“ Bailouts and Financial Fragility ” by Todd Keister

1. “Bailouts and Financial Fragility” by Todd Keister Discussion by Giovanni Calice University of Southampton and University of Bath Oslo - September 3, 2010

2. My Foremost Comments The purpose of the paper is to provide a further step towards evaluating the desiderability of bank bailouts and their effects on financial stability • Trying to investigate the effects of bailouts in formal economic models is a very worthwhile undertaking - It is clear that much effort has gone into the writing of this paper. It is a promising piece of work - My comments are really all in the spirit of “what would I change to make the paper more convincing to the reader” • There is a great deal to be learned from studying this type of literature. And the non-specialist reader (such as myself) can gain a great deal of insight - Consequently, I will try to identify the limitations that underlie this research, particularly with respect to the approach taken Discussion

3. Overall The paper uses the classic approach put forth in the work of Diamond and Dybvig (1983, JPE) to develop a model of financial intermediation and fragility - The paper examines the economic effects of public sector bailouts of banking institutions in an environment with idiosyncratic liquidity risk and limited commitment This paper is in the fine tradition of the well thought out highly intuitive banking policy and financial fragility literature in the mould of work by luminaries such as Diamond and Dybvig (1983, JPE) - Previous works have examined the incentive effects of financial sector bailouts and optimal regulatory policy (see, e. g., Chari and Kehoe (2009), and Green (2010, FRB, EQ) • The model deviates from the studies by Gale and Vives (2008, WP) who study dollarization as a device fir limiting a central bank’s ability to engage in bailouts, Fahri and Tirole (2009, NBER) who focus on the strategic complementarities generated by indiscriminate bailouts - The focus of the paper is in fact on the related concepts of “illiquidity” and “financial fragility” and on mechanisms of public intervention such as government ad-hoc “bailouts” • The theme of the paper hence is closely related to both the literature on the incentive effects of bailout policies and the literature on financial stability - Overall, this is a valuable extension to the existing literature, although subject to a few limitations Discussion

4. Contributions (Scheme and Findings) The paper represents an instalment on a very important research agenda • Simple measure, some elegance in the sense that the structure of the model is used to derive the q-efficient allocation of resources - Key novelty of the paper is simply to assess the trade-offs between discretionary government-orchestrated bailouts and commitment to not rescue financial institutions and their implications on financial stability - To shed some light on the optimal policy arrangements, the paper presents the allocation of resources that emerges in equilibrium welfare under 2 asymmetric policy regimes (1. discretion; 2. committing to no-bailout) • This particular instalment offers some interesting new “facts” - In the big picture of understanding the effects of public-sector bailouts on the efficient allocation of resources and financial stability, the author reports on some significant and “innovative” findings 1. The insurance provided by a bank bailout can have a stabilizing effect on the financial system 2. Perhaps surprisingly, the commitment to a no-bailout policy would make the financial system even more fragile and thus lessen the aggregate welfare 3. Imposing ex-ante a Pigouvian tax on short-term liabilities (the maturity transformation function of intermediaries) can be an effective policy measure to offsetting the bailout distortionary effects on ex ante incentives Discussion

5. Comments I have some relatively minor concerns about specific aspects of the analysis • The paper is primarily a theoretical exercise • In general, the relationship between government’s bailout policies and financial fragility is very complex • The approach is based on this one assumption that the distortions created by the bailout policy cause intermediaries to become too illiquid - The paper thus does not cater to the intellectual foundation of capital as buffer against insolvency (to promote safety and soundness of banks) and as incentive device against excessive risk taking or stopgap measure providing room for supervisory intervention • Possible limitations - Goodhart’s repeated liquidity conundrum: Think about also the inclusion of capital requirements (in period one as well as subsequent periods) - Why not to incorporate explicitly in the model a role for central banks (A dynamic model of central bank intervention)? - After all central banks act as a lender of last resort to the banking sector during times of financial crisis • Systemic Risk Considerations - A special regime for systemically important financial institutions? - Would a bankruptcy procedure be appropriate instead? - See the recent paper by Ayotte and Skeel Jr. (2009, JCL) Discussion

6. Comments The author identifies the degree of illiquidity as the ratio between short-term liabilities and short-run value of banks assets. So he assumes that this indicator has information (which is true) as we all know that maintaining a balance between short-term assets and short-term liabilities is critical • I should say that Proposition 3 is beautifully simple and intuitive and for once you do not feel that any nasty assumptions have been made to obtain this solution • However, what about the cost of liquidity (illiquidity)? - A bank can attract significant liquid funds, but at what cost? - Lower costs generate stronger profits, more stability, and more confidence among depositors, investors, and regulators • Is this the right apparatus to assess the relationship between illiquidity and financial fragility? - Is financial instability related to idiosyncratic or aggregate shocks? - Are we sure that only liquidity really matters? What about insolvency? • Moreover, I see the need to include some structure on the liability side • Section 4 is probably the weakest and I assume that more work will be done here - The author’s objective is obvious, build a structural model from which the elements of the equilibrium allocation of resources can be determined Discussion

7. Comments The work is somewhat difficult to interpret • This is not a criticism - However, there is a lack of much of an overall conceptual framework to help us to understand the possible sources of connections between changes in expected market tail risk (e. g. Bearn Stearns default) and the array of public policy interventions - Put differently, we need to consider the sources of heterogeneity in macro adjustments at the most basic level and how this heterogeneity is likely to interact with changes in financial fragility • An additional query is with the comparative statics, which seem a bit light, if for example the author wished to target a big hit such as Economic Theory Could the model be extended to consider also the portfolio asset allocation strategies of financial institutions? • Models that combine:  - Asset volatility - Liability structure - Market measures - And sensitivity to macro conditions   are pretty much the only “full spectrum” solutions Discussion

8. Conclusions • Frontier paper - Nice theoretical framework - Punch-line is well taken and convincing - Interesting findings (new facts) • Impressive paper • A pleasure to read • To get a big hit, it needs that sections 4 and 5 spruced up and a bit of cleaning in terms of the writing • The paper provides a basis also for future empirical work - We need more structure and further analysis to interpret and understand these new facts - More theoretical and empirical work is required to have a broader view of which market failures are important (Ex: recapitalization costs in downturns vs. moral hazard in upturns) and which regulations are needed to address them • There is much promise in this line of work In sum: - The paper by Keister considers an interesting and important topic (especially for policymakers and regulators) - It makes only a start on this topic - I very much look forward to a more comprehensive analysis in his future research Discussion