Banking, Fragility and Regulation

Xavier VivesIESE Business School, Barcelona

Bologna, September 2013

Proportion of countries with banking crises: 1900-2008

Weighted by their share of world income

World War I

The Panic of 1907

The Great Depression

The First Global Financial Crisisof 21st Century

Emerging Markets, Japan, the Nordic Countries, and US (S&L)

Perc

ent o

f cou

ntrie

s

Source: Figure 1 in Reinhart & Rogoff (2008), “Banking Crises, An Equal Opportunity Menace”, NBER WP 14587.

Is the current crisis similar or not to past crises?

• Both the past and the current crises have in common – maturity mismatch – contagion through interbank exposures – and coordination problems:

• participants in the interbank market and in the commercial bond market do not renew their credit because of fear others will not either.

• Contagion exacerbated by market channels: liquidity crisis?

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Managing liquidity or controlling solvency?

• Great Depression– Lack of attention to liquidity (Friedman and

Schwartz)• Great Recession

– Lack of attention to solvency?• European banking problems are liquidity problems• Draghi’s put and the euro fragility as a self-fulfilling

crisis• Greenspan put as precursor

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Banking crises

• Theory:– Panics– Information on fundamentals– Both

• Evidence– Panics: Friedman and Schwartz– Fundamentals– Both

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Some underlying factors in the crisis• Trends

– Increase in competition/liberalization– Decrease in liquidity ratios– Decrease in capital ratios (up to Basel II)

• Balance sheets with increased – short term market funding– maturity transformation– opaqueness

• Amplification channels:– Negative feedback loops– Large impact of public (bad) news

• ABX index• IndyMac Bancorp’s bank run in June 2008 follows public release of

letters by Senator Schumer • Stigma from borrowing at the discount window• Credit ratings

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Increased competition for banksDistribution of US financial assets by main types of

financial intermediaries

Distribution of Eurozone financial assets by the main types of financial intermediaries

Source: Eurostat

Source: Adrian-Shin (2010)

The weight of historyCapital ratios for UK and US banks

Source: Banking of the State, Bank of England, Nov 2009. (FT Lex, Jan 23, 2010)

Source: Veronesi and Zingales (2009), Paulson’s Gift. Data: Sep. 30, 2008*, for Goldman Sachs and Morgan Stanley as of 08/31/2008.

Stable funds vs. other (US banks)

SIV

Assets Liabilities

Conduits

Source: GFSR (April 2008), IMF.

Typical SIV and Conduits’ Balance Structure

Source: Adrian-Shin (2010)

Challenge for regulators• Disentangle liquidity from solvency risk• Some regulatory proposals:

– BIS (2009): Introduction of liquidity requirements/limit maturity transformation

– Dodd-Frank Act (2010): introduces a leverage limitation for financial holding companies above a certain size.

• Debate:– Should liquidity and solvency/leverage requirements

be related?– How far should we go on transparency?

• Role of credit agencies– How to deal with derivatives markets? Do they

increase fragility?Xavier Vives

Two examples of runs

The 2007 run on SIV

The 2007 run on SIV• The run began on ABCP conduits and SIVs which

had some percentage of securities backed by subprime mortgages.

• These vehicles were funded with short term maturity paper and the run amounted to investors not rolling over the paper.

• The run seems to have been triggered by an unexpected decline in the ABX indexes in 2007.

The accumulated bad news in the ABX indexes culminated in the panic of August 2007 when BNP Paribas froze a fund because of a complete evaporation of liquidity in some segments of the US securitized market.

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ABX index • Launched in January 2006 to track the evolution

of residential mortgage-based securities (RMBS).

• The index is a credit derivative based on an equally weighted index of 20 RMBS tranches(and there are also subindexes of tranches with

different rating, for different vintages of mortgages). • The ABX index has provided two important

functions: – information about the aggregate market valuation of

subprime risk, and – an instrument to cover positions in asset-based

securities, for example by shortening the index itself (Gorton (2008, 2009)).

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SIV 2007 run

• The public signal is the price of a derivatives’ market with RMBS as underlying asset (ABX index).

0t SIV formed with I RMBS

1 2t / Public signal p released

2t return on RMBS unit realized

1t Funds managers receive private signal and decide on CD renewal

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Run on sovereign debt

• The public signal may be a credit rating

0t Invest I D0: ST external debtM:safe reserves

1/2t Public signal P released

2t return

realized

1t Funds managers receive private signal and decide on debt rollover

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A framework of analysis

A binary action Bayesian game of strategic complementarities

Best response, SC and multiplicity

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Coordination failure, illiquidity risk and solvency risk

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SIV run• Introduction of the ABX index implies a discrete increase in

the public precision which raises strategic complementarity.

• A high level of noise in the signals will also increase strategic complementarity.

– Imprecise signals of SIV investors are likely given the opaqueness of the structured subprime products and distance from loan origination

• When bad news strike then a run equilibrium is induced.

• The impact of the bad news is magnified since short-term leverage and the cost of funds (because of competition) were high and fire sales penalties for early asset sales became high during the crisis (all those factors make strategic complementarity high).

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Regulating liquidity and solvency

A regulator that wants to control probabilities of insolvency and

illiquidity

Solvency (S ) and liquidity (L) constraints to control probabilities of insolvency and illiquidity

with a solvency (inverse short-term leverage ratio) ( 1 E D ) and a liquidity ratio (m M D )

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Regulatory implication SIV• Low private precision and conservative

investors call for increased liquidity requirement when there is more transparency (derivatives market)

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Prudential policy in a MU

• To limit risk of country insolvency and illiquidity constraints must be put on short-term external leverage and the ratio of safe reserves.

• The prudential constraints have to be adjusted in the presence of public sovereign credit ratings.

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Summary of results• Probability of failure increases with

– balance sheet stress (short-term leverage, low liquidity, high return on short-term debt);

– market stress (fire sales penalty, more conservative investors), and with

– the precision of public information when fundamentals are weak.• Fragility (equillibrium sensitivity to small changes and

possibility of discrete jumps) increases with SC:+ short-term leverage, competition, fire sales penalty, precision of

public information• Higher disclosure or introducing a derivatives market

may backfire, aggravating fragility (in particular when the asset side of a financial intermediary is opaque).

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Policy implications: a piecemeal approach will not work

• The regulator needs to look at the composition of the balance sheet of a financial intermediary and to the degree of transparency to control the probabilities of insolvency and illiquidity:– Liquidity and leverage requirements are partially substitutable and

have to be set together:• In an environment with high market illiquidity and conservative

investors the liquidity requirement has to be tightened while the solvency one relaxed.

– Prudential constraints may have to be modified with higher transparency (e.g. with stricter liquidity requirement, relaxed solvency).

• Competition policy and prudential regulation are not independent: In a more competitive situation leverage limits have to be strengthened.

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Background references• Vives, X. (2005), "Complementarities and

Games: New Developments", Journal of Economic Literature, 43, 2, 437-439.

• Vives, X. (2008), Information and Learning in Markets, Princeton: Princeton University Press.

• Vives, X. (2011), “Competition and Stability in Banking”, in Monetary Policy under Financial Turbulence, Proceedings of the Annual Conference of the Central Bank of Chile.

• Vives, X. (2013), “Strategic Complementarity, Fragility, and Regulation”.

See http://webprofesores.iese.edu/xvives

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