Deregulation Deregulation will lead to More competition More efficiency More welfare More innovation More risk Deregulation always requires reregulation of the new risks

Crisis in the financial system

The traditional banking model Distribute and hold banks have financed mortgage lending through deposits (originate and hold) Limit to the amount of mortgage lending. Loans and default risk appear on the balance sheet Bank needs capital to cover its risk Screening, monitoring and information processing are of the essence

The new model of banking Originate and distribute model Brokers sell the mortgages Banks provide financing for the loan But then repackage the loan and sell it to bond markets. Hence the rise of new financial instruments This process is called securitisation

Economic advantages of originate and distribute model Securitisation enhances secondary market for loans, which will enhance the credit supply Investors get broader risk-return opportunities Risks (theoretically) spread more broadly (system more capable of absorbing “stress”) Research suggests that securitisation leads to lower spreads in consumer credit and softens interest-rate shocks for banks

Risks of originate and distribute model

Structured finance: instruments RMBS – Residential Mortgage Backed Securities CMBS – Commercial Mortgage Backed Securities MBS – Mortgage Backed Securities ABS – Asset Backed Securities CDO – Collateralised Debt Obligations CDS – Credit Default Swaps 7

The magic of CDO’s Mortgage-backed securities (MBS) and other structured credit were repackaged in CDO’s Banks create special purpose vehicle (SPV) Asset side: MBS Liability side: Collateralized debt obligations (CDO) Cut MBS in risk tranches, repackage them and sell as bonds (CDO) Make even further derivatives (CDO’s of CDO’s) Rating agencies rate these CDO’s, but nobody has a clue of their real value

Cashflow waterfall origin

Cash waterfall destination

Why are banks interested in distribute and hold model? Business proved extremely profitable for banks: Banks get more balance-sheet flexibility which allows them to economize on capital (BIS rules) They can lend without raising deposits or capital and without the cost of screening and monitoring The risk does not appear on their balance sheet They earn a fee for each mortgage they sold on. They urged mortgage brokers to sell more and more of these mortgages. All competitors do so, rational herdin.

Why do banks take the bite I? Lack of basic understanding of risks Liquidity risk Counterparty risk Disaster myopia Subjective probability of crisis depends on the frequency of an event Subjective probabilities may be off mark with low frequency events and long time lapses Certainly if there is a threshold heuristic

Disaster myopia (Tverksy and Kahneman) Subjective probability of disaster Subjective probability = f(time since last crisis) Real probability Treshold heuristic time Last crisis

How disaster myopia works? How to compete with myopic banks in the absence of a crisis This is almost impossible So banks mimic each other’s behavior So at the next crisis, the market is often dominated by myopic banks Herding behavior This may even be rational

Implication In the presence of competition, financial markets will always be driven to instability This means we need Buffers in the form of capital rules Limits on bank models in the form of leverage and liquidity rules Not too much deposit insurance, because this only reinforces the moral hazard problem A resolution mechanism that actually kills the myopic banks if a crisis strikes