Financial Regulation: externalities and incentives Marcus Miller University of Warwick

Hi financial crisis! Wrenching financial crises are familiar to EMEs: Tequila 95/6, SE Asia crisis 96/97, Russian default 98, Argentine peso collapse 2001/2…. But this time it’s different! It’s the supposedly well-regulated US and UK financial systems that have suffered from near meltdown, calling for financial intervention adding up to 75% of GDP since early Why so?

Focus of attention Financial externalities due to amplification effects associated with constraints such as and collateral requirements, cf. Kiyotaki and Moore, Krishnamurthy, Adrian and Shin, Korinek Principal agent problems within financial firms due to asymmetric information,cf.Bhattacharya,Hellman et al.,

black holes exist in outer space

and also exist in economies with financial constraints Richard Koo describes how - when the gigantic asset bubble burst in many Japanese businesses were dragged into insolvency as their assets fell below the value of their debts. The efforts of firms to sell assets to pay down their debts only seemed to make things worse …

Leverage and asset bubbles Consider first the system in a fevered state with an asset bubble: firms borrow but that’s no problem as asset prices keep rising to match the debts. Then, unexpectedly, the music stops – the bubble bursts. System may recover, or it may collapse. Miller and Stglitz (2009) ‘Leverage and asset bubbles’

Trailer: Asset bubble and ‘black hole’

Financial Externalities exist in economy with financial constraints Market economies with constraints that depend on market prices (such as collateral requirements) are not constrained efficient. Rational atomistic agents take asset prices as given and do not internalize the fact that their fire-sale disposals give rise to amplification effects when financing constraints are binding. Korinek (2009)

This leads to over-borrowing and over investing by banks Value of liquidity in a crisis is undervalued and this leads to distortoted decisions Bankers take on too much risk - over borrow and over-invest

What if expectations are incorrect? Korinek goes on to point out that amplification effects magnify the impact of any unexpected change to liquidity position In crisis times when constraints are binding, welfare costs of asset price corrections are much larger than in normal times

Taxing the HLI*s who generate e externalities Relaxing financial constraints (forbearance) leads to Moral Hazard So does providing price guarantees So Korinek(2009) advocates Pigovian taxation of externalities associated with HLIs – e.g. by capital adequacy ratios and presumably liquidity ratios *inc any player who might get involved in ‘fire-sales’, banks, shadow banks and hedge funds.

The Economic Universe we live in? RB C: no Black Holes Representative Agent Rational Expectations ‘every financial system has a black hole’

2. Principal-agent problems within the financial firm Banks where the owners only lose their franchise when a gamble fails may be tempted to gamble if failure is a low frequency event. Forcing banks to risk own capital is one way of checking this Another is to increase the franchise value by deposit ceilings Hellman, Murdock and Stiglitz AER(2000)

Minimum Capital Adequacy Ratio (w & w/o deposit rate ceiling) Hellman, Murdock and Stiglitz AER(2000)

A hedge fund need not reveal it’s portfolio: leads to a ‘lemons problem’ * a trader who has no skill can - by using derivatives off- balance sheet - replicate the outturns of an ‘alpha’ trader and collect the rewards for a considerable period before the fund goes bust this means that no-one in the industry knows who is good and who is faking it Could lead to collapse of industry * Foster and Young,2007,‘The hedge fund game

How creating monopoly profits can prevent gambling - you’ve something to lose! Franchise value   k "Punishment " VπVπ "Temptation” Franchise value For low rates on deposit, franchise value is high even for investment in safe assets Gross deposit rate r Note that “Temptation” is shown for the special case where Gross return on safe asset Gross return on risky asset Gambling GAMBLING NO GAMBLING

Conclusion US and UK banks are borrowing at low rates and posting great profits and not lending much. So it seems that the solution being followed is to fatten the fat cats so they won’t risk their wealth! Reminds one of pre FDR USA with big steel, big oil and JP Morgan. Is that the future? Why not update the regulatory structure that FDR created taking account of the externalities and oioncentive issues. r

Post script Many EMEs have already moved: need to take a leaf from their book. Sovereign borrowers need to have their leverage checked ex ante And may need Chapter 11 restructuring ex post. Like international flight rules - financial regulations will need to be coordinated.

Portfolio risk ‘Value at risk’ constraint ALPHA TB Normal investors diversify risk holding uncorrelated assets ‘Alpha’ hedge funds look for correlated assets in same risk class so they can increase returns by shorting one and going long on the other Portfolio return Lei Zhang’s diagram HF ‘Fake alpha’ funds increase returns by taking on extra risk e.g. by shorting TBs and going long on Mortgage Backed Securities (MBSs) Long-short strategy of a hedge fund Hyun Shin, Radcliffe Lectures, 2008 MBS