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Financial System Diversity and Macroprudential Policy. Preliminary. Not to be circulated without permission of the authors and the Bank of Canada. Kartik Anand , Etienne Bordeleau , Mark Carney & Prasanna Gai. Roadmap. Motivation Model set-up Key propositions/results - PowerPoint PPT Presentation
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Financial System Diversity and Macroprudential PolicyPreliminary. Not to be circulated without permission of the authors and the Bank of Canada
Kartik Anand, Etienne Bordeleau, Mark Carney & Prasanna Gai
Roadmap
Motivation Model set-up Key propositions/results Comparative statics – role of macroprudential policy Some empirical connections – Canada and the US
Comments welcome!
Motivation
“…A bank may consider a course of action it wishes to take to be acceptable – as it may well be in a limited context. But the same course might, if widely copied by other banks, have unfortunate effects on the banking system as a whole. It is part of the supervisors’ job to take that wider, systemic view and sometimes to curb practices which even prudent banks might, if left to themselves, regard as safe.”Sir George Blunden, Deputy Governor, Bank of England
Motivation
What drives the choice between market versus bank-finance?
Under what circumstances do financial firms pursue the same business strategy (increasing collective exposure to systemic risk as they individually diversify idiosyncratic risk)?
How to characterise notions of “risk illusion” (e.g. Boivin/Carney/Tucker)?
How might “macroprudential” policies shape the diversity of business practices and temper risk illusion?
Different policymaker perspectives...
“with exposures largely staying on balance sheet, Canadian bankers remained bankers rather than warehousers...”, Mark Carney
“Australian banks displayed...more conservative lending practices and...better lending decisions.”, Glenn Stevens
“Banks’ balance sheets, like Tolstoy’s happy families, grew all alike...At the height of the boom, financial imitation turned into near-cloning.”, Andy Haldane
– Our framework seeks to nest these views.
Points of contact with the policy debate
UK-style “ring-fencing”
Capital requirements for trading books
Credibility, transparency, and standards for securitization
Design of shadow banking regulation
Role of central bank facilities, backstops
Main ideas Nothing wrong in securitization per se. Choice of market or bank
finance arises as banks balance gains from trade versus costs of monitoring
• decision depends on a bank’s perceptions of macroeconomic risks which, in turn, colour its views on the quality of collateral
But pooling equilibria are possible. These mean that “optimists” and “pessimists” can mimic each other for certain parameter values. System-wide fragility can result.
Different macroprudential tools can have quite different consequences for the nature of financial intermediation
Points of contact with the literature Builds on Plantin (2011), Park and Sabourian (2011), Rabin and
Schrag (1999) Shadow banking and lack of system diversity (Haldane-May, 2011;
Gennaioli-Shleifer-Vishny, 2011a, Beale et.al, 2011) Financial innovation, “local think” (Gennaioli-Shleifer-Vishny, 2011b)
Relatedly... Information sensitivity of securities (DeMarzo-Duffie, 1999; Dang-
Holmstrom-Gorton, 2009) Credit booms and busts as coordination failure (Rajan,1994; Aikman-
Haldane-Nelson, 2010) Incentives, tranche retention, transparency (Chiesa, 2008; Fender-
Mitchell, 2009, Pagano-Volpin, 2010)
Model Set-up Three dates: t = 0, 1, 2. One risk-neutral bank and
passive end-investors
Bank receives an initial endowment at t=0, which it invests in illiquid assets (loans) that pay out at t=2
Bank is impatient, so there are gains from trade to exploit
Three states of the world, θ, corresponding to boom (H), normal (M), recession (L)
Loans are either good or poor in quality – good loans repay with probability 1, poor loans always default
Let α be the fraction of good quality loans– a random variable that is (high, low)
Information structure Bank receives a signal, S, about the state of the
macroeconomy. And an independent signal, Q, about loan quality.
Signals on macroeconomic risk are “U-shaped” in the spirit of Park and Sabourian (2011)
Signal on the macroeconomy “colours” the view on underlying collateral of the loan :
Confirmatory bias in the spirit of Rabin and Schrag (1999)
Interim monitoring
Bank can invest in lending relationships further via interim monitoring between dates 1 and 2.
Cost of interim monitoring, M > 0, (= benefits lost from not shirking).
