Walking Wounded or Living Dead? Making Banks Foreclose Bad Loans Max Bruche and Gerard Llobet discussed by: Ulrich Hege (HEC Paris) U Vienna/ÖNB/CEPR Oct. 3, 2011

2 Living Dead Distortion Distressed banks inefficiently avoid liquidating projects if it triggers their demise, as continuing creates uncertainty and increases prob. of survival Failure to liquidate akin to risk-shifting Private info. on θ, random payoff ε Given liabilities D, distortion arises for high θ bang-bang decision on continuation/liquidation, as usual Regulator’s challenge: propose optimal mechanism two part tariff s(θ), F(θ) generally implements optimal mechanism Uli Hege – Comments on Bruche and Llobet

3 Countervailing Incentives and Optimal Solution Because of countervailing incentives, mechanism can squeeze information rents to zero incentive to overstate θ to get higher transfer s(θ), to understate θ to avoid high fixed payment F(θ) useful in particular from ex ante perspective, to avoid distortions in screening incentives (but see comment) Authors carefully discuss many extensions: foreclosure of good projects, imposing losses on debt holders, Also: private info on ε, deposit guarantees and social cost to bank failure, signal effect to depositors if bank participates, time-varying recovery rates or costs of bank funds Uli Hege – Comments on Bruche and Llobet

4 Some Short-cuts Some issues are not addressed in the model, or only informally (many acknowledged by authors): they consider only long-term funding (no maturity transformation) banks have no informational advantage about the size of the shock no discussion of optimal entry point of regulation: as it stands, mechanism implemented at all times, with optional participation, like a “buyback window” high informational demand on regulator, especially when accounting for time variability and bank heterogeneity Uli Hege – Comments on Bruche and Llobet

5 Banks … … once in distress, are explosive Uli Hege – Comments on Bruche and Llobet

6 Comments: Optimality Is the mechanism first best? It isn’t: Bank owners expect an ex ante gain from the living dead distortion. They keep this rent even when the scheme is implemented – so there is an ex ante distortion it adds to existing bailout bias (e.g., Kelly, Lustig & Van Nieuwerburgh, 2011) Worst banks issue ( θ > θ * ) : because T(θ) is convex, regulator finds that including types θ > θ * into scheme is too expensive – that is, the ex post worst banks. Will they be left alone. Uli Hege – Comments on Bruche and Llobet

7 The Balanced Budget Issue Mechanism contains no balanced budget condition for regulator. It “may” run deficit In equilibrium, the regulator will always run a deficit: debt holders gain, equity holders are neutral, so the mechanism will subsidize the debt holder’s gain It will be impossible to expropriate depositors We do not know how large the expected budget shortfall would be. Some skepticism seems in order Uli Hege – Comments on Bruche and Llobet

8 An Alternative Bruche-Llobet mechanism pertains to banks in distress, i.e. no or little value of bank equity left Alternative: regulator takes over banks in distress, does resolution on its own (taxpayers’) account call it nationalization requires some information on distress (signal on θ ) That is, idealized FDIC-style bank resolution: Once sign of distress appear, bank swiftly taken over, restructure (sell and liquidate assets) no guarantee for bank creditors beyond deposit guarantees (fka deposit insurance), unlike many bank nationalizations of late no evidence that private resolution works better Uli Hege – Comments on Bruche and Llobet

9 Horse Race: Comparing Two Mechanisms Bruche-LlobetNationalize Optimal liquidation incentives for bad projects (with E [ ε] < ρ ) YY Truthful revelation of θ without information rent YN Avoid ex ante distortion on bank equity value NY Address the worst banks ( θ > θ * ) NY Optimal continuation/liquidation decision for all projects, incl. those with E [ ε] > ρ ?Y Asymmetric info advantage of banks N / ? (“yes, if buy back”) Y Uli Hege – Comments on Bruche and Llobet

10 Relevance How important is the living dead distortion? Theoretical argument perfectly sound: distressed banks have an incentive to gamble Example Japan. But little other examples. Counterexample: US home foreclosures. Thoughts why its importance may be exaggerated: only relevant if there are important holes in bailout put short-term funding, reduces risk-shifting incentives (Barnea, Haugen, and Senbet, 1980) for non-distressed banks, the distortion goes the other way round: if a non-performing loan can be liquidated, doing so is rational even if socially inefficient (“paradox of puttable debt”) (regulatory) capital constraints and liquidity constraints will force banks to liquidate assets Uli Hege – Comments on Bruche and Llobet

11 Unintended Consequences Imagine Bruche-Llobet becomes law; some of the likely problems to arise: Ex ante risk-shifting incentives likely exacerbated: banks’ equity rents from living dead distortion preserved. Plus now they will survive for sure ! The θ > θ * problem: leaving the worst banks alone most likely not credible - or if it is, mechanism will distort the distribution of θ that banks target In general, the hold-up, idiosyncratic and systemic, issues the political economy of banking. Uli Hege – Comments on Bruche and Llobet

12 Conclusion Very elegant and rigorous analysis, clear proposal Nice find that information rents can be avoided, and discussion of regulatory benefits Real effort to add extensions and discuss model limitations Still, proposal best locked away in hard-to-reach outlet Uli Hege – Comments on Bruche and Llobet