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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

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