Financial System Diversity and Macroprudential Policy

1. Financial System Diversity and Macroprudential Policy Preliminary. Not to be circulated without permission of the authors and the Bank of Canada KartikAnand, Etienne Bordeleau, Mark Carney & Prasanna Gai

2. Roadmap • Motivation • Model set-up • Key propositions/results • Comparative statics – role of macroprudential policy • Some empirical connections – Canada and the US • Comments welcome!

3. Motivation “…A bank may consider a course of action it wishes to take to be acceptable – as it may well be in a limited context. But the same course might, if widely copied by other banks, have unfortunate effects on the banking system as a whole. It is part of the supervisors’ job to take that wider, systemic view and sometimes to curb practices which even prudent banks might, if left to themselves, regard as safe.” Sir George Blunden, Deputy Governor, Bank of England

4. Motivation • What drives the choice between market versus bank-finance? • Under what circumstances do financial firms pursue the same business strategy (increasing collective exposure to systemic risk as they individually diversify idiosyncratic risk)? • How to characterise notions of “risk illusion” (e.g. Boivin/Carney/Tucker)? • How might “macroprudential” policies shape the diversity of business practices and temper risk illusion?

5. Different policymaker perspectives... • “with exposures largely staying on balance sheet, Canadian bankers remained bankers rather than warehousers...”, Mark Carney • “Australian banks displayed...more conservative lending practices and...better lending decisions.”, Glenn Stevens • “Banks’ balance sheets, like Tolstoy’s happy families, grew all alike...At the height of the boom, financial imitation turned into near-cloning.”, Andy Haldane • Our framework seeks to nest these views.

6. Points of contact with the policy debate • UK-style “ring-fencing” • Capital requirements for trading books • Credibility, transparency, and standards for securitization • Design of shadow banking regulation • Role of central bank facilities, backstops

7. Main ideas • Nothing wrong in securitization per se. Choice of market or bank finance arises as banks balance gains from trade versus costs of monitoring • decision depends on a bank’s perceptions of macroeconomic risks which, in turn, colour its views on the quality of collateral • But pooling equilibria are possible. These mean that “optimists” and “pessimists” can mimic each other for certain parameter values. System-wide fragility can result. • Different macroprudential tools can have quite different consequences for the nature of financial intermediation

8. Points of contact with the literature • Builds on Plantin (2011), Park and Sabourian (2011), Rabin and Schrag (1999) • Shadow banking and lack of system diversity (Haldane-May, 2011; Gennaioli-Shleifer-Vishny, 2011a, Beale et.al, 2011) • Financial innovation, “local think” (Gennaioli-Shleifer-Vishny, 2011b) Relatedly... • Information sensitivity of securities (DeMarzo-Duffie, 1999; Dang-Holmstrom-Gorton, 2009) • Credit booms and busts as coordination failure (Rajan,1994; Aikman-Haldane-Nelson, 2010) • Incentives, tranche retention, transparency (Chiesa, 2008; Fender-Mitchell, 2009, Pagano-Volpin, 2010)

9. Model Set-up • Three dates: t = 0, 1, 2. One risk-neutral bank and passive end-investors • Bank receives an initial endowment at t=0, which it invests in illiquid assets (loans) that pay out at t=2 • Bank is impatient, so there are gains from trade to exploit

10. Three states of the world, θ,corresponding to boom (H), normal (M), recession (L) • Loans are either good or poor in quality – good loans repay with probability 1, poor loans always default • Let α be the fraction of good quality loans • a random variable that is (high, low)

11. Information structure • Bank receives a signal, S, about the state of the macroeconomy. And an independent signal, Q, about loan quality. • Signals on macroeconomic risk are “U-shaped” in the spirit of Park and Sabourian (2011)

12. Signal on the macroeconomy “colours” the view on underlying collateral of the loan : • Confirmatory bias in the spirit of Rabin and Schrag (1999)

13. Interim monitoring • Bank can invest in lending relationships further via interim monitoring between dates 1 and 2. • Cost of interim monitoring, M > 0, (= benefits lost from not shirking). • Effects of monitoring • Loan repayment rates improve in slowdowns by amount p. • Prevents repayment rates deteriorating in recessions

14. Fraction of loan book that pays off for the bank

15. Result (1) • At t=1, bank decides if it wants to securitize its entire loan portfolio and abstain from monitoring, or retain a stake and monitor (partial securitization). • Updates its beliefs on the quality of borrowers and state of the economy based on private signals • Compares expected value of portfolios under the two alternatives. • Trade off between gains from trade from securitization versus incentive to monitor. Comment • outcome is constrained efficient. • As discount rate (r) increases, bank pursues market-based finance

17. Result (2) – “Frontiers” of intermediation • We seek bounds to the parameters in Result 1 that describe when both “types” of bank will either opt for • Holding a stake and monitoring • selling the loan portfolio in its entireity • Extent of this depends on expected fraction of good loans perceived by the (biased) bank.

18. “Frontiers” for market/bank-based finance and financial system diversity

19. Comparative Statics (1): Lowering monitoring costs for the optimist

20. Comparative Statics (2): Lowering monitoring costs for the pessimist

21. Comparative Statics (3): The dark-side of credibility

22. Comparative statics (4): Black box to open source

23. Risk illusion versus local think • Local think: agent neglects certain low probability states of the world. I do my Bayesian updates over selected sub-set of states (those which occurred often in the past) • Risk illusion: U-shaped beliefs mean that I discount some information content in my private signal on macro risk. The consequences amplify as information on loan quality and central bank communications get misinterpreted

24. Stylised facts: US and Canada

25. Bank-based and market-based intermediation

26. Screening and origination standards

27. Securitization of insured mortgages

28. Risk illusion and securitization – 1

29. Risk illusion and securitization – 2 U.S. Canada

30. Points of contact with policy -- revisited • Universal banks or UK-style “ring-fencing”? • Differential capital requirements on the trading book and the SIFI debate. • Communication, transparency, and financial stability. • Drawing perimeters for shadow banking

31. Thank you!