Imperfect Competition in the Inter-Bank Market for Liquidity as a Rationale for Central Banking

1. Imperfect Competition in the Inter-Bank Market for Liquidity as a Rationale for Central Banking Viral V. Acharya London Business School and CEPR With Denis Gromb and Tanju Yorulmazer April 17, 2008

2. Outline • Central Banking has been motivated as a response to market failure arising from asymmetric information, lack of depositor coordination, etc. • This paper: • Motivates Central Banking as a response to market power in inter-bank liquidity transfers • Surplus banks extract rents from power in these markets • Rent extraction can lead to inefficient allocation of assets • Central Bank, by being a credible lender at competitive rates, can improve liquidity transfers • Virtual and virtuous role • Public provision of liquidity improves private provision

3. Outline (cont’d) • Different ways in which banks interact during crises • Inter-bank lending: Limited due to moral hazard • Asset sales: Inefficient due to specificity of assets • Co-insurance • Crises may however confer market power on some causing co-insurance arrangements to break down • Ample evidence in support of such breakdowns • Competitive and strategic effects can start playing a role

4. Historical motivation • Clearing houses: Before the establishment of Federal Reserve in 1914 • Private arrangements by banks during crises for co-insurance, started in New York in 1853. • Acted as LOLR during crises, suspending convertibility and issued joint claims to protect member banks. • One member bank assigned the central administration role.

5. Historical motivation (cont’d) • In practice, the clearing-house arrangements often failed to organize quickly. • Anecdotal evidence– Timberlake (1984), Goodhart (1988), Park (1991), Goodhart-Schoenmaker (1999), Freixas-Giannini-Hoggarth-Soussa (1999), etc. • Healthier banks may gain deposits, customers, acquire assets at fire-sale prices • Slovin, Sushka and Polonchek (1999), Schumacher (2000) • Incentives to force a competitor out of business by not providing normal-time loans/assistance in the relationship

6. Failure of clearing houses and commercial Central Banks • Episodes from England • Bank of England orchestrated an insurance fund for Baring Brothers in 1890. • However, BoE was unwilling to support Overend and Gurney in 1866. • Goodhart-Shoenmaker (1999) attribute this to a commercial rivalry between the two banks. • Evidence from France • Goodhart (1988) reports similar commercial rivalry between Banque de France and Credit Mobilier in 1867 • Similar evidence from Australia • Associated Banks, a co-insurance arrangements, did not support Federal Bank in 1893 due to rivalry (Pope, 1989)

7. Panics in the US – I • JPMorgan during the 1907 panic (Park, 1991) • Knickerbocker Trust, Trust Company of America, Lincoln Trust, Moore and Schley were among Trust companies experiencing trouble • NY Clearinghouse, led by Morgan, first offered support only to Mercantile National Bank (the source of the panic through a copper squeeze) and other affiliated banks, but not to trusts (some solvent) • Morgan offered support to Trusts only after two weeks • During this period, six strongest clearing house banks gained in deposits (Sprague, 1910)

8. Panics in the US – I (cont’d) • JPMorgan made a windfall gain in the process (The House of Morgan by Chernow, 1990) • Morgan’s favourite creation US Steel acquired Tennessee Coal and Iron’s assets estimated to be worth $1 billion for $45 million • Moore and Schley, one of the assisted brokerage houses held a large stake in Tennessee Coal and Iron • The deal would not have been possible under Sherman Anti-trust Act during normal times, but President Roosevelt approved it • Grant B. Schley later admitted that they could have been rescued by an outright cash loan rather than the sale of Tennessee Coal

9. Panics in the US – I (cont’d) • Financial Times “Leadership in times of panic – The Crisis of 1907” (17 August 2007): “… The creation of the Fed was a natural response to the realization that control and leadership of the US financial system had effectively been outsourced to one private businessman.”

10. Panics in the US - II • National City Bank during the 1893, 1907 panics (Citibank, by Cleveland and Huertas) • National City had higher reserve and capital ratios. • During the panics, it gained deposits and loans relative to its competitors. • Grew into Citibank through rapid expansion during these panics • Hoarded liquidity for purchases at fire-sale prices • Not much evidence for its usage in inter-bank markets

11. Panics in the US – II (cont’d) • Vanderlip's (Vice President) complaint in early 1907 that National City's low leverage and high reserve ratio was depressing profitability. • Stillman (President) to Vanderlip (Vice-president): “I have felt for sometime that the next panic and low interest rates following would straighten out good many things that have of late years crept into banking. What impresses me most important is to go into next Autumn (usually a time of financial stringency) ridiculously strong and liquid, and now is the time to begin and shape for it... If by able and judicious management we have money to help our dealers when trust companies have suspended, we will have all the business we want for many years.”

