Ademu Research outlined as presented at the Kick-Off Conference

1. Bank Opacity and Financial Crises
Joachim Jungherr
Institut d’An`alisi Econ`omica - CSIC and Barcelona GSE
ADEMU Conference, Cambridge
October 09, 2015
Introduction Basic Model Market Discipline Private Information Bank Competition Efficiency & Policy

2. Work Package 3: Macroeconomic and
Financial Imbalances and Spillovers
Macroeconomic Imbalance Procedure (2011)
European Commission’s new early warning system
Scoreboard warns if:
private credit flow exceeds 15% of GDP
private stock of debt exceeds 133% of GDP
growth rate of financial sector liabilities to be included
Indicators partly reflect the view that European banking sector
contributed to imbalances
Introduction Basic Model Market Discipline Private Information Bank Competition Efficiency & Policy

3. Bank Opacity and Financial Imbalances
Definition
Bank Opacity: uncertainty about banks’ risk exposure
Bank opacity contributes to crises:
Ex-ante: lack of market discipline
Ex-post: which bank is solvent and which bank is not?
Introduction Basic Model Market Discipline Private Information Bank Competition Efficiency & Policy

4. Bank Opacity and Policy
Basel II (2004, implemented after 2008):
semi-annual (or quarterly) disclosure of bank-level credit
risk (broken down by region, risk class, maturity, sector,
counterparty type)
Since 2009: bank stress tests and transparency exercises in US
and Europe
disclosure of bank-level information varies across exercises
Introduction Basic Model Market Discipline Private Information Bank Competition Efficiency & Policy

5. Bank Opacity and Policy
Basel II (2004, implemented after 2008):
semi-annual (or quarterly) disclosure of bank-level credit
risk (broken down by region, risk class, maturity, sector,
counterparty type)
Since 2009: bank stress tests and transparency exercises in US
and Europe
disclosure of bank-level information varies across exercises
Important: Banks’ stock price reacts to surprises in stress test
results (Peristiani, Morgan and Savino, 2010; Petrella and
Resti, 2013)
⇒ Bank opacity endogenous
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6. Research Question & Model Results
Research question:
Why do banks choose not to disclose their risk exposure?
Where is the market failure?
Model results:
Banks’ investment decisions are proprietary information
Banks are inefficiently opaque and take on too much risk
More bank competition increases transparency and
financial stability
Transparency policies can improve market outcome (but
they also can make things worse)
Introduction Basic Model Market Discipline Private Information Bank Competition Efficiency & Policy

7. Outline
1. Introduction
2. Basic Model
3. Market Discipline
4. Private Information
5. Bank Competition
6. Efficiency & Policy
Introduction Basic Model Market Discipline Private Information Bank Competition Efficiency & Policy

8. Outline
1. Introduction
2. Basic Model
3. Market Discipline
4. Private Information
5. Bank Competition
6. Efficiency & Policy
Introduction Basic Model Market Discipline Private Information Bank Competition Efficiency & Policy

9. The Basic Model
A simple bank:
t = 0, 1, 2
amount k can be invested by the bank at t = 0
safe project with return 1 at t = 2
risky project with return R > 1 at t = 2
maximum project size θ uncertain
θ ∼ U(µ − a, µ + a)
if i > θ: i − θ is wasted
Value of bank’s portfolio at t = 2:
V = k − i + R min{ i , θ }
Introduction Basic Model Market Discipline Private Information Bank Competition Efficiency & Policy

10. The Basic Model
Roll-over game at t = 1:
short-term debt of amount D needs to be rolled over
otherwise liquidation cost Φ
i is publicly observed and θ is realized already at t = 1
Equilibrium:
two equilibria if
D < k − i + R min{ i , θ } < D + Φ
I select the Pareto dominant
⇒ bank run if and only if:
k − i + R min{ i , θ } < D
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11. The Basic Model
Bank’s portfolio choice t = 0:
max
i
Eθ k − i + R min{i, θ} − Prrun(i) Φ
Solution:
i∗
= E[ θ ] − a
2
R
− 1 −
Φ
R2
increasing in E[θ]
if 1 < R < 2: decreasing in uncertainty a
increasing in R
decreasing in Φ
Introduction Basic Model Market Discipline Private Information Bank Competition Efficiency & Policy

