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Financial Stability & Integration in Europe Session IVa: Market Discipline & Bank Risk Discussion by Javier Suarez

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Overview (i) Two interesting, thought-provoking papers Dealing with hot conceptual issues in the world of banking regulation & supervision –Book vs fair value accounting Adoption of the new IAS in Europe –Market discipline (or market-based supervisory discipline) Pillar 3 of Basel II

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Overview (ii) Three common features: 1.Rigorous, analytical, well written, and… preliminary 2.Tackle with issues whose relevance many economists (including myself) have been traditionally skeptical to accept (Probably because of the absence of solid theoretical foundations for the arguments of the practitioners who talk about them)

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3.They touch on issues & modeling devices somewhat out of my area of expertise OLG models, social security banks a la Allen-Gale, accounting,… Inspection games, informed & liquidity trading in a maket-maker based securities market,… (I will take the standpoint of an outside observer of the corresponding literatures) Overview (iii)

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Overview (iv) Both papers have contributed to keep my initial skepticism high The analysis by Freixas&Tsomocos has only partially convinced me of the importance of accounting conventions: –IF accounting conventions go together with accounting-based rules that constrain the behavior of agents, THEN accounting matters.

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Overview (v) –More specifically, accounting matters because, for banks to play an efficient intertemporal risk-sharing role in an OLG economy, regulation needs to constrain their dividend policy. –IF the constraint is indexed to accounting profits, THEN accounting standards matter for the allocation of resources.

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Overview (vi) The reasons why the paper by Lehar & his coauthors keeps my skepticism high come from the paper’s own conclusions: –If the regulator cannot commit to an ex ante suboptimal auditing policy, market- based supervision can lead to more risk- taking. –Regulatory use of market information can decrease investors incentives to acquire costly information

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Freixas & Tsomocos (i) First, a simplified version of the model: –Non-overlapping generations economy with two goods: A storable numeraire (fruit) A fixed-supply asset (a tree) that yields random fruit y t+1 at end of each period t –One-period lived risk-averse agents Expected utility maximizers: EU(c t+1 ) Inherit shares of the tree or any reserves of fruit x t from their parents

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Freixas & Tsomocos (ii) In the absence of inter-temporal arrangements or constraints, generations would eat: –The whole fruit from the tree –The whole reserves of fruit This would involve no risk-sharing –First generation EU(c 1 ) = EU(x 0 +y 1 ) –Next generations EU(c t+1 ) = EU(y t+1 )

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Freixas & Tsomocos (iii) But an inter-temporal social planner could provide a better steady-state allocation by forcing generations to keep reserves These reserves would serve an inter- temporal risk-sharing purpose For large enough x t & E(y t+1 )=y (for all t), it would be possible to approximately guarantee: EU(c t+1 ) = U(y)> EU(y t+1 )

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Freixas & Tsomocos (iv) With a discount factor <1, the planner’s problem would be akin to a standard precautionary savings model with infinitely lived agents: –If reserves were too low they would be built up gradually by making c t+1 lower than y –If reserves were too large they would be drained by making c t+1 higher than y This resembles a social security system

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Freixas & Tsomocos (v) But the actual implementation of the arrangement is difficult if generations are as greedy as assumed –What can prevent them from eating up all available fruit? –Altruism? A benevolent dictator? –A benevolent bank supervisor? As Allen & Gale (JPE 1997), the authors defend the latter

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Freixas & Tsomocos (vi) How? Banks that… –own the tree and keep reserves –are subject to constraints to their dividend policy The socially optimal dividend at t+1 would be a function of the relevant state variable: f(x t +y t+1 ) (obtained from the dynamic problem)

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Freixas & Tsomocos (vii) BUT if dividends are constrained to be a function of some accounting variable, THEN accounting standards may matter Specifically, –in an OLG structure in which one can properly define the market price p t of the risky asset own by the bank –if dividend rules are based on “profits”… there are situations in which book-value accounting produces better outcomes than fair value accounting.

