September, 2011 FDIC/JFSR Conference FDIC/JFSR Conference Discussion of: Discussion of: “Bailouts, contagion, and Bank risk Bailouts, contagion, and Bank risk ‐ ‐ taking taking” ” “ by Dell ‘ ‘Ariccia and Ratnovski Ariccia and Ratnovski by Dell “Regulatory capture and banking supervision reform “ Regulatory capture and banking supervision reform” ” by Boyer & Ponce by Boyer & Ponce “Capital Regulation and tail risk Capital Regulation and tail risk” ” “ by Perotti, Ratnovski and Vlahu by Perotti, Ratnovski and Vlahu By: Anja n V. T ha ko r Jo hn E . Simo n Pro fe sso r o f F ina nc e a nd Dire c to r o f the PhD Pro g ra m 1
Overview Overview T he se a re thre e pa pe rs tha t ha ve the fo llo wing • c o mmo n q ue stio n uniting the m: o Wha t fo rms o f mic ro prude ntia l a nd ma c ro prude ntia l re g ula tio n (inc luding re g ula to ry struc ture ) a re mo st e ffe c tive in c o ntro lling b a nk risk ta king ? Perotti ‐ Dell ‘Ariccia ‐ Boyer ‐ Ponce Ratnovski ‐ Ratnovski (BP) Vlahu (DR) (PRV) Microprudential Macroprudential Organization of regulation in the regulation in the regulatory agencies. form of capital form of bailouts. requirements. 2
Wha t is a lso c o mmo n to a ll thre e pa pe rs is tha t • e a c h se e ks to o ve rturn c o nve ntio na l wisdo m: o PRV: hig he r c a pita l re q uire me nts ma y induc e b a nks to ta ke mo re risk. o DR: b a ilo uts ma y induc e b a nks to ta ke le ss risk. o BP: ha ving multiple re g ula to rs ma y le a d to b e tte r re g ula tio n a nd le ss risk. 3
Capital Regulation and Tail Risk Capital Regulation and Tail Risk by: Perotti, Ratnovski, and Vlahu by: Perotti, Ratnovski, and Vlahu Q ue stio n : Do e s hig he r c apital always le ad to lo we r risk taking by the bank? • Co nve ntio na l wisdo m sa ys “ye s”. T he insig ht tha t hig he r c a pita l induc e s ba nks to ta ke lo we r risk g o e s ba c k a t le a st to Me rto n’ s 1977 JBF pa pe r: iso mo rphic c o rre spo nde nc e be twe e n c o mmo n sto c k put o ptio ns a nd de po sit insura nc e . o Ba nks c a n inc re a se the va lue o f the de po sit insura nc e put b y inc re a sing risk a nd le ve ra g e . o T o c o unte r the se inc e ntive s a nd re in in the risk-ta king pro pe nsity o f b a nks, we ne e d re g ula to ry c a pita l re q uire me nts. 4
T his pa pe r a rg ue s, ho we ve r, tha t whe n b a nks c a n • inve st in “ta il risk” pro je c ts (whe re a suffic ie ntly a dve rse re a liza tio n c a n wipe o ut all o f the ba nk’ s e q uity c a pita l, re g a rdle ss o f the le ve l o f c a pita l), the n a ba nk with hig he r c a pita l ma y ta ke mo re risk. Why? Higher Capital • a. b. Lower probability of Payoff in tail ‐ risk state is 0 breaching minimum capital regardless of level of capital. requirement in low ‐ return state and having to make costly capital adjustment 5
A ba nk – whic h is a ve rse to sta te a – c a n “a ffo rd” to • ta ke g re a te r risk with mo re c a pita l sinc e hig he r c a pita l me a ns lo we r pro ba bility o f re a c hing sta te a , whe re a s c a pita l do e s no t a ffe c t sta te b. Pa pe r a rg ue s tha t this is wha t ha ppe ne d in the re c e nt • c risis – ba nks with mo re c a pita l to o k mo re ta il risks. T wo ke y assumptio ns : • i. Pa yo ff to b a nk sha re ho lde rs whe n ta il risk e ve nt is re a lize d is inde pe nde nt o f c a pita l le ve l. ii. Ra ising c a pita l in lo w-re turn sta te in whic h minimum c apital re q uire me nt is b re a c he d is c o stly fo r the b a nk b e c a use “…e q uity issue s a re vie we d b y ne w inve sto rs a s ne g a tive sig na ls”. Ba se d o n this, the pa pe r pre sc ribe s tha t re g ula tio n • sho uld fo c us o n mo nito ring ta il risk in a dditio n to c a pita l re g ula tio n. 6
Comme nts : • I nte re sting pa pe r: Ana lysis is pla usib le . Pa pe r is c a re ful no t to o ve r-re a c h in re g ula to ry pre sc riptio ns (e .g . do e s no t pre sc rib e uppe r b o und fo r c a pita l re q uire me nts). • But, nume ro us issue s to de a l with: 1. Pa pe r sho uld e xpla in diffe re nc e s b e twe e n its a na lysis a nd Cale m and R obb’s JFI pape r (“Impac t of Capital-Base d Re gulation on Bank Risk T aking: A Dynamic Mode l”) Capital is so high that Risk probability of bankruptcy Standard becomes low enough to make effect risk taking attractive. Capital Ma in ide a he re se e ms q uite simila r! 7