12. Outline
1. Introduction
2. Basic Model
3. Market Discipline
4. Private Information
5. Bank Competition
6. Efficiency & Policy
Introduction Basic Model Market Discipline Private Information Bank Competition Efficiency & Policy

13. Market Discipline
Assumption
Bank’s portfolio choice i publicly observable with probability π
Roll-over game at t = 1:
if i is not observable, bank run if and only if:
k − E[i] + R E [ min{ i , θ } ] < D
⇒ Bank run depends on creditors’ belief about i, not on
bank’s actual choice of i
Introduction Basic Model Market Discipline Private Information Bank Competition Efficiency & Policy

14. Market Discipline
Bank’s portfolio choice t = 0:
max
i
Eθ k − i + R min{i, θ}
− π Prrun(i) Φ − (1 − π) Prrun(E[i]) Φ
Solution:
i∗
= E[ θ ] − a
2
R
− 1 −
π Φ
R2
Opaque bank faces a commitment problem
Transparency π lowers risk taking
Expected net value of the bank’s portfolio increasing in π
Introduction Basic Model Market Discipline Private Information Bank Competition Efficiency & Policy

15. Outline
1. Introduction
2. Basic Model
3. Market Discipline
4. Private Information
5. Bank Competition
6. Efficiency & Policy
Introduction Basic Model Market Discipline Private Information Bank Competition Efficiency & Policy

16. Private Information
Assumption
With probability p, bank learns value of θ already at t = 0
portfolio choice: i = θ
Roll-over game at t = 1:
bank run if V < D
i is observable
informed bank: Vi (θ) = k − θ + θR
uninformed bank: Vu(θ) = k − i∗
+ R min{ i∗
, θ }
i not observable
informed and uninformed bank look alike:
Vopaque(θ) = pVi (θ) + (1 − p)Vu(θ)
Introduction Basic Model Market Discipline Private Information Bank Competition Efficiency & Policy

17. Private Information
Low realization of θ:
i is observable: bank run with probability 1 − p
i not observable: bank run with probability 1
p is sufficiently high ⇒ unconditional bank run risk lower for
opaque bank (for a given i)
“Hirshleifer effect” (e.g. Dang, Gorton, Holmstr¨om, Ordo˜nez,
2014)
Introduction Basic Model Market Discipline Private Information Bank Competition Efficiency & Policy

18. Private Information
Medium realization of θ:
i is observable: bank run with probability 1 − p
i not observable: bank run with probability 0
p is sufficiently high ⇒ unconditional bank run risk lower for
opaque bank (for a given i)
“Hirshleifer effect” (e.g. Dang, Gorton, Holmstr¨om, Ordo˜nez,
2014)
Introduction Basic Model Market Discipline Private Information Bank Competition Efficiency & Policy

19. Private Information
Medium realization of θ:
i is observable: bank run with probability 1 − p
i not observable: bank run with probability 0
p is sufficiently high ⇒ unconditional bank run risk lower for
opaque bank (for a given i)
“Hirshleifer effect” (e.g. Dang, Gorton, Holmstr¨om, Ordo˜nez,
2014)
Introduction Basic Model Market Discipline Private Information Bank Competition Efficiency & Policy

20. Private Information
Medium realization of θ:
i is observable: bank run with probability 1 − p
i not observable: bank run with probability 0
p is sufficiently high ⇒ unconditional bank run risk lower for
opaque bank (for a given i)
“Hirshleifer effect” (e.g. Dang, Gorton, Holmstr¨om, Ordo˜nez,
2014)
Introduction Basic Model Market Discipline Private Information Bank Competition Efficiency & Policy

21. Outline
1. Introduction
2. Basic Model
3. Market Discipline
4. Private Information
5. Bank Competition
6. Efficiency & Policy
Introduction Basic Model Market Discipline Private Information Bank Competition Efficiency & Policy

22. Bank Competition
Two banks: bank A and bank B
two risky projects with maximum project size θA and θB
θA and θB correlated
Information externality:
If banker B learns θB, she sets iB = θB.
If banker A does not learn θA but observes iB, she sets:
i∗
A = E[ θA|θB ] − a
2
R
− 1 −
πA Φ
R2
Introduction Basic Model Market Discipline Private Information Bank Competition Efficiency & Policy

