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

2. Crisis in the financial system

3. 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

4. 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

5. 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

6. Risks of originate and distribute model

7. 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

8. 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

9. Cashflow waterfall origin

10. Cash waterfall destination

11. 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.

12. 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

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

14. 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

15. 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