Regulating systemic risk | Barcelona GSE Lecture XX

REGULATING SYSTEMIC RISK Barcelona GSE Lecture Banc Sabadell, March 31, 2011 Jean Tirole

I. INTRODUCTIONBackground 1. Banking and euro crises; realization that macro-policies and micro-supervision deeply intertwined. 2. Creation of systemic risk councils: European Systemic Risk Board (ESRB) [November 17, 2010. Together with three new European Supervisory Authorities, for banking, insurance & pensions, securities] “will monitor and assess potential threats to the stability of the ﬁnancial system”. Financial Stability Oversight Council (FSOC) [July 21, 2010/Dodd-Franck Act.] 2

Macro-prudential policies: definitions and rationalesInterpretation # 1: Intelligent micro-prudential supervision [Still micro-prudential, but a proper risk assessment requires predicting future interest rates, asset prices, exchange rates, etc., variables that are fully endogenous (requires a global knowledge of the financial institutions’ balance sheets).] Protect authorities against risk of being held hostage by an institution or by the financial system as a whole.Interpretation # 2: Regulate to correct market failures in financial markets. Which is the proper interpretation ? 3

# 1 “Macroprudential policy focuses on the interactions between financial institutions, markets, infrastructure and the wider economy. It complements the microprudential focus on the risk position of individual institutions, which largely takes the rest of the financial system and the economy as given.”# 2 “[Systemic risk is defined by the IMF, FSB and BIS for the G20] as a risk of disruption to financial services that is caused by an impairment of all or parts of the financial system and has the potential to have serious negative consequences for the real economy”. [Committee on the Global Financial System, paper 38, emphasis added.] 4

OutlineII. Financial stability: meaning and mandate/policies The multiple facets of ﬁnancial stability. Many different phenomena are regrouped under this heading. The toolkit: depends on what is meant by “macro-prudential supervision”. [We’ll focus on policies. But similar questions arise with respect to detection of potential systemic threats: macro stress tests, signals (credit expansion), Adrian-Brunnermeier’s Co-Var (measuring an institution’s contribution to systemic risk). CDS signals are not very useful here due to anticipation of government guarantees.] 5

III. The institutions of macro-prudential supervision. Agency’s mandate Agency’s incentives and behavior Subsidiarity-related issues.WARNING: many more questions than answers. 6

II. THE MULTIPLE FACETS OF FINANCIAL STABILITY OR SYSTEMIC RISK1. Imbalances # 1: Bubbles Bubbles burst, and, worse, they burst “at the wrong time” [Farhi-Tirole on “Bubbly Liquidity”: Bubbles (1) increase liquidity/stores of value (“liquidity effect”) (2) but, ceteris paribus, reduce ﬁnancing ability/leverage by raising interest rates, (3) as long as they last raise interest rates and, if positive outside liquidity, investment. Crash of bubble creates not only a wealth effect, but also generates a shortage of stores of value and lowers interest rate; so equity is scarce precisely when it can/should be levered up easily. See also Martin-Ventura.] 7

Intuition for double whammyBasic investment equation: pledgeable income ρ 0 it At At it = + or it = ρ0 1 + rt+1 1− 1 + rt+1 funding hoarded/ liquidity market liquidity or net worthBubble bursts =⇒ At and rt+1 fall![note: rt+1 falls even in the absence of policy intervention.] 8

Bubble crash can be very costly if bubble held by high-leverage entities.Who holds the bubble?Theory: low-leverage entities ( ρ0 small: private equity, family ﬁrms, ...) should hold the bubble, because they are relatively less subject to double whammy.Recent crisis: high-leverage entities, because counted on government bailout (see later). 9

Toolkit if imbalances are due to asset bubbles[regulatory implications still speculative] monetary policy: high interest rates may help a bit, but not the right instrument; prudential and ﬁscal policy: control new investments: Loan to Value/Debt to Income regulations, stop subsidies to home ownership; control risk to net worth: provisioning (countercyclical buffers in Basel III). 10

