Who Borrows from the Lender of Last Resort? 1 Itamar Drechsler ⋄ , Thomas Drechsel † , David Marques-Ibanez † and Philipp Schnabl ⋆ ⋄ NYU Stern and NBER † ECB ⋆ NYU Stern, CEPR, and NBER November 2012 1 The views expressed herein are those of the authors and do not necessarily represent the position of the European Central Bank or the Eurosystem.
Introduction Lender of Last Resort (LOLR) Theory of the LOLR (Bagehot, 1873) Financial crises are characterized by lack of funding for banks Lack of funding is due to market failure (information asymmetry, bank runs) Inherently ‘good’ banks cannot finance assets and need to sell them at fire sale discounts. This depletes bank capital and leads to a credit crunch LOLR should prevents a credit crunch by lending to illiquid (but solvent) banks, which produces large welfare gains LOLR plays important role in economic policy Central banks were set up to act as LOLR (e.g., Federal Reserve) Large LOLR interventions during recent financial crisis European Central Bank’s (ECB) main policy for addressing the financial crisis ECB currently has e 1 trillion in loans outstanding
Introduction This paper Why do banks take up LOLR funding from the ECB during the financial crisis? 1 – Is borrowing driven by the need to avoid fire-sales as Bagehot had hoped? – Or do other motivations explain bank borrowing?
Introduction Literature Theory – Thornton (1802), Bagehot (1873), Diamond and Dybvig (1983), Goodhart (1987), Goodfriend and King (1988), Goodhart (1995), Freixas, Giannini, Hoggarth, and Rochet (1999), Repullo (2000), Rochet and Vives (2004), Diamond and Rajan (2005), Freixas and Rochet (2008), Tucker (2009), Stein (2012) Empirics – Miron (1986), Bordo (1990) Contribution – First paper using LOLR micro-data to analyze motivation for banks’ borrowing – Important because welfare implications of LOLR intervention depend on banks’ motivation
Introduction Outline Data and Institutional Background 1 LOLR Theories 2 Identification Strategy and Results 3 Aggregate Asset Reallocation 4
Introduction Novel LOLR micro-data ECB data (proprietary) ECB lending for each bank and week from August 2007 to December 2011 1 2 Collateral pledged against borrowing (at ISIN-level) Bank and securities data (public) 1 Securities characteristics (Bloomberg) Bank characteristics (Bankscope, SNL Europe) 2 3 Euro bank stress test data Sample represents the universe of European banks
Haircut Subsidies ECB is the LOLR in Europe ECB provides loans via repos (i.e., loans against collateral) – Accepts a wide range of collateral from many banks – Each type of collateral has a haircut (just as in private repos) – E.g., if haircut is 10%, then bank can borrow $45 against $50 market value bond – do not depend on which bank is borrowing – Note: These are full recourse loans Since late 2008, ECB allows unlimited borrowing against eligible collateral – Only constraint on bank borrowing is having collateral For risky assets, ECB haircuts are less than in private markets (“haircut subsidy”) Interest Rates – but the interest rate is higher than in private repo markets – consistent with Bagehot’s advice to “lend freely at a penalty rate”
Haircut Subsidies Example: Greek Sovereign Bonds (Figure 1) Figure plots CDS on Greek Government Debt 4.5 Main Exchange Stops Lehman Clearing Greek Bonds Bankrupcty 4.0 (market haircut of 100%) 3.5 3.0 2.5 Log(CDS) 2.0 1.5 1.0 0.5 0.0 August-07 August-08 August-09 August-10 August-11 Private repo markets stopped accepting Greek bonds as collateral in March 2010
Haircut Subsidies Example 1: Greek Sovereign Bonds (Figure 1) 30.0% 4.5 Main Exchange Stops Lehman Bankrupcty Clearing Greek Bonds (market haircut of 100%) 4 25.0% 3.5 20.0% 3 Log(CDS) 2.5 Average ECB Haircut 15.0% 2 10.0% 1.5 1 5.0% 0.5 0.0% 0 6-Aug-07 6-Oct-07 6-Dec-07 6-Feb-08 6-Apr-08 6-Jun-08 6-Aug-08 6-Oct-08 6-Dec-08 6-Feb-09 6-Apr-09 6-Jun-09 6-Aug-09 6-Oct-09 6-Dec-09 6-Feb-10 6-Apr-10 6-Jun-10 6-Aug-10 6-Oct-10 6-Dec-10 6-Feb-11 6-Apr-11 6-Jun-11 6-Aug-11 6-Oct-11 6-Dec-11 ECB continues lending against Greek collateral at less than 8% haircut ⇒ Provides large haircut subsidy on Greek bonds
Haircut Subsidies Example 1: Greek Sovereign Debt Migrates to ECB 90 Lehman Main Exchange Bankrupcty Stop Clearing Greek Bonds 80 (market haircut of 100%) 70 Greek Sovereign Debt (in $ billion) 60 50 40 ECB 30 Private Market 20 10 0 Dec-07 Feb-08 Apr-08 Jun-08 Aug-08 Oct-08 Dec-08 Feb-09 Apr-09 Jun-09 Aug-09 Oct-09 Dec-09 Feb-10 Apr-10 Jun-10 Aug-10 Oct-10 Dec-10 Feb-11 Apr-11 Jun-11 In early 2008, most Greek sovereign debt used in private repo markets By mid 2010, Greek sovereign debt migrates to ECB
