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“Deposit Insurance and the Coexistence of Commercial and Shadow Banks”

This paper explores how the design of deposit insurance affects the structure of the financial system, specifically the coexistence of insured commercial banks and uninsured shadow banks. It discusses key insights and implications for the financial system.

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“Deposit Insurance and the Coexistence of Commercial and Shadow Banks”

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  1. “Deposit Insurance and the Coexistence of Commercial and Shadow Banks” By Stephen F. LeRoy and Rish Singhania Discussed by Pongsak@Hoontrakul.com (as of May 24, 2017)

  2. Disclaimer / Safe Harbor The view expressed here is solely the author’s personal view, not Sasin, Schulich, UOL Group Limited, UOB Group and/or any institution(s) which the author may be associated with. The data, information, fact and opinion presented here are reasonably reliable and accurate at the time of presentation to the best of the author’s knowledge. The viewers and audience are advised to use their own judgment on all matters related to this presentation. All rights are reserved 2017.

  3. Executive Summary 1 – Setting & Model A simple micro-based model in competitive general equilibrium is used to exposit how the design of deposit insurance affects the structure of financial system in risk neutral economy. At t=0, agents are assumed to allocate all their endowment – riskless & risky assets to either insured commercial or uninsured shadow banks. At t=1, after productivity shocks and deposit insurance premium (DIP) paid, banks trade risky asset among themselves for optimal return. At t=2, after second productive shocks, all banks are liquidated and all agents receive their claims at possible maximum allowance.

  4. Executive Summary 2 – Key Insights • Under rational expectation and optimization by all agents, commercial and shadow banks, competitive price equilibrium is derived in micro- efficient manner with some key insights: • Endogenizing subsidized DIP onto commercial banks economy, there exists coexistence of insured commercial and uninsured shadow banks within a range of DIP. (Proposition 4 and 5) • The size (and type) of DIP determine the structure of the financial system - equilibrium mix between commercial and shadow banks. (proposition 5 and pp 27-33) • Deposit based DIP is recommended over risky asset based DIP. • Like DIP, increasing capital requirement reduce the DIP subsidy to commercial banks & reduce the price distortion.

  5. Illustration I : How The Structure of the Financial System Is Determined by The Size of The Deposit Insurance Premium (DIP) in the Micro based Model of LeRoy and Singhania (2017) Implications Commercial Bank Issues Results Risk Asset Price distorted “Comparative Trading Advantage” Moral Hazard Adverse Selection… = + (Favorable) Subsidized Deposit Insurance Premium (DIP) REVENUE NEUTRAL Fair = 0 • Actuarial and No Trade Bank Bailout (?) Unfair • Lump-Sum Taxes? Risk Asset Price distorted “Comparative Trading Advantage” Moral Hazard Adverse Selection.. = - (Dis-favorable) “Taxing” (i.e. higher cost of capital, lower bankruptcy cost, etc.) Capital Requirement (e.g. Basel III, Liquidity Ratio,…) Source: Pongsak Hoontrakul (June 2017)

  6. Discussion 1: why Shadow Banks Exist ? • Both commercial and shadow banks do intermediary and credit/ liquidity/ maturity risks transformation business. Drivers for shadow banks are • Regulatory Arbitrage: This paper by LeRoy and Singhania (LS) “first” proves this theoretically by endogenously testing various parameters of DIPs and capital requirements in competitive market. (QED ?) • 2. Demand for Functional and Franchise Value: Complimentary • Pozsar et al (Dec 2013, NY FRB): “internal” shadow banking vs “external” shadow banking subsystem • Stijn Claessens and Lev Ratnovski (2014, IMF): The differences between commercial & shadow bank are in risk re-packaging and re-distribution – on its single balance sheet & diversify away to the market respectively.

  7. Discussion 2a: What are Shadow Banks ? In Europe (post Lewis Turning Point), lending by insurance firms… In China (~LTP), “Wealth Management Products” offered by banks. In India (pre LTP), like Thailand pre-1997, bank-affiliated finance firms. Source: Stijn Claessens and Lev Ratnovski (2014, IMF). See also appendix I with Pozsar et al (Dec 2013) p2, Hoontrakul (2017), chapter 2 and Lewis (1954).

  8. (D2b) A LTP and Three Phases of Industrialization:The distribution of resources between financial sector and real economy depends on the level of financial innovation and financial regulation. (p 32) Source: Hoontrakul (forthcoming 2017) and Lewis (1954).

  9. D3: No short sale and incomplete market On p 8, the RS model prohibits short sale (for mathematic convenience). The corollary is this market is not a complete market in Arrow and Debreu (1954) sense. Thus, the RS market is not perfect because there is not always a price for every asset in every possible state of the world. No derivative market can not be performed effectively. In sum, the major implication is to be careful to apply new insights derived from very restrictive market model (e.g. no short sale, only competitive shadow banks, etc.) into the real world, particularly in advance economy.

  10. D4: Shadow Banks improving social welfare ? One implicit assumption is all agents, regulators and bankers have equally access to the same information about risky asset investment opportunities. Ordonez (2017): Shadow banking improves social welfare because it is an escape channel and spanning efficient investment opportunities in excessive regulations. The RS paper’s proposition 1: No deposit insurance means no commercial bank and no trade. Asymmetry in institutional setting works well. Shadow banks improves social welfare, even in symmetric equilibria (p35).