2. Imbalances # 2: Foreign exchange (i) Structure of borrowing: Crises often associated with trilogy of dangerous liabilities: debt, short-term debt, foreign currency denominated. Makes it difficult to devalue: liabilities of the private and public sectors are then inflated. Capital flow volatility. Run on the country. Trade-off between country commitment and country risk management [dangerous forms of debt also make government more accountable because it bears more of the costs of its misbehavior. Still there may be a case for existence of excessively dangerous forms of debt, due to attempts at signaling.] Depends on politics and expectations: add domestic/foreign held ratio. [e.g., Tirole 2003 and Broner-Ventura] 11

(ii) Level of borrowing: Public debt + bank debt that later will become public debt [Spain, Ireland]Toolkit capital controls, monitoring of share of foreign currency loans*, capital adequacy requirements (increase capital requirements to reflect FX- related risk), ... surveillance of competitiveness, prudential regulation and public deficits, fiscal rules, ... * e.g. credit lines and other commitments in foreign currency. 12

3. Market freezes/fire sales Multiple reasons: (i) Accounting: Under historical cost accounting, or MVA but expectation of reclassification opportunity, banks sell winners/keep losers. Accounting rules are then appropriate tool. [Related argument: keeping losers akin to gambling for resurrection: Diamond-Rajan.] (ii) Shortage of buyers with sufficient financial muscle (“local liquidity”) [Not a completely obvious proposition: expectation of fire sale prices should induce potential buyers to hoard liquidities and discourage potential sellers from investing in “illiquid” assets. Relevance of “pecuniary externalities”? Missing insurance contract between potential buyers and sellers of these assets.] (iii) Lack of trust in the assets [Adverse selection/freezes increase when bad news; even little news can have a big impact on price and volume: (a) Akerlof, (b) Dang-Gorton-Holmström.] (iv) Expectation of a bailout (a “TARP”) 13

Spiral : Fire sales low price loss of net worth fire sales. [Brunnermeier-Pedersen]Toolkit limit fire sales. Hanson-Kashyap-Stein 2010 variant of this argument: ask for recapitalizations; do not give choice between equity issuance and asset sale [reduces fire sales and alleviates adverse selection in equity issuance market] jumpstart market. Costly because if successful, expectation of market rebound and high prices and so government must pay a substantial amount. [Argument that institutions willing to sell at discount because they need cash is valid, but this discount is anticipated in market, which nonetheless freezes. Philippon-Skreta, Tirole.] 14

More on jumpstarting markets... Game is to reduce adverse selection, but not too much... A rather comprehensive clean up leaves top assets in the market place, which then command a very high price. Anticipating this.... Government should optimally buy back weakest assets, then take a partial stake in some intermediary-quality assets (leaving them on the institutions’ balance sheets), the ﬁrms with the best assets not taking part in the government scheme. No cost of not being able to shut down the market. 15

4. Widespread maturity mismatches If too many financial institutions adopt an illiquid balance sheet and take correlated risks (e.g., on a real estate bubble), then authorities have no choice but engaging in triple-play bailouts: monetary (low interest rates), accounting (reclassification), and “fiscal” (acceptance of low-quality collateral, equity injections, loan guarantees, ...) [Farhi-Tirole on “Collective Moral Hazard, Maturity Mismatch and Systemic Bailouts”; Diamond-Rajan]. Toolkit Regulation of liquidity (liquidity coverage and net stable funding ratios; contingent capital; etc.), with an eye on the entire financial system. 16

5. Procyclicity of Basel II Basel I was already procyclical: banks lose revenue =⇒ reduce their credit [Holmström-Tirole 1997 on impact of bank capital on economic activity]. Basel II: Market value accounting implies that institutions are very well (poorly) capitalized during booms (recessions). [Plantin-Sapra-Shin 2008 on countercyclical (procyclical) properties of HCA(MVA).] Toolkit : What is at stake is not so much MVA per se, but the way it is applied: LT-liabilities institutions, exit price: value of asset in contingency of default very different from the current value. Need more research on this crucial point. 17

