Riding for a fall? Concentrated banking with hidden tail risk
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Riding for a fall? Concentrated banking with hidden tail risk
Marcus Miller, Lei Zhang and Han Hao LiUniversity of Warwick
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Independent Commission on Banking (ICB):background and mandate
• ‘The global financial crisis that began in 2007 has exposed fundamental weaknesses in banking systems and related financial markets. Major financial institutions, including in the UK, were saved from failure only by massive government support schemes. Others were taken over by competitors, or collapsed. ‘
• ‘Securing a stronger and better functioning financial system is the goal of a range of public policy initiatives.’
• ICB established June 2010 to make recommendations by Sep 2011 on ‘measures to promote stability and competition in banking for the benefit of consumers and businesses
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ICB :Call for Evidence
• Warwick group of 5 – including Sayantan Ghosal, Peter Hammond and Michael Waterson as well as two of the current authors - responded to the ‘Call for Evidence’ last year.
• 150 Submissions available on ICB website. • What follows is based on the paper attached to
our Evidence - revised for presentation at RES Conference in April.
• Comments and suggestions welcome !
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Financial crisis and support packages, Haldane (2009)
UK GDP in $ is $2.28 trillions approx.Exchange rates used: FSR Euro / US dollar exchange rate of 0.710. Sterling / US dollar exchange rate of 0.613.
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How UK banking sector grew from half to five times annual GDP
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How leverage has increased from 20 to 40
08.0
AssetsTotalAssetsWRisk
CapitalAssetsTotal
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Evidence of a “productivity miracle” in finance?
The share of banking in Gross Value Added rose from 5% in 1970 to 8% in 2008, but the share of profits in economy-wide profits rose 10 fold (from 1.5% to 15%).
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UK Banks
Excess risk-taking (‘gambling’)
‘Skin in the game’
Too Big To Fail
?
Outline of argument
Franchise Value
Concentration
Capital buffers + Competition
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J. Stiglitz, born 1943M. Friedman 1912-2006
I. Fisher 1847-1947
J. M. Keynes 1883 – 1946
K. Marx 1818-1883
Money Matters – how and why?
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Two period endowment economy, short and long assets and early and late consumers with
preference uncertainty.
Proposition 1 : The optimal competitive banking contract
satisfies the first order condition for inter-te mporal efficiency, ,
satisfies the zero profit condition, .
This contract has the feature that: .
(for convenience, we assume risk aversion to be greater than 1).
NOTE : The Modigliani-Miller Theorem applies : so capital structure may be varied without any
implications for the asset side of the balance sheet :
Diamond & Dybvig / Allen & Gale workhorse model of competitive banking – and bank runs
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A
Market equilibrium
Competitive banking
Iso-EU
Inter-temporal efficiency
Participation constraint
Figure 1. Competitive banking: Diamond & Dybvig, Allen & Gale
R
1
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Competitive banking
A
Market equilibrium
Iso-EU
Inter-temporal efficiency
Figure 3. Competitive banking: Portfolio allocation
x y 1
R
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Proposition 2:
The optimal monopoly banking contract
satisfies the FOC for inter-temporal efficiency, ,
satisfies participation constraint, .
This contract exists if and only if and it must satisfy .
Monopoly bank that does not gamble but widens its spread on intermediation
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Monopoly bank
A
Market equilibrium
Competitive banking
Iso-EU B
‘Monopoly Profit’
Inter-temporal efficiency
Participation constraint
Figure 2. Competitive and monopoly banking with no gambling
S
R
1
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Proposition 3:
(1) An increase in will increase the value of the outside option. Consumption at date 2, ,
increases, with a rising spread between and .
(2) An increase in , the fraction of early consumers, has no effect on the outside option. So goes
down and goes up.
(3) An increase in the utility, , associated with the outside option will result in an increase in
consumption in both dates.
In their chapter entitled ‘ What is the contribution of the financial sector? in The Future of
Financ, Haldane et al (20100 consider two different interpretations of the` sharp rise in value added
in banking: Miracle or Mirage?
Monopoly bank: comparative statics
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A positive productivity shock!
B’’
N
A’
B’
B
A
New market equilibrium
Inter-temporal efficiency with R
Participation constraint
R
R’
Inter-temporal efficiency with R’>R
New participation constraint
N’
1
Productivity miracle
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Proposition 4:
(1) If the bank uses the risky technology, and if , then the optimal
contract is a solution to and .
(2) If , the optimal deposit contract is the same as that in Proposition
1.
Note: Because it assumes no tax distortions, transactions costs, agency problems, or asymmetries of
information, Modigliani and Miller theorem (1958) does not apply.
