REGULATING SYSTEMIC RISK

Barcelona GSE Lecture

Banc Sabadell,

March 31, 2011

Jean Tirole

I. INTRODUCTION

Background

1. Banking and euro crises; realization that macro-policies andmicro-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 stabilityof the financial system”.

Financial Stability Oversight Council (FSOC)[July 21, 2010/Dodd-Franck Act.]

2

Macro-prudential policies: definitions and rationales

Interpretation # 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 heldhostage by an institution or by the financialsystem as a whole.

Interpretation # 2: Regulate to correct market failures in financialmarkets.

Which is the proper interpretation ?

3

# 1 “Macroprudential policy focuses on the interactions betweenfinancial institutions, markets, infrastructure and the widereconomy. It complements the microprudential focus on therisk position of individual institutions, which largely takesthe 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 animpairment of all or parts of the financial system and has thepotential to have serious negative consequences for the realeconomy”.

[Committee on the Global Financial System, paper 38, emphasis added.]

4

Outline

II. Financial stability: meaning and mandate/policies

The multiple facets of financial stability. Many differentphenomena are regrouped under this heading.

The toolkit: depends on what is meant by “macro-prudentialsupervision”.[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 FINANCIALSTABILITY OR SYSTEMIC RISK

1. 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 whammy

Basic investment equation:

pledgeableincome

it =ρ0it

1 + rt+1︸ ︷︷ ︸ + At︸︷︷︸ or it =At

1− ρ0

1 + rt+1fundingliquidity

hoarded/marketliquidityor net worth

Bubble 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 byhigh-leverage entities.

Who holds the bubble?

Theory : low-leverage entities ( ρ0 small: private equity, familyfirms, ...) should hold the bubble, because they arerelatively less subject to double whammy.

Recent crisis : high-leverage entities, because counted on governmentbailout (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 notthe right instrument;

prudential and fiscal policy:

control new investments: Loan to Value/Debt to Incomeregulations, stop subsidies to home ownership;control risk to net worth: provisioning (countercyclicalbuffers 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 currencydenominated.

Makes it difficult to devalue: liabilities of the private andpublic sectors are then inflated.

Capital flow volatility. Run on the country.

Trade-off between country commitment and countryrisk 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: adddomestic/foreign held ratio.[e.g., Tirole 2003 and Broner-Ventura]

11

(ii) Level of borrowing : Public debt + bank debt that later will becomepublic debt[Spain, Ireland]

Toolkit capital controls, monitoring of share of foreigncurrency loans*, capital adequacy requirements(increase capital requirements to reflect FX-related risk), ...

surveillance of competitiveness, prudentialregulation 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 sellwinners/keep losers. Accounting rules are then appropriatetool.[Related argument: keeping losers akin to gambling for resurrection: Diamond-Rajan.]

(ii) Shortage of buyers with sufficient financial muscle (“localliquidity”)[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 worthfire sales.

[Brunnermeier-Pedersen]

Toolkit limit fire sales. Hanson-Kashyap-Stein 2010 variant ofthis argument: ask for recapitalizations; do not givechoice 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 sogovernment 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 marketplace, which then command a very high price. Anticipatingthis....

Government should optimally buy back weakest assets, thentake a partial stake in some intermediary-quality assets (leavingthem on the institutions’ balance sheets), the firms with the bestassets 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 sheetand take correlated risks (e.g., on a real estate bubble), thenauthorities have no choice but engaging in triple-play bailouts:

monetary (low interest rates),accounting (reclassification), and“fiscal” (acceptance of low-quality collateral, equity injections, loanguarantees, ...)

[Farhi-Tirole on “Collective Moral Hazard, Maturity Mismatch and Systemic Bailouts”;

Diamond-Rajan].

Toolkit Regulation of liquidity (liquidity coverage and net stablefunding ratios; contingent capital; etc.), with an eye on theentire 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 arevery 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 theway it is applied:

LT-liabilities institutions,

exit price: value of asset in contingency of default verydifferent from the current value.

Need more research on this crucial point.

17

Countercyclical capital buffer (proposal of Basel Committee)

Basis: deviations ofcreditGDP

ratio from trend

(“excess credit growth”).

Repullo:creditGDP

gap is negatively correlated with business cycle.

Downturns: GDP growth slow or negative, credit demandcontinues + firms draw on credit lines.

Measurement: financial innovation (securitization).

More generally, ratio has only a tenuous link with theoreticaldeterminants of riskiness =⇒ Basel committee offers “supervisoryjudgement” (guidelines?).

18

6. Cross-exposures and contagion

Well-known that OTC markets, by making commercial banksexposed, in an opaque way, to the failure of investment banks(including AIG holding) allowed the latter to rely on access totaxpayer money (the prospect of a bailout allowing them tokeep borrowing up to the end).

Toolkit : Central clearing counterparty. [Need to be closelysupervised: TBTF. US FSOC’s emphasis on monitoring of“financial market utilities” is warranted.]

19

Systemically important intermediaries

Argument cuts across various arguments above.

Boundary problem :[FSOC: mandate to designate systemically important financial firms.]

If default is what preoccupies authorities, not clear thatoverarching regulation is solution: migration to hedge funds,private equity firms, energy companies, etc.

Measuring interconnectedness : Better to protect regulatedsphere against default by lightly regulated or unregulatedentities. Good data on cross-exposures requireexchanges/standardized products.

20

III. THE INSTITUTIONS OFMACRO-PRUDENTIAL SUPERVISION

Particular focus on ESRB (some applies also to FSOC).

(a) Communication policy

X Friend...

consolidates information (example: points at mutuallyinconsistent plans)(more cynical view) management consultant

X ... 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)

Warnings&

recommendations

(2)

“Act orexplain”

(3)

Can makerecommendationspublic (afterinformingCouncil).

X May affect how much information ESRB receives fromNSAs.

22

X Conundrum

how can one put pressure on NSAs without making informationpublic?

making information public raises possibility of runs and freezes[FSOC: “closed portion of meeting if disclosure of information could lead to

instability/financial speculation.”]

X Incentives

assessment of performance and accountability[in case of transparency, measurement of risk affects it.]

career/legacy concerns: incentive to cry wolf? Speedof 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 financialinstitutions and cross-border crises)

1. Reporting (NSAs to, say, ESRB)

2. Subsidiarity in policy-making

prudential regulation (think of Ireland)deposit insurancemonetary 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