Countercyclical capital buffer (proposal of Basel Committee) creditBasis: deviations of ratio from trend GDP(“excess credit growth”). credit Repullo: gap is negatively correlated with business cycle. GDP Downturns: GDP growth slow or negative, credit demand continues + ﬁrms draw on credit lines. Measurement: ﬁnancial innovation (securitization). More generally, ratio has only a tenuous link with theoretical determinants of riskiness =⇒ Basel committee offers “supervisory judgement” (guidelines?). 18

6. Cross-exposures and contagion Well-known that OTC markets, by making commercial banks exposed, in an opaque way, to the failure of investment banks (including AIG holding) allowed the latter to rely on access to taxpayer money (the prospect of a bailout allowing them to keep borrowing up to the end). Toolkit : Central clearing counterparty. [Need to be closely supervised: TBTF. US FSOC’s emphasis on monitoring of “ﬁnancial market utilities” is warranted.] 19

Systemically important intermediariesArgument cuts across various arguments above. Boundary problem: [FSOC: mandate to designate systemically important financial firms.] If default is what preoccupies authorities, not clear that overarching regulation is solution: migration to hedge funds, private equity firms, energy companies, etc. Measuring interconnectedness: Better to protect regulated sphere against default by lightly regulated or unregulated entities. Good data on cross-exposures require exchanges/standardized products. 20

III. THE INSTITUTIONS OF MACRO-PRUDENTIAL SUPERVISIONParticular focus on ESRB (some applies also to FSOC).(a) Communication policy Friend... consolidates information (example: points at mutually inconsistent plans) (more cynical view) management consultant ... or foe? “forces” (moral suasion) national authorities to take action. [European Council: “ESRB will address warnings and recommendation to EU or to member states or to European or National Supervisory Authorities”.] 21

Europe: (1) (2) (3) Warnings “Act or Can make & explain” recommendations recommendations public (after informing Council). May affect how much information ESRB receives from NSAs. 22

Conundrum how can one put pressure on NSAs without making information public? making information public raises possibility of runs and freezes [FSOC: “closed portion of meeting if disclosure of information could lead to instability/ﬁnancial speculation.”]Incentives assessment of performance and accountability [in case of transparency, measurement of risk affects it.] career/legacy concerns: incentive to cry wolf? Speed of reporting? transparency and the incentives to pander. 23

(b) Scope ESRB has limited scope: no ﬁscal or monetary policy. Yet, distinctions are increasingly blurred: conventional vs non-conventional monetary policies, capital requirements vs. tax on real estate, fongibility of public and bank debt, and so forth. Limited scope may imply policy mix changes/arbitrage. 24

(c) Strong externalities of public policies (trans-national ﬁnancial institutions and cross-border crises) 1. Reporting (NSAs to, say, ESRB) 2. Subsidiarity in policy-making prudential regulation (think of Ireland) deposit insurance monetary policy (when different currencies) resolution, bankruptcy procedures, and ring fencing, bailouts, etc. European prudential regulator would solve some problems (harmonization, internalization, competency), but not all. 25

IV. CONCLUDING THOUGHTS Financial stability supervision: an idea whose time has come Division of labor ◦ NRAs - Systemic Risk Board ◦ monetary/prudential/ﬁscal authorities more and more uncertain.My purpose has been to expose the main question marks. We need tocome to grips with these challenging issues! 26

Thank you very much! 27

Regulating systemic risk | Barcelona GSE Lecture XX

by Barcelona Graduate School of Economics (GSE) on Apr 01, 2011

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Regulating systemic risk | Barcelona GSE Lecture XX — Presentation Transcript