12. Panics in the US – III • Potential strategic effects in inter-bank call loan rates (Donaldson, 1992): • US data for banking panics during 1873-1993 period • Interest rates during panics larger with extremely high volatility during pre-1914 (pre-Fed) panics – Dependence of interest rates in pre-Fed panics on cash reserves of banks before 1914 but not after • Preliminary evidence that creation of the Federal Reserve had a stabilizing effect on inter-bank lending

13. Panics in the US – III (cont’d) Donaldson (JFI, 1992)

14. Relationship to (some) literature • Goodfriend and King (1988) • Central Bank should inject liquidity through open-market operations and inter-bank markets will allocate this efficiently • Thus, no need for a lender of last resort operation • Frictions can break down Goodfriend-King result • Our paper: No guarantee that liquidity with surplus institutions that have market power will find its way to the needy institutions • Dunn and Spatt (1984) • Model of strategic behavior by lenders when the borrower is captive over a part of the loan • Our paper: Both inter-bank and asset markets • Carlin, Lobo and Viswanathan (2007) • Switch from co-operative to strategic equilibrium in a dynamic model of trading when continuation game is not that valuable

15. Relationship to (some) literature • Other frictions may also be of relevance: • Flannery (1996) • Asymmetric information about assets and/or shocks • Bhattacharyya and Gale (1987) • Asymmetric information about assets and/or shocks • Free-riding by banks on other banks’ liquidity • Aggregate liquidity shortages may thus result • Repullo (2005) • Banks may free-ride on (unconditional) injection of liquidity by Central Banks

16. Basic structure of the model • Similar to Holmstrom and Tirole (1998) • Bank A and B, three dates t= 0, 1, 2, risk-neutrality, no discounting • t=0: Bank A owns Iunits of loans to corporate sector. • Inormalized to one for now • t=2: Loans pay off based on state of the world (R or 0), but probability of R depends on monitoring at t=1 • pHorpL ; Δp > b, the private benefit from poor monitoring • t=1: Loans need refinancing ρIwith prob. x • Bank B has excess liquidity • Bank A raises funds by borrowing and/or asset sales

17. Borrowing • Limited liability, so borrow against a repayment rin high state • Incentive compatibility: • Maximum interest satisfies: • Debt capacity per unit of asset:

18. Asset sales • Transfer of ownership at price P. • Bank B has less expertise in running A’s assets: • Asset-specificity thus implies that borrowing is more efficient than asset sales. • But, transfer of ownership is better than running assets with moral hazard

19. Interaction amongst banks

20. Solution • First, solve stage 2 of bargaining when Bank B makes take-it-or-leave-it offer • Next, solve stage 1 based on stage 2 offer • Stage 2: Bank B’s problem is

21. Stage 2 outcomes • Offer: • Bank B’s expected payoff:

22. Stage 1 • Bank A’s problem is • Solution:

23. Comparative statics • Fraction of Bank A’s assets sold to Bank B and the associated inefficiency • Increase with Bank B’s market power • Increase with Bank B’s outside option • Increase with Bank B’s opportunity cost of capital • Decrease with Bank A’s outside option • Decrease with Bank B’s effectiveness at running Bank A’s assets

24. Determinants of Outside Options • A fraction θof Bank A’s loans are “big” and rest are “small” • Bank B has an advantage in small loans relative to outsiders, and thereby, also in monitoring Bank A • Asset sales: for B as well as outsiders for outsiders • Borrowing:

25. When bargaining has broken down... • Bank A raises finance from outsiders • Efficient to sell big loans first • Sell small loans, only if necessary • Bank A’s outside option XA increases in θ and decreases in bo • In turn, the total fraction of assets liquidated in equilibrium and the associated inefficiency decrease in θ and increase in bo • Generalization: The loan size θis distributed F(θ), ranked by FOSD

26. Generalization • The loan size θis distributed F(θ) • Smaller values of θcorrespond to more specific (or smaller) loans • Fraction of assets sold is above a threshold θ • Bank-A specificity and overall bank-specificity of loans is correlated

27. Central Banking • A Central Bank can alleviate the inefficiency if it can improve upon Bank A’s outside options • If it can do so, then it can play a “virtual and virtuous” role • CB does not lend in equilibrium • Under what conditions can a Central Bank (or cannot) improve upon the market outcome?

28. Different cases of LOLR • No loss-making loans and no supervision: • CB cannot improve upon the market outcome • Some loss-making loans, but no supervision: • Akin to lowering collateral quality for lending • CB can reduce Bank B’s market power • Supervision: • Again, CB can reduce Bank B’s market power • Commitment to the LOLR role, no moral hazard

29. Central Banking (cont’d) • Suppose that the Central Bank can better monitor banks than can outsiders: • As the Central Bank's monitoring advantage over outsiders increases, the equilibrium outcome is more efficient: Bank A borrows more from and sells less assets to Bank B. • Bank A’s outside option XA increases

30. Supervision as a commitment to lend • Central Banking effective at little cost as in equilibrium Central Bank does not lend to Bank A • But, there may be commitment issues… • The Central Bank must be prepared to lend against collateral that outsiders will not lend against • Either suffer loss on loans ex post OR Invest in better supervision ex ante • Bank supervision thus naturally coincident with the liquidity provision role of Central Bank • Provides the commitment to be willing to lend ex post

31. Other options • Why don’t outsiders improve their monitoring? • Banks may be unwilling to share information with markets, but be prepared to do so with a Central Bank • Central Bank can set price caps • But need to set them effectively in all markets for liquidity transfers • Central Bank can auction some of Bank A’s assets, contingent on lending at competitive rates

32. TO DO and Applications • Fuller modeling of Central Bank role, liquidity auctions,… • Ex-ante markets for liquidity insurance • Incentives for banks to commit ex ante to providing co-insurance • Optimal ex-ante schemes may, however, lack time consistency • May be renegotiable due to lack of verifiability of private liquidity shocks • Evidence of market power amongst financial institutions during crises • LTCM (1998) – Predators also potential acquirors • Amaranth (2006) – JPMorgan, the lender, blocked acquisition and arranged its own bid soon after