Monopoly bank that gambles with “fake alpha” investment*
* As in Rajan (2005, 2010), and Foster and Young (2010).
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N
A’
S
B
B’’ A
Market equilibrium
Inter-temporal efficiency condition
Monopoly with tail risk
Participation constraint
1
R
A productivity ‘mirage’: monopoly banking with tail risk
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Mixture of miracle and mirage
B’’
N
A’
B’
B
A
New market equilibrium
Inter-temporal efficiency with R
Participation constraint
R
R’
Inter-temporal efficiency with R’>R
New participation constraint
N’
1
Productivity mirage
Productivity miracle
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Rising incomes in financial services and inequality
Cumulative fraction of income
Cumulative fraction of population from lowest to highest incomes 1-σ 1
1
Figure 4: Gambling and Gini Coefficient: Miracle or Mirage
O
P
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No Gambling Condition: and ‘mimicking’ as in Foster and Young (2010)
Taking on ‘tail risk’ Gambling
Figure 4. No-gambling-condition (NGC) and the mimicking constraint
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Capital Buffers, Franchise Value and Gambling
M
Gambling
No Gambling
Capital buffers
Franchise value
L
N'
Higher tail risk
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Impact of “Too Big To Fail”
Capital Buffers
Gambling
No Gambling
Concentration TBTF
Gambling
Figure 6. How bailouts increase the risk of imprudent banking
L
R
N'
UK
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Capital Buffers
Gambling
No Gambling
Concentration TBTF
Gambling
Figure 6. How bailouts increase the risk of imprudent banking
L
R
N'
UK Re-regulation
Resolution
Steps to promote competition and stability
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Martin Hellwig et al. (2010)
• Banks’ high leverage, and the resulting fragility and systemic risk, contributed to the near collapse of the financial system. Basel III is far from sufficient to protect the system from recurring crises. If a much larger fraction, at least 15%, of banks’ total, non-risk-weighted, assets were funded by equity, the social benefits would be substantial. And the social costs would be minimal, if any.
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David Miles et al (2010)
• It is remarkable to note that our central estimate for the marginal cost and benefit of higher capital suggests an optimal capital ratio of about 50% of risk weighted assets – which might mean a capital to total assets ratio of around 17% and leverage of about 6. This would be about 5 times as much capital – and one fifth the leverage – of banks now.
(Setting aside risk of GDP fall, our central estimate of optimal capital is 19% of risk-weighted assets. )
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Need for reform: Diane Coyle (2011).
• ‘The truth is that banks are again doing well out of banking, but businesses and consumers are not... Bonuses are back... they are a measure of monopoly rents in the business, it does not take great talent to make a profit by taking excessive risk, safe from effective competition and sure of a bail-out if needed.’
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Haldane on the history of banking*
• ‘In the Middle Ages… the biggest risk to the banks were from the sovereign. Today, perhaps the biggest risk to the sovereign comes from the banks.’
Andrew Haldane is Director of Financial Stability at the Bank of England
*P. Alessandri and A. Haldane (2010) ‘Banking on the state’, Bank of England
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Structure of paperUsual assumptions (DD&AG)
Market conditions This paper
Market structure Competition Concentration Competition – and monopoly
Information Symmetric Asymmetric Symmetric – and Asymmetric
Liabilities Retail Deposits: short and long
Deposits: retail and interbank deposits
Retail Deposits: short and long
Assets Loans Retail lending (Household and SME) and Wholesale
Retail or wholesale
Market failure: multiple equilibria
Bank runs Bank runs (e.g. Northern Rock)
Bank runs
Market failure: agency problem
N/A Excessive risk taking Gambling with asymmetric information
Policy N/A Low capital buffers, insolvency followed by bailout and/or nationalisation
Insolvency, bailouts and capital buffers
Footnote: liquidity problems sidestepped
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Banks v Hedge Funds : battle of the giants Banks Hedge funds Deposits Insured deposits Investment by qualified
investors with limited partnership
Liability Limited Liability Partners with unlimited liability
Leverage
High: 30 -40 Low: less than a tenth of that of the largest global banks*
Profits (net, 2010 H2) FT Wed March 2, 2011.
$26b (Goldman Sachs, JPMorgan, Citi, Morgab Stanley, Barclays, HSBC)
$28b top 10 (inc Quantum, Paulson)
* Source: Haldane (2009, p. 9)’Banking on the state’, Bank of England, who comments:
(a) the structure of the hedge fund sector has emerged in the absence of state regulation and supports ;
(b) it might be that the structure of this sector [has]delivered greater systemic robustness than could be achieved through prudential regulation.
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Karl Marx
Mike Artis