Walking Wounded or Living Dead? Making Banks Foreclose Bad Loans

1. Walking Wounded or Living Dead? Making Banks Foreclose Bad Loans Max Bruche and Gerard Llobet discussed by: Ulrich Hege (HEC Paris) U Vienna/ÖNB/CEPR • Oct. 3, 2011

2. Living Dead Distortion • Distressed banks inefficiently avoid liquidating projects if it triggers their demise, as continuing creates uncertainty and increases prob. of survival • Failure to liquidate akin to risk-shifting • Private info. on θ, random payoff ε • Given liabilities D, distortion arises for high θ • bang-bang decision on continuation/liquidation, as usual • Regulator’s challenge: propose optimal mechanism • two part tariff s(θ), F(θ) generally implements optimal mechanism UliHege – Comments on Bruche and Llobet

3. Countervailing Incentives and Optimal Solution • Because of countervailing incentives, mechanism can squeeze information rents to zero • incentive to overstate θto get higher transfer s(θ), to understate θto avoid high fixed payment F(θ) • useful in particular from ex ante perspective, to avoid distortions in screening incentives (but see comment) • Authors carefully discuss many extensions: • foreclosure of good projects, • imposing losses on debt holders, • Also: private info on ε, deposit guarantees and social cost to bank failure, signal effect to depositors if bank participates, time-varying recovery rates or costs of bank funds UliHege – Comments on Bruche and Llobet

4. Some Short-cuts • Some issues are not addressed in the model, or only informally (many acknowledged by authors): • they consider only long-term funding (no maturity transformation) • banks have no informational advantage about the size of the shock • no discussion of optimal entry point of regulation: as it stands, mechanism implemented at all times, with optional participation, like a “buyback window” • high informational demand on regulator, especially when accounting for time variability and bank heterogeneity UliHege – Comments on Bruche and Llobet

5. Banks … … once in distress, are explosive UliHege – Comments on Bruche and Llobet

6. Comments: Optimality • Is the mechanism first best? It isn’t: • Bank owners expect an ex ante gain from the living dead distortion. They keep this rent even when the scheme is implemented – so there is an ex ante distortion • it adds to existing bailout bias (e.g., Kelly, Lustig & Van Nieuwerburgh, 2011) • Worst banks issue (θ >θ*): because T(θ)is convex, regulator finds that including types θ > θ*into scheme is too expensive – that is, the ex post worst banks. Will they be left alone. UliHege – Comments on Bruche and Llobet

7. The Balanced Budget Issue • Mechanism contains no balanced budget condition for regulator. It “may” run deficit • In equilibrium, the regulator will always run a deficit: • debt holders gain, equity holders are neutral, so the mechanism will subsidize the debt holder’s gain • It will be impossible to expropriate depositors • We do not know how large the expected budget shortfall would be. Some skepticism seems in order UliHege – Comments on Bruche and Llobet

8. An Alternative • Bruche-Llobetmechanism pertains to banks in distress, i.e. no or little value of bank equity left • Alternative: regulator takes over banks in distress, does resolution on its own (taxpayers’) account • call it nationalization • requires some information on distress (signal on θ) • That is, idealized FDIC-style bank resolution: • Once sign of distress appear, bank swiftly taken over, restructure (sell and liquidate assets) • no guarantee for bank creditors beyond deposit guarantees (fka deposit insurance), unlike many bank nationalizations of late • no evidence that private resolution works better UliHege – Comments on Bruche and Llobet

9. Horse Race: Comparing Two Mechanisms UliHege – Comments on Bruche and Llobet

10. Relevance • How important is the living dead distortion? • Theoretical argument perfectly sound: distressed banks have an incentive to gamble • Example Japan. But little other examples. Counterexample: US home foreclosures. • Thoughts why its importance may be exaggerated: • only relevant if there are important holes in bailout put • short-term funding, reduces risk-shifting incentives (Barnea, Haugen, and Senbet, 1980) • for non-distressed banks, the distortion goes the other way round: if a non-performing loan can be liquidated, doing so is rational even if socially inefficient (“paradox of puttabledebt”) • (regulatory) capital constraints and liquidity constraints will force banks to liquidate assets UliHege – Comments on Bruche and Llobet

11. Unintended Consequences Imagine Bruche-Llobet becomes law; some of the likely problems to arise: Ex ante risk-shifting incentives likely exacerbated: banks’ equity rents from living dead distortion preserved. Plus now they will survive for sure ! The θ > θ* problem: leaving the worst banks alone most likely not credible - or if it is, mechanism will distort the distribution of θthat banks target In general, the hold-up , idiosyncratic and systemic, issues the political economy of banking. UliHege – Comments on Bruche and Llobet

12. Conclusion • Very elegant and rigorous analysis, clear proposal • Nice find that information rents can be avoided, and discussion of regulatory benefits • Real effort to add extensions and discuss model limitations • Still, proposal best locked away in hard-to-reach outlet UliHege – Comments on Bruche and Llobet