2. T he c la im tha t the re is a ne c do ta l e vide nc e tha t b a nks with hig he r c a pita l to o k mo re risks prio r to the c risis se e ms to be que stio na ble . I n fa c t, e ve n tho ug h ba nks did ha ve hig h c a pita l in the e a rly 2000s, ma ny spe nt hundre ds o f millio ns o f do lla rs in re purc ha sing sto c k to re duc e c a pita l…Prio r to the c risis, c a pita l ra tio s in inve stme nt ba nks we re de c lining . (Re me mbe r Be a r-Ste a rns ha d the lo we st c a pita l ra tio a mo ng the ma jo r inve stme nt ba nks.) • T he re is a lso e vide nc e tha t ba nks with hig he r c a pita l a c tua lly did be tte r in te rms o f surviving the c risis a nd a lso in g a ining ma rke t sha re a nd fina nc ia l pe rfo rma nc e (se e Be r ge r and Bouwman, “How Doe s Capital Affe c t Bank Capital Dur ing Cr ise s?”, Whar ton F in. Inst. Ce nte r WP, 2011). 8
3. Simila rly, the a utho rs ne e d to re c o nc ile the ir a rg ume nt with the e vide nc e in Me hr an and T hakor , “Bank Capital il 2011 -- bank and Value in the Cr oss-Se c tion”, RFS , Apr c a pita l a nd va lue a re po sitive ly re la te d in the c ro ss-se c tio n! 4. T he ke y a ssumptio n tha t raising a dditio na l c a pita l wo uld be c o stly fo r the ba nk due to a dve rse -se le c tio n-induc e d dilutio n is inc o nsiste nt with the e mpiric a l e vide nc e . Cor ne tt and T e hr anian, “An E xamination of Voluntar y ve r sus Involuntar y Se c ur ity Issuanc e s by Comme r c ial Banks: T he Impac t of Capital Re gulations on Common Stoc k Re tur ns”, JFE 1994 , do c ume nts tha t whe n ba nks e ng a g e in “invo lunta ry e quity issue s” (to me e t c a pita l re quire me nts), the pric e re a c tio n (a nno unc e me nt e ffe c t with a 2-da y windo w) is statistic ally insig nific ant . 9
5. Pa pe r ma y a lso b e ne fit fro m a dire c t c o mpa risio n to Ac har ya, Me hr an and T hakor , “Caught be twe e n Sc ylla and Char ybdis: Re gulating Bank L e ve r age e is Re nt-Se e king and Risk Shifting ” whic h Whe n the r hig hlig hts be ne fits a nd c o sts o f ha ving ba nk c a pita l. Appropriate range of leverage Bank leverage Bank Leverage is so low that is so high that it creditors lack invites risk sufficient skin shifting that in the game to increases bank threaten shareholder credible value but is liquidation to socially discipline rent inefficient. seeking by bank’s 10 manager.
6. No t a t a ll c le a r tha t ba nks de libe ra te ly to o k ta il risks. Ra the r, like e ve ryb o dy e lse , the y we re lulle d into a fa lse se nse o f se c urity b y a ve ry lo ng string o f g o o d o utc o me s. E vide nc e in F ac h and Stulz ( JFE , 2011) milita te s ahle nbr a g a inst the no tio n o f de lib e rate ta king o f ta il risks. 11
Bailouts, Contagion, and Bank Risk Bailouts, Contagion, and Bank Risk by: Giovanni Dell ‘ ‘Arricia and Lev Ratnovski Arricia and Lev Ratnovski by: Giovanni Dell Co mmo n wisdo m is tha t b a ilo uts – e spe c ia lly tho se • tha t do no t impo se a ny ha irc uts o n c re dito rs – inc re a se inc e ntive s o f b a nks to ta ke mo re risks b e c a use the y c re a te mo ra l ha za rd. T his pa pe r a rg ue s the o ppo site . • 12
I de a : • Risk a. b. Systematic risk of entire Idiosyncratic risk of failure banking system failing for a bank (beyond bank’s control). (within bank’s control). Ba ilo uts insure a g a inst sta te a a nd thus induc e the b a nk to • inve st mo re prude ntly b e c a use the ma rg ina l re turn to b e ing prude nt is e nha nc e d b y insura nc e a g a inst sta te a . I ntuitio n so me wha t simila r to princ ipa l-ag e nt mo de l in whic h • insuring the a g e nt a g a inst risks b e yo nd his c o ntro l (i.e . b y no t pre dic a ting his pa yo ff o n sig na ls tha t a re uninfo rma tive in the om (1979) se nse ) he lps to impro ve inc e ntive s. Holmstr Ba ilo uts a re no t a b a d re g ula to ry to o l. • No te tha t hig he r c a pita l re q uire me nts c a nno t pro vide the • sa me a tte nua tio n tha t b a ilo uts c a n. 13
Comme nts : • Ve ry pro mising pa pe r. Simple b ut ne a t ide a . • I ts the first fo rma l justific a tio n I ha ve se e n fo r b a ilo uts b a se d o n e x ante e ffic ie nc y g ro unds. He re a re so me sug g e stio ns fo r impro ve me nts: 1. A b ig imple me nta tio n pro b le m fo r re g ula to rs is disting uishing b e twe e n syste mic and idio sync ratic failure s. I n re a l time , syste mic fa ilure s do no t a ll o c c ur simulta ne o usly – the y o c c ur se q ue ntia lly. So …whe n o ne o r a fe w b a nks fa il, ho w do yo u kno w if it is idio sync ra tic o r syste mic ? 14
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