Economic Theory and Lender of Last Resort Policy V. V. Chari & - PowerPoint PPT Presentation

Economic Theory and Lender of Last Resort Policy V. V. Chari & Keyvan Eslami University of Minnesota & Federal Reserve Bank of Minneapolis October 2017

What Makes Banking Special? Not so much the assets they hold Liabilities of banks are disproportionately short term debt Good reasons to think that private costs/benefits different from social costs/benefits Deposit insurance, bailouts, financial frictions Regulation should focus on what kinds of assets should be backed by short term debt Chari & Eslami Economic Theory & Lender of Last Resort Policy

Common Medium of Exchange Socially Valuable Avoids double coincidence of wants Think of medium of exchange as fiat money or gold Assume medium of exchange bears no interest Will refer to medium of exchange as money Chari & Eslami Economic Theory & Lender of Last Resort Policy

Medium of Exchange and Private Incentives Trusted intermediaries (banks?) offer “deposits” Deposits are promises redeemable in money May come to be used in many transactions Effectively becomes medium of exchange Works only if financial frictions “large” Chari & Eslami Economic Theory & Lender of Last Resort Policy

The Value of Deposits as Medium of Exchange Most of the time not all people will redeem simultaneously Can use idle assets to invest in high return projects Can offer interest rates on deposits or other services Socially valuable High return projects funded by idle assets Chari & Eslami Economic Theory & Lender of Last Resort Policy

Deposits, Illiquidity, and Banking Panics Fragile system If everyone else runs to the bank, I should too Multiple equilibria Historically handled by Suspension of convertibility Deposit insurance Lender of last resort Chari & Eslami Economic Theory & Lender of Last Resort Policy

Policy and Banks All of these policies create incentives to take on risk Moral hazard Problem Tough to tell illiquidity from insolvency Need some sort of regulation Chari & Eslami Economic Theory & Lender of Last Resort Policy

Radical Policies Pawnbroker of last resort Swedish idea: nationalize 3 of 4 banks, quickly return to new equity holders Reminiscent of Resolution Trust Corporation in the US Contrast with Japan: Zombie banks lending to zombie firms, lots of forbearance Chari & Eslami Economic Theory & Lender of Last Resort Policy

Nerd Notes I Framework different from that in celebrated Diamond-Dybvig paper D&D mechanism does not really work if illiquid assets are widely held outside banking system Framework closely related to Chari-Phelan They show that when financial frictions are large, mechanism described here is socially efficient When financial frictions small, outcome is still an equilibrium but not efficient Chari & Eslami Economic Theory & Lender of Last Resort Policy

Nerd Notes II Should really think of banking panics as rollover crises In 2008 crisis, short term uninsured creditors refused to roll over their debt Message of rollover crisis literature is to shif to long term debt Private agents may continue to issue short term debt if they think they will be bailed out Chari & Eslami Economic Theory & Lender of Last Resort Policy

Market Collapses as a Source of Fragility Adverse selection story Originators/holders of assets beter informed than buyers Holders sometimes need to sell for liquidity/diversification reasons In normal times, buyers offer a price that breaks even in expectation If buyers think only bad assets will be sold will offer a low price Good assets will not be sold Nice story but questionable economics Chari & Eslami Economic Theory & Lender of Last Resort Policy

Market Collapses as a Source of Fragility Chari, Shourideh, & Zetlin-Jones show market collapses can occur in a dynamic reputation based model But also show that such collapses may be part of an efficient allocation Bailouts do not induce good assets to be sold They simply transfer money to holders of bad assets Chari & Eslami Economic Theory & Lender of Last Resort Policy

Lender of Last Resort Proposals Evaluated Private incentives for “shadow banks” to offer media of exchange Ring fencing effectiveness limited “Sharia” law on unregulated entities? Key point: Short-term debt can have external costs Sensible case for a Pigouvian tax or regulation Chari & Eslami Economic Theory & Lender of Last Resort Policy

What Do Banks in the US Really Do? Mainly in the mortgage business Assets: $19 trillion in 2017 Q2 Mortgages: 41% of assets C&I loans: 18% of assets Do we really need to fund 30 year mortgages with overnight paper? Depository institution hold roughly 50% of outstanding home mortgages Not the only way to fund mortgages Chari & Eslami Economic Theory & Lender of Last Resort Policy

Banks Hold Lots of Mortgages Chari & Eslami Economic Theory & Lender of Last Resort Policy

Loans Smaller Fraction of Bank Assets Chari & Eslami Economic Theory & Lender of Last Resort Policy

Large Decline in Publicly Traded Securities Chari & Eslami Economic Theory & Lender of Last Resort Policy

Banks Not Only Holders of Mortgages Chari & Eslami Economic Theory & Lender of Last Resort Policy

Are We Prisoners of History? Are we preserving banks in the amber of orthodox thought? Consider no financial frictions extreme No need for banks as described here When need money, ask broker to convert wealth to money Transfer money to seller Small financial frictions increases returns banks must pay Makes system more fragile Chari & Eslami Economic Theory & Lender of Last Resort Policy

Why I Like Meryn King’s Proposal Restricts short term liabilities to be no more than haircut adjusted value of assets Focuses atention on question of what assets should be backed by short term debt Incremental rather than wholesale change in system Strategic rather than tactical in the face of crises Geting haircuts right is main problem Ring fencing is a problem Chari & Eslami Economic Theory & Lender of Last Resort Policy

A Truly Radical Proposal General idea is that a Pigouvian tax on short term debt desirable Limit short term debt relative to assets for all businesses above threshold Payment system restricted to hold government debt How would businesses or mortgages be funded? Intermediaries with equity and long term debt Benefits: Avoid crises Costs: Hedge funds have to change Chari & Eslami Economic Theory & Lender of Last Resort Policy