Effects of monitoring– Loan repayment rates improve in slowdowns by amount p.– Prevents repayment rates deteriorating in recessions
14
Fraction of loan book that pays off for the bank
Result (1) At t=1, bank decides if it wants to securitize its entire loan
portfolio and abstain from monitoring, or retain a stake and monitor (partial securitization).
– Updates its beliefs on the quality of borrowers and state of the economy based on private signals
– Compares expected value of portfolios under the two alternatives.
Trade off between gains from trade from securitization versus incentive to monitor.
Comment– outcome is constrained efficient.– As discount rate (r) increases, bank pursues market-based
finance
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Result (2) – “Frontiers” of intermediation
We seek bounds to the parameters in Result 1 that describe when both “types” of bank will either opt for
• Holding a stake and monitoring• selling the loan portfolio in its entireity
Extent of this depends on expected fraction of good loans perceived by the (biased) bank.
18
“Frontiers” for market/bank-based finance and financial system diversity
19
Comparative Statics (1): Lowering monitoring costs for the optimist
20
Comparative Statics (2): Lowering monitoring costs for the pessimist
21
Comparative Statics (3): The dark-side of credibility
Comparative statics (4): Black box to open source
Risk illusion versus local think
Local think: agent neglects certain low probability states of the world. I do my Bayesian updates over selected sub-set of states (those which occurred often in the past)
Risk illusion: U-shaped beliefs mean that I discount some information content in my private signal on macro risk. The consequences amplify as information on loan quality and central bank communications get misinterpreted
Stylised facts: US and Canada
1980 1981 1983 1984 1986 1987 1989 1990 1992 1993 1995 1996 1998 1999 2001 2002 2004 2005 2007 2008 20100%
10%
20%
30%
40%
50%
60%
Canada U.S.
%
Securitization as a share of total household credit
Last observation: 2010Q3Source: Bank of Canada, Federal Reserve Board, Federal Reserve Bank of Australia
Bank-based and market-based intermediation
1980 1981 1983 1984 1986 1987 1989 1990 1992 1993 1995 1996 1998 1999 2001 2002 2004 2005 2007 2008 20100
1000
2000
3000
4000
5000
6000
7000
8000
0
100
200
300
400
500
600
700
800
U.S. - Bank Based (left) U.S. - Market Based (left) Canada - Bank Based (right) Canada - Market Based (right)
$bn $bn
Mortgage Markets
Last observation: 2010Q3Source: Bank of Canada and Federal Reserve Board
Screening and origination standards
2005
2005
2005
2005
2006
2006
2006
2006
2007
2007
2007
2007
2008
2008
2008
2008
2009
2009
2009
2009
2010
2010
2010
2010
0
5
10
15
20
25
30
Commercial Banks RMBS
%
Delinquency Rates on Residential MortgagesU.S.
Last observation: 2010Q4Bloomberg and Federal Reserve Board
Securitization of insured mortgagesCanada - NHA-MBS U.S. - GSE and agency MBS
LTV range 80%-95% 80%-96.5%
Translates into a leverage of: 5-20 5-28.6
Insurance coverage Full amount of the loan Losses exceeding the 80% LTV ceiling
Minimum credit score 620 620
Debt to income ratio requirements: Housing costs Total debt
32%40%
28% 36%
Share of securitization market as of 2005Q4 84% 66%
Risk illusion and securitization – 1
2001
2001
2001
2001
2002
2002
2002
2002
2003
2003
2003
2003
2004
2004
2004
2004
2005
2005
2005
2005
2006
2006
2006
2006
2007
2007
2007
2007
100
200
300
400
500
600
700
800
900
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
4.5%
High Yield - Investment Grade Bond Spread (left) Net Securitization income as a % of non-interest income (right)
basis points %
Search for yield and risk illusion
Last observation: 2007Q4Source: Federal Reserve FRY-9C Report & Merrill Lynch Bond Indices
Risk illusion and securitization – 2
U.S. Canada
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20-0.004
-0.002
0.000
0.002
0.004
0.006
0.008
0.010
<Chart #>:Shock to Risk IllusionResponse of Securitization/bank credit outstanding
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20-0.004
-0.002
0.000
0.002
0.004
0.006
0.008
0.010
<Chart #>:Shock to Risk IllusionResponse of Securitization/bank credit outstanding
Points of contact with policy -- revisited
Universal banks or UK-style “ring-fencing”?
Differential capital requirements on the trading book and the SIFI debate.
Communication, transparency, and financial stability.
Drawing perimeters for shadow banking
Thank you!