23. Bank Competition
Banker A competes at t = 0 for funding by choosing:
her compensation share τA
transparency πA
Introduction Basic Model Market Discipline Private Information Bank Competition Efficiency & Policy

24. Bank Competition
Banker A competes at t = 0 for funding by choosing:
her compensation share τA
transparency πA
max
πA,τA
τA E VA − 1runA
Φ
s.t.:
(1 − τA)E VA − 1runA
Φ
kA
=
(1 − τB)E VB − 1runB
Φ
kB
Introduction Basic Model Market Discipline Private Information Bank Competition Efficiency & Policy

25. Bank Competition
Banker A competes at t = 0 for funding by choosing:
her compensation share τA
transparency πA
max
πA,τA
τA E VA − 1runA
Φ
s.t.:
(1 − τA)E VA − 1runA
Φ
kA
=
(1 − τB)E VB − 1runB
Φ
kB
Information externality:
banker A’s choice of πA affects E[ VA − 1runA
Φ ], but it
also affects E[ VB − 1runB
Φ ]
Introduction Basic Model Market Discipline Private Information Bank Competition Efficiency & Policy

26. Outline
1. Introduction
2. Basic Model
3. Market Discipline
4. Private Information
5. Bank Competition
6. Efficiency & Policy
Introduction Basic Model Market Discipline Private Information Bank Competition Efficiency & Policy

27. Efficiency
Marginal benefit of increasing πA
Bank Competition: Market Discipline − Hirshleifer effect
− Information Externality
Social Planner: Market Discipline − Hirshleifer effect
+ Information Externality
Introduction Basic Model Market Discipline Private Information Bank Competition Efficiency & Policy

28. Efficiency
Marginal benefit of increasing πA
Bank Competition: Market Discipline − Hirshleifer effect
− Information Externality
Social Planner: Market Discipline − Hirshleifer effect
+ Information Externality
Introduction Basic Model Market Discipline Private Information Bank Competition Efficiency & Policy

29. Efficiency
Marginal benefit of increasing πA
Bank Competition: Market Discipline − Hirshleifer effect
− Information Externality
Social Planner: Market Discipline − Hirshleifer effect
+ Information Externality
⇒ Market allocation too opaque, risk of a bank run
inefficiently high
Introduction Basic Model Market Discipline Private Information Bank Competition Efficiency & Policy

30. Efficiency
Marginal benefit of increasing πA
Bank Competition: Market Discipline − Hirshleifer effect
− Information Externality
Social Planner: Market Discipline − Hirshleifer effect
+ Information Externality
⇒ Market allocation too opaque, risk of a bank run
inefficiently high
Higher number of banks reduces information externality
⇒ bank competition increases transparency (see Jiang, Levine,
Lin, 2014)
Introduction Basic Model Market Discipline Private Information Bank Competition Efficiency & Policy

31. Efficiency
Marginal benefit of increasing πA
Bank Competition: Market Discipline − Hirshleifer effect
− Information Externality
Social Planner: Market Discipline − Hirshleifer effect
+ Information Externality
⇒ Market allocation too opaque, risk of a bank run
inefficiently high
Higher number of banks reduces information externality
⇒ bank competition increases transparency (see Jiang, Levine,
Lin, 2014)
Introduction Basic Model Market Discipline Private Information Bank Competition Efficiency & Policy

32. Policy
Transparency ’ex ante’:
e.g.: public disclosure requirements, regular stress tests
generally has interior solution π∗
∈ (0, 1)
optimal transparency policy reduces risk of a bank run
(through market discipline)
Introduction Basic Model Market Discipline Private Information Bank Competition Efficiency & Policy

33. Policy
Transparency ’ex ante’:
e.g.: public disclosure requirements, regular stress tests
generally has interior solution π∗
∈ (0, 1)
optimal transparency policy reduces risk of a bank run
(through market discipline)
Transparency ’ex post’:
e.g.: stress test during a crisis
reveal iA and iB in the interim period
beneficial if policy maker only cares about avoiding bank
runs
harmful if discretionary policy maker also tries to reduce
credit spreads of banks which do not face a run
Introduction Basic Model Market Discipline Private Information Bank Competition Efficiency & Policy