Deregulation

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 waterfallorigin

10. Cash waterfalldestination

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, financialmarketswillalwaysbedriven to instability • Thismeans we need • Buffers in the form of capitalrules • Limitson bank models in the form of leverage and liquidityrules • Nottoomuchdepositinsurance, becausethisonlyreinforces the moral hazard problem • A resolutionmechanismthatactuallykills the myopicbanksif a crisis strikes