Erik Heitfield Federal Reserve Board FDIC/JFSR 8 th Annual Bank Research Conference

1. Comments on“Counterparty Risk in Financial Contracts:Should the Insured Worry about the Insurer?” Erik HeitfieldFederal Reserve BoardFDIC/JFSR 8th AnnualBank Research Conference September 18, 2008

2. Paper touches on 3 vital issues • Credit risk transfer and counterparty risk • Liquidity risk management • Overlapping asymmetric information problems

3. Counterparty risk • Bank seeks to transfer credit risk to an insurer • Insurer manages its own liquidity position given beliefs about the risk of its contingent liabilities • Outcomes • If no credit event occurs, the bank receives principal and interest on its exposure and the insurer receives guarantee fee income • Bank , Insurer  • If a credit event occurs and insurer is liquid, bank receives principal and interest and insurer bears credit loss • Bank , Insurer  • If a credit event occurs and the insurer is illiquid, insurer defaults and bank bears credit loss • Bank , Insurer 

4. Liquidity management • Insurer has a liquid asset endowment A • Invests premium income in a liquid asset L or an illiquid asset I • Illiquid asset pays higher return: I > L • But it is not available to pay claims • Insurer has a contingent liability C • Endowment is insufficient to pay claim: A < C • Liquid portfolio is sufficient to pay claim: A + L > C • Insurer believes claim will occur with probability b • Insurer invests premium in I iff:

5. Overlappingasymmetric information problems • Adverse selection • Bank has better information about the risk of its credit exposure than the insurer • A bank with a risky exposure has an incentive to lie about the exposure’s credit quality • Moral hazard • Insurer determines its liquidity position after the insurance contract is negotiated • Insurer has in incentive to invest in less liquid, higher return assets even though this increases the chances that it will not be able to pay claims

6. Equilibrium is not what you’d expect • Traditional asymmetric information story • Insurer cannot distinguish between safe and risky exposures, so insurance premiums do not reflect underlying risk • Likewise, insurer liquidity management is not risk sensitive • The paper’s result • The bank truthfully reports the risk of its credit exposure and the insurer believes it • The insurer invests in more liquid assets if the bank’s credit exposure is high risk

7. Intuition • Counterparty risk depends on insurer’s beliefs • If the insurer believes that a credit event is likely, it has reason to invest in liquid assets • If the insurer believes that a credit event is unlikely, it can increase profits at low risk by investing in illiquid assets • The bank’s cost of bearing counterparty risk depends on the likelihood of a credit event • A bank with a safer insured exposure is less concerned about counterparty risk because the likelihood of a credit event is lower • A bank with a riskier insured exposure is more concerned about counterparty risk because the likelihood of a credit event is higher • Result: It is more costly for a bank with a risky exposure to report that its exposure is safe • A bank with a riskier exposure truthfully reports this information, and the insurer believes it • A bank with a riskier exposure pays higher premiums but bears less counterparty risk

8. Problematic Assumption #1Insurer has unlimited liability Insurer Asset Value Insurer Obligations Default Point Investment Payoff Standard Model: limited shareholder liability Current Model: bankruptcy costs borne by shareholders with unlimited liability

9. Problematic Assumption #2:No coordination problem among banks • According to the basic model • Insurer endowed with an initial portfolio of assets and liabilities • A single credit guarantee contract affects insurer balance sheet in two ways • Insurer receives up-front fee income held as an asset • Insurer holds a new contingent liability whose ex ante valuation depends on the insurer’s beliefs about the likelihood of a credit event • After the contract is negotiated, the only decision available to the insurer is whether to invest the contract fee income in a liquid/low-yield asset or an illiquid/high-yield asset • Implication: • Insurer’s beliefs about a single contingent liability determines its liquidity management • The bank is the only source new information about this liability • The bank has a strong incentive and ability to influence insurer beliefs

10. Extension to N banks • Insurer has a liquid asset endowment A • Invests premium income in a liquid asset L or an illiquid asset I • Illiquid asset pays higher return: I > L • But it is not available to pay claims • Insurer has N contingent liabilities of (C/N) from N banks • Endowment is insufficient to pay all claims: A < C • Liquid portfolio is sufficient to pay all claim: A + L > C • Insurer believes claim i will occur with probability bi

11. Investment equilibrium with N banks • Number of claims n, is a random variable whose probability distribution depends on the insurer’s belief vector (b1…bN) • Insurer invests in illiquid asset iff: • When N is large, changing bi alone will have a negligible affect on insurer liquidity decision • As N∞, no separating equilibrium in idiosyncratic information possible (Lemma 7) • Separating equilibrium only preserved if a bank can reveal information about the risk of other banks’ credit exposures (Lemma 8) • Assumes systematic shock affects all banks and • Each bank knows the magnitude of the systematic shock

12. Conclusions • Should the insured care about the insurer? • YES, YES, YES! • Does signaling by insured affectinsurer behavior? • Unlikely • Insured exposure must be very large relative to other contingent liabilities of the insurer, or • Insured must have access to information about insurer contingent liabilities not available to the insurer