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Freixas & Tsomocos (viii) My skepticism about the results is not due to technical reasons, although the corresponding part of the current draft is… –somewhat sketchy –complicated by simultaneously considering deposits and the possibility of bankruptcy –limited by the imposition of an exogenous dividend rule

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Freixas & Tsomocos (ix) It is more about the applicability of such setup to the understanding of real world banking: –with explicit social security arrangements –without so much regulatory interference in banks’ dividend policies (what is the real-world counterpart of the dividend rule?)

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Freixas & Tsomocos (& x) In sum, the model is a nice theoretical construction & poses a challenging conjecture on the relevance of accounting standards But perhaps the authors should think about other aspects of banking… in which the need for rules based on accounting variables might produce similar but more practical conclusions (e.g., contemporaneous rather than inter- generational conflicts of interest)

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Lehar, Seppi & Strobl (i) The model is made up of two blocks: –A inspection game between a bank & a supervisor –A competitive market-making securities market for the bank’s stock, with a potentially informed trader (IT) The blocks interact non-trivially

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Lehar, Seppi & Strobl (ii) In the inspection game block: –The bank chooses between a safe and a (worse on average) risky asset (standard risk-shifting temptations) –The supervisor decides to costly audit the bank (w.pr. a) to find out asset choice & signal of returns (risky investment + bad signal early liquidation, to save on DI costs)

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Lehar, Seppi & Strobl (iii) In the stock trading block: –The IT invests in order to get w.pr. signal about the bank’s asset returns (correlated with the regulator’s). –Her trade is confounded with that of liquidity traders (LT), whose arrival is perfectly -vely correlated with arrival of IT’s signal [Dow&Gorton (JF 1997) trick for simple Kyle (Ectrica 1985) model]

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Lehar, Seppi & Strobl (iv) Sequence of events: 1.Bank’s asset choice q 2.IT information investment 3.Stock trading price p 4.Supervisory audit a + intervention 5.Final payoffs IT can influence p through the order flow (but, despite the possibility of supervisory intervention, good signal buy order )

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Lehar, Seppi & Strobl (v) Paper first considers benchmark in which supervisor ignores market info (p): The mixed strategy equilibrium in the audit game is unaffected by stock trading block In contrast, here & in the general context with some a(p), stock trading outcomes (p) would be affected by the equilibrium of the audit game: The prospects of asset choice & supervisory intervention affect value of IT’s info

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Lehar, Seppi & Strobl (vi) The effect of a given a (or a(p)) on depends on the correlation between the signals: –High correlation positive effect –Low correlation negative effect Why? With high corr. “the closure policy can be predicted by IT, which makes his information more valuable to him” (p.13) (??)

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Lehar, Seppi & Strobl (vii) More importantly, when the auditing policy is contingent on p, the outcomes of the inspection game block change How can we find the equilibrium? –Finding equilibrium in q, a+, a- for given (p+, p- do not matter) (Prop. 2?) –Finding: Optimized given q, a+, a- Fixed point with =F(q( ), a+( ), a-( )) (Prop. 6&7?)

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Lehar, Seppi & Strobl (viii) The paper spends some time comparing equilibrium in q, a+, a- for given with benchmark case: –q is higher if risk-shifting incentives are too high (due to commitment problem for a+>0) and vice versa(Prop. 3) –a is lower (higher) when the correlation between supervisory and market signals is high (low)(Prop. 5)

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Lehar, Seppi & Strobl (ix) The paper also spends time comparing equilibrium under market-based supervision with the benchmark case: –Equilibrium is lower if risk-shifting incentives are low and may be higher otherwise (Prop. 6) –IT always profits from higher correlation with the supervisory signal, while the supervisor only profits from correlation in specific circumstances(Prop. 7) (low risk-shifting incentives & high L)

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Lehar, Seppi & Strobl (&x) All this sounds very interesting What is missing? –More intuition about the results (presentation is sketchy towards the end) –A fuller / compact characterization of the equilibrium (low/high audit regimes depend on , which is determined in equilibrium, perhaps differently in each regime!!) –Discussion on robustness

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Conclusion Very nice, thought-provoking papers Hot, timely topics Preliminary in one way or another Hard job for the discussant I very much thank the organizers!

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