granting loans to sell them rather then to keep them endangered banks incentives to perform in depth screening & monitoring of the borrowers, so that lending standards rapidly deteriorated. Ø And the evaluation of the creditworthiness of the loans underlying securitizations fell back on the rating agencies who founded such evaluation on past historical default rates, but these were based on OTH and, thus, the agencies systematically gave overly optimistic ratings. 27
5. The importance of the bank business model 3 Ø For too long we had a crossed-eye theory of finance: Market theory based on complete markets & perfect information; Financial intermediary theory based on asymmetric information & delegated monitoring. Ø When, with liberalization, financial markets became dominating banks practice and even regulatory principles (e.g. IAS, Basel 2) moved toward financial market type activities while weakening banks credit function we applied to banks the theory which if adequate to financial markets is inappropriate to banks Ø It s wrong subordinating banks to financial markets (and also the opposite would be a mistake) we need to build on the banksmarkets complementarity (Allen & Gale, 2000). 28
6. Asymmetric information and financial crises 1 When the risks of adverse selection and moral hazard reach very high levels, they can trigger financial crises. The literature on information asymmetries identifies three key variables at the origin of a crisis: interest rate value of collateral bank runs. i risk of adv. sel. b/c they displace good-quality borrowers out of the credit market. The risk of financing low-quality businesses and creditors may S C A in value of collaterals FC. In fact, if a debtor goes into default, the creditor may seize the collateral, sell it and recover part of the loan. 29
6. Asymmetric information and financial crises 2 H/e, if the value, in case of default the share of funds the creditors can recover is reduced S C. The in the value of collaterals can be the consequence of a drop in the stock market or of the devaluation of the ER. bank runs FC. For example, suppose the economy is hit by a shock and 5% of the banks go bankrupt within a few months. In the case of Asy. Info., depositors are not able to tell whether their bank is one of that 5% of banks going bankrupt. Ø Both depositors of solvent banks and depositors of insolvent banks will try to withdraw their funds immediately. 30
6. Asymmetric information and financial crises 3 As banks will refund depositors in accordance with their order of arrival at the bank branch, every depositor will have the incentive to be the first to arrive at their bank. Since the bank has to return funds to its clients, it may run out of funds, as its assets cannot be easily liquidated at short term and the forced sales can determine extensive losses. If the government does not act to re-establish the trust of the savers, with special guarantees on deposits, even solvent banks may become illiquid and go bankrupt triggering a dangerous domino effect that could transform a liquidity crisis into a serious financial crisis. 31