  11. D5: Deposit Based or Risky Asset Based DIP ? The RS paper advocates deposit based DIP over risky asset based DIP (p 27) derived from its micro based model insights. 1 In deposit based DIP, shadow banks sell the risky asset at prices that exceed its expected payoff. Hence, risky assets are more in the hand of commercial banks. 2. In risky asset based DIP, shadow banks buy the risky asset at prices that are lower than expected payoff. Hence, risky assets are more in the hand of shadow banks. This deposit based policy advocate may be over-extended in the real world. -Commercial banking can macro-economically create large financial instability and systemic risk when the (tail) risk is underestimated. -Without loss capacity absorption, shadow banks may be riskier during financial instability, but these are known ex ante unlike commercial banks.

  12. D6: Is capital requirement like BIS III good ? At the heart of the RS paper lies an asymmetry in how commercial & shadow banks response asymmetrically to the change in different DIP premium and/or in capital requirement. As opposed to Modigliani and Miller (1958), Allen et al (2014) proves having positive (but costly) capital in banks reduce bankruptcy cost (and deposit insurer’s cost) but the role of capital requirement is crucial when deposits are insured. Using the numerical examples, like Allen et al, the RS paper (p32) claims increasing in the capital requirement is like decreasing the subsidized DIP to each commercial bank. Thus, RS paper (footnote 7) compliments Allen et al claim capital requirement restored efficiency and hence improve the market outcome.

  13. D7 More discussion and Future Research: Topics • Full and partial deposit Guarantee Issues, • Lump-sum taxes financed deposit insurance • = implicit and Explicit Deposit Guarantee ? • 3. From risk neutral to risk adverse world • From optimized expected value to optimized utility • 4. Game theory approach for oligopolistic banking structure • 5. Since optimal banking capital structure is unique in contrary to Modigliani and Miller, costly equity is a big issue for both the design of DIP and capital requirement.

  14. (D8) Banking Market Structure Matters Oligopolistic Fragmented Market Dynamic Financial Stabilty By default, orderly exit /Ent Both Exo-/ Endogenous risks > Market Discipline > Financial Safety Net > Flow Concept Steady > Differential Risk Premium >Full fledge DIS, Bank resolution > Ex. USA, Indonesia, Argentina (?) • Static Financial Stability • By Definition Mkt Failure • Endogenous Risk Concern > Regulatory Discipline > CB hand on > Stock Concept – Target > Flat Rate Tendency > Pay box Tendency Ex: TH, Sg, China (?)

  15. Reference: (1) Allen, Franklin et al (2014) “Deposits and Bank Capital Structure”, U of Pennsylvania May 12, 2014, 49 pages, https://spiral.imperial.ac.uk/bitstream/10044/1/29002/6/acm_final_with_names_to_be_circulated_12May14.pdf Arrow, Kenneth J. and Gerard Debreu (1954) “Existence of an Equilibrium for a Competitive Economy”, Econometrica, Vol. 22, No 3, July 1954, pp. 265-290. https://web.stanford.edu/class/msande311/arrow-debreu.pdf Claessejs, Stijn and Lev Ratnovski (Feb 2014) “What is Shadow Banking?”, IMF, 9 pages https://www.imf.org/external/pubs/ft/wp/2014/wp1425.pdf Hoontrakul, Pongsak (forthcoming 2017) “Economic Transformation and Business Opportunities in Asia”, NY: Palgrave. Lewis, W. Arthur (1954) “Economic Development with Unlimited Supplies of Labour”, The Manchester School, May 1954, Vol 22, Issue 2, pp 139-191.

  16. Reference: (2) Modigliani, F. and M. Miller (1958) “The Cost of Capital, Corporation Finance and the Theory of Investment”, American Economic Review, 48, 261-297. Ordonez, G (2017) “Sustainable Shadow Banking”, U of Pennsylvania, 25 pages. https://www.sas.upenn.edu/~ordonez/pdfs/Shadow.pdf Pozsar, Z et al (Dec 2013) “Shadow Banking”, NY Fed, 16 pages https://www.newyorkfed.org/medialibrary/media/research/epr/2013/0713adri.pdf

  17. Appendix - I Map: The Shadow Banking System https://www.newyorkfed.org/medialibrary/media/research/economists/adrian/1306adri_map.pdf Appendix 1: The Government-Sponsored Shadow Banking System https://www.newyorkfed.org/medialibrary/media/research/economists/adrian/1306adri_A1.pdf Appendix 2: The Credit Intermediation Process of Bank Holding Companies https://www.newyorkfed.org/medialibrary/media/research/economists/adrian/1306adri_A2.pdf Appendix 3: The Credit Intermediation Process of Diversified Broker-Dealers https://www.newyorkfed.org/medialibrary/media/research/economists/adrian/1306adri_A3.pdf Appendix 4: The Independent Specialists-Based Credit Intermediation Process https://www.newyorkfed.org/medialibrary/media/research/economists/adrian/1306adri_A4.pdf Source : Pozsar et al (Dec 2013) p2.

  18. Appendix I Appendix 5: The Independent Specialists-Based Credit Intermediation Process https://www.newyorkfed.org/medialibrary/media/research/economists/adrian/1306adri_A5.pdf Appendix 6: The Spectrum of Shadow Banks within a Spectrum of Shadow Credit Intermediation https://www.newyorkfed.org/medialibrary/media/research/economists/adrian/1306adri_A6.pdf Appendix 7: The Pre-Crisis Backstop of the Shadow Credit Intermediation Process https://www.newyorkfed.org/medialibrary/media/research/economists/adrian/1306adri_A7.pdf Appendix 8: The Post-Crisis Backstop of the Shadow Banking System https://www.newyorkfed.org/medialibrary/media/research/economists/adrian/1306adri_A8.pdf Source : Pozsar et al (Dec 2013) p2.

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