Haircut Subsidies ECB Haircut Subsidies Not only for Greek Debt but other risky collateral haircut subsidies also on other risky collateral, e.g., mortgage-backed securities, covered bonds, etc. Haircut subsidies are largest for the riskiest collateral e.g., distressed-country sovereign bonds (Ireland, Italy, Portugal, Spain) but not safe sovereign bonds (e.g., German bunds) Total ECB subsidy received by a bank: = Total Borrowing × Average Haircut subsidy Are there differences in banks’ take-up of ECB subsidies? ⇒ Look at whether high-borrowing banks also use riskier collateral
The Take-up of ECB Subsidies Proxy for collateral risk by credit rating Sort banks into quintiles by borrowing as of July 2010 Collateral Risk 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0 7-Jan-09 7-Mar-09 7-May-09 7-Jul-09 7-Sep-09 7-Nov-09 7-Jan-10 Haircut Subsidies 7-Mar-10 7-May-10 7-Jul-10 7-Sep-10 7-Nov-10 7-Jan-11 7-Mar-11 7-May-11 7-Jul-11 7-Sep-11 7-Nov-11 Borrowing Low
Haircut Subsidies The Take-up of ECB Subsidies 5.0 First Greek Bailout 4.5 4.0 Collateral Risk 3.5 Low 3.0 Borrowing High 2.5 Borrowing 2.0 1.5 7-Jan-09 7-Mar-09 7-May-09 7-Jul-09 7-Sep-09 7-Nov-09 7-Jan-10 7-Mar-10 7-May-10 7-Jul-10 7-Sep-10 7-Nov-10 7-Jan-11 7-Mar-11 7-May-11 7-Jul-11 7-Sep-11 7-Nov-11 Collateral risk of high-borrowing banks increases starting early 2010 ⇒ There is a divergence in the take-up of ECB subsidies across banks!
Haircut Subsidies The Take-up of ECB Subsidies: Measure #2 0.25 0.2 Periphery Sovereign Debt Share 0.15 Low 0.1 Borrowing 0.05 0 7-Jan-09 7-Mar-09 7-May-09 7-Jul-09 7-Sep-09 7-Nov-09 7-Jan-10 7-Mar-10 7-May-10 7-Jul-10 7-Sep-10 7-Nov-10 7-Jan-11 7-Mar-11 7-May-11 7-Jul-11 7-Sep-11 7-Nov-11 Sort banks into quintiles by borrowing as of July 2010 Proxy for collateral risk by share of distressed-country sovereign debt
Haircut Subsidies The Take-up of ECB Subsidies: Measure #2 0.25 First Greek Bailout 0.2 Periphery Sovereign Debt Share 0.15 Low Borrowing 0.1 High Borrowing 0.05 0 7-Jan-09 7-Mar-09 7-May-09 7-Jul-09 7-Sep-09 7-Nov-09 7-Jan-10 7-Mar-10 7-May-10 7-Jul-10 7-Sep-10 7-Nov-10 7-Jan-11 7-Mar-11 7-May-11 7-Jul-11 7-Sep-11 7-Nov-11 ⇒ Divergence in take-up of ECB subsidies across banks starting early 2010!
Theories Why do banks take up subsidies from the ECB? Banking panics 1 Risk-shifting 2 Political Economy 3
Empirical Analysis Banking panics – Banks cannot roll over short-term financing of assets because of a market failure (e.g., bank runs) ⇒ Need financing for their pre-existing holdings of risky assets, otherwise fire sale – LOLR financing allows them to finance assets while they slowly de-lever, avoiding fire sales ⇒ Use LOLR funding to finance existing (not new) holdings of risky assets – Some banks suffer more illiquidity than others (to explain cross-sectional pattern) – Explains divergence if some banks suffered a series of worse financing shocks over time and in response pledged increasingly risky collateral
Empirical Analysis Risk-shifting – Decline in bank asset values → increased likelihood of default → risk-shifting Weakly-capitalized banks want to buy risky assets whose downside correlates with their own default – Haircut subsidies allows banks to risk-shift onto LOLR Lending is under-collateralized → LOLR takes some loss if bank defaults Attractive to weakly-capitalized banks → Haircut subsidy is bank-specific: bigger for weakly-capitalized banks – Cost of taking subsidy: LOLR interest rate > private-market interest rate ⇒ Net benefit is positive for weakly-capitalized banks They borrow from LOLR to buy risky assets, pledging them as collateral – Explains divergence if weakly-capitalized banks used LOLR loans to purchase risky assets by pledging them as collateral
Empirical Analysis Identification Strategy Analyze if weakly-capitalized banks risk shift onto the LOLR 1 Do they borrow more and pledge riskier collateral over time Identification Problem: During a crisis banks’ financial strength is endogenous 2 – Measures of bank’s strength during the crisis may reflect concerns about the likelihood of runs Solution: Use bank capital before the start of the crisis to proxy for banks’ 3 strength/risk-shifting incentives during the crisis – Banks with less pre-crisis capital are more likely to have risk-shifting incentives during the crisis – Proxy for pre-crisis capital using bank credit rating as of August 2007 Main concern: Pre-crisis bank capital may correlate in the cross-section with 4 future bank runs (e.g., country of domicile)
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