Discussion Resolution Policy and the Cost of Bank Failures

1. DiscussionResolution Policy and the Cost of Bank Failures

2. Bank Liability Structure, FDIC Losses and Time to Failure • Two general issues addressed in the paper • What are the determinants of FDIC losses? • Are the determinants of the most costly failures different from other failures? Are there important nonlinearities? • Are resolution costs related to structure of a failed bank’s liabilities? • What factors impact the time to failure (conditional on failure)?

3. Some Conceptual Issues • How should costly failures be defined? • Relative to assets/deposits • Aggregate costs • What is the purpose? • Regulatory policy • Adequacy of aggregate reserves • Estimate receivership costs. • How are the FDIC’s costs related to the failed bank’s liability structure? • Directly by effecting the FDIC’s obligations and relative position among creditors (note this has changed over time). FDIC loss= Insured Deposits + Recovery or paid claims of uninsured creditors-Estimated Value of assets. • Indirectly through market discipline and its effect on asset quality. • Techniques to deal with non-linearity • Structural: Specify a functional relationship • Limit sample/ Create binary measure for the dependant variable • Quantile Regression

4. Some Specific Questions/Comments • What is the explanation for a positive relation between losses and fed funds purchased for the most costly transactions? • First Republic and First City cross/guarantees? • Interaction with depositor preference? • Pre-FDICIA • Interpretation of the coefficients for contemporaneous balance sheet variables: Ceteris is not paribus. • Nonlinearities or outliers? • How important are nonlinearities/ Any statistical tests for differences?? • How would one use quantile regressions as a predictive tool? • Interpreting the time to failure results/ duration analysis • Difficult to use as a predictive tool: Conditioned on failure. • Evidence of market discipline? • Break down liabilities into insured/secured categories • How does one explain the same sign on deposits and federal funds?

5. Cash in the Market and Optimal Resolution of Bank Failures • Model objectives: • Demonstrate that ex post bailouts and provision of liquidity to healthy banks are equivalent from a social welfare perspective: Both policies prevent inefficient transfers of assets outside of the banking sector. • Demonstrate the ex ante liquidity provision provides incentives against herding and thus is superior. Subsidies to healthy banks increase the rents associated with acquiring failed banks.

6. Overview of the Model Some key assumptions: • Two period risk neutral world. • Banks invest in risky loans using one period fully insured deposits. • The banking sector has limited liquidity at t+1. (Both debt and equity is limited) • Banks are more efficient users of failed bank assets (a la Shleifer and Vishny). • Government can provide liquidity to the banking sector either through bailouts or through assisting healthy banks acquire failed banks. Purchases of failed banks by healthy banks are subsidized. • Government provision of funding for bailouts or liquidity involves fiscal costs that are increasing in the size of government expenditures. • The governments objective is to minimize fiscal costs and maximize efficient asset use. • There are agency costs associated with outside equity (insiders must retain a theta of profits to invest in good projects).

7. Results and Intuition • At time t + 1, k banks are insolvent. Given limited bank liquidity the sale price of the assets of will depend on the number of bank failures • For a k > k the government trades efficiency losses associated with the sale of assets to “outsiders” against the fiscal costs associated with bailouts or providing liquidity. Since the both bailouts and liquidity provision have the same efficiency gains and fiscal costs (i.e. require p of funding) they are equally efficient ex post. • Ex ante providing liquidity is better because it provides a subsidy for good behavior.

8. Some Comments • Note that for prices p (k) < p surviving banks earn a profit on acquiring bank assets. What are the impediments to capital flows into the banking sector at time t+1? • Moral hazard? • Shouldn’t rents accrue to the existing owners and the price of outside equity be determined by the risk free rate? • What about additional debt financing? • Sector uniqueness is not necessarily equivalent to lost going concern value

9. Prices and Rents For Failed Bank Assets full price p intermediate price reservations price p low price w/n k k = n k

10. Designing Countercyclical and Risk Based Aggregate Deposit Insurance Premia • Objectives: • What does a counter cyclical premium structure look like? • How should one think about the appropriate fund size or initial capitalization of the fund? • Given historical loss rates, the current asset distribution of banks what are the trade-offs between “countercyclical” rebates, the premium rebates, assessment rates and the default probability of the fund

11. Contributions/Results • Determination of the target fund size involves specifying a fund “default probability” over a given horizon. Given bank failures are not independent, the insurance fund requires an initial capitalization which in turn implies premiums that are higher than “actuarially fair”. • The default probability under the current system is surprisingly high (assuming the loss rate and failure rate assumptions are correct). • Trade-offs in the design of countercyclical premium system. Policy parameters are: • Loss rate rebate • Premium rebate • Assessment rate • Default probability

12. Some Question • While table 5 shows the trade-off, what are reasonable values for countercyclical rebates? • How are losses on bank failures correlated with the shadow price of capital to the banking system? Should we ignore market signals? (Acharya and Yorulmazer model) • Are historical losses and a Poisson constant arrival rate reasonable? • Politically is this feasible? As failures increase the FDIC reduces its premiums!! • Requires a lot of faith that there is no regime shift. • Moral hazard incentives are correlated with the shadow price of capital.