Preventive policy means targeting incentives over cycle

Enrico PerottiUniv Amsterdam, DNB and DSF

Basel III From exogenous to endogenous risk control

• Statistical view of risk in Basel II, independent of rules and cycle

• No account of incentives; bank equity as pure buffer; exogenous correlation

• Market liquidity never a problem• But risk creation evolves with risk shifting

incentives

Some lessons to learn1. When credit expands fast, incentives for

more correlated investment choices• Self reinforced via prices bubbles • Correlation increases chance of bailout

2. Excess credit growth feeds on short term funding

– Favored by reduced monitoring

3. Risk incentives not linear• Once capital falls below some threshold,

risk preferences jump

A preventive risk control policy must be incentive-based

•Ensure a opportunity cost of gambling by using risk sensitive instruments

•equity•long term funding

•Induce investors to keep risk bearing as risk increases: more equity, long term debt

•Fully charge for risk externalities

Concrete examples

• Ensure countercyclical ratios at the system level

• Design CoCo to have early conversion thresholds

• Raises gambling cost in good times• Slow down carry trades in exhuberant

markets by taxing unstable funding

Prevent, not absorb

Choose equity ratios not as buffers, but as tools to align incentives

Contain risk creation early on. Trigger adjustment to funding to restore incentives when they deteriorate

Measure precisely few critical risk factors, track them closely

Signal early on any risk build up, enabling markets to question it before too large, least disclosure may lead to panic.

Optimal liquidity regulationQuantity versus price policy

(Perotti Suarez, 2010)

Price (liquidity charges): • Solvent banks use too much short term funding

as they do not feel all liquidity risk costs • Pigouvian charges aligns private and social

costs, still allows better banks to lend more

Quantity (capital or funding ratios)• Low charter value banks may gamble (risk shift

to deposit insurance), not deterred by levies• Here, better quantity constrains. Capital ratios

contains risk shifting (low charter value banks)

Liquidity buffers

• Liquidity buffers least efficient– As ratios, disadvantages better lenders

– Net liquidity risk is the same (unless liquidity costly, then it is a tax)

– Main net result is subsidy to Treasury bills at cost of funding cost for banks

– Keeping incentives stable requires adjusting buffers to risk spreads

Limit risk incentives with CoCos

Avoid discontinuity of CoCo prices at conversion. Conversion at par is simple, harder to game, avoids multiple equilibria

Conversion at market value (implying more dilution) ensures bankers will become careful earlier, contain increased risk incentives

A gradual conversion scheme so that triggers occur before problem is large, limit market response

Summary

Quantity instruments (capital ratios, net funding ratios) best to contain gamblers

Price tools (eg liquidity charges) increase opportunity costs of strategies with externality effects

Price tools easier to adjust than ratios

Price tools should be used with higher frequency for preventive goals

Liquidity Risk Regulation: Quantity versus Prices

• Losses in liquidity crisis larger if aggregate ST funding larger (forces faster fire sales)

• Banks differ in – credit assessment (incentive to expand lending)– charter value (incentive to remain solvent; limits

gambling)

• Short term funding only way to boost credit • Both good credit banks and low charter

banks want to expand credit more

Levies contain solvent banks

• Solvent banks borrow more short term than socially optimal as they do not internalize the liquidity risk externality

• Better banks wants to lend more

• An optimal liquidity charge corrects by adjusting private cost

Advantages of prices and ratios

Price: • Solvent banks expand loans too much as they

do not feel all liquidity risk costs • Liquidity charges allows better banks to lend

more than others

Quantity (capital or funding ratios)• Low charter value banks take zero NPV gambles

(risk shift to deposit insurance)• Capital requirement screen out pure risk shifting

banks (low charter value banks)