Discussion of A Model of Shadow Banking (by N. Gennaioli, A. Shleifer and R. Vishny)

1. Discussion of A Model of Shadow Banking (by N. Gennaioli, A. Shleifer and R. Vishny) Oscar Arce CNMV - Research and Statistics Department Director Debt and Credit, Growth and Crisis BdE - WB Madrid, 18 June 2012

2. What the paper does • It provides a comprehensive story on the links between aggregate savings (the savings “glut”), the scarcity of safe assets and the role of securitizationin their production, interest rates, leverage and financial stability. • A relatively simple model: • - A demand for safe assets by risk-averse investors (lenders) • - A supply of safe assets by risk-neutral intermediaries. Two cases: • i) If low demand, intermediaries’ own collateral suffice to meet it • ii) If high demand, intermediaries produce new “safe assets” securitization • 3. Central results: • If risks are correctly assessed, securitisation contributes to financial stability (risk diversification -pooling) and is Pareto-improving (efficient risk allocation –tranchingand originators retention). • If tail risks are neglected, securitisation may become a driver of financial instability through ex post 1) excessive leverage and 2) illiquidity

3. What I like most • A relatively simple model sheds light on the links between some key developments before and during the crisis in a credible way • The shocks-transmission mechanisms (aggregate contagion of idiosyncratic risks through securitization and illiquidity) help understand the velocity and intensity with which the initial turbulences of August 2007 spread over the entire system • Some key pieces in the model are well grounded on empirical evidence: • The role of securitization in producing high-quality assets • The role of securitization holdings by leveraged intermediaries in amplifying the shocks

4. Key model elements (I) • The role of securitization in producing high-quality assets: Global issuance of AAA-rated long-term fixed income assets (1990-2009) Source: Dealogic The rapid growth in global AAA-assets (from 20% of total assets in 1990 to 60% in 2003) was largely due to securitisation

5. Key model elements (II) • The high volume of securitization in the leveraged institutions’ balance-sheets (key for the transmission of shocks in the model and in reality too): Distribution of the holdings of GSE-backed securities Source: Shin (2009) Leveraged institutions (commercial banks, investment banks and hedge funds) were the main holders of ABS

6. What I find less convincing • A “static” and “partial equilibrium” framework is used to explain some facts of “general equilibrium” (systemic) nature, thus missing some interesting dimensions, e.g.: • In the model only one type of productive investment which exogenous wrt to how it is financed. • In reality, most problematic ABS were linked to mortgages (RMBS and CMBS). Some argue that the housing bubble was indeed fuelled by securitisation • A conjecture: if securitisation favours the emergence of housing bubbles, then securitisation may not be that good in the first place, even under RE (e.g. in terms of financial stability or general welfare –e.g. Arce & López-Salido 2011) • A (big) conjecture: can “too much” securitisation generate endogenous aggregate instability through its effects on the investment mix?

7. What I find less convincing • The assumption that originators (think that) retain all the risk seems at odds with data ----too little “skin in the game” Tranche retention by originators (% average share of retained deal volume) Source: IMF GFSR • More realistic to assume two types of intermediaries: • i) some with productive-investment opportunities that sell ABS; • ii) some without such opportunities that buy ABS and not only their AAA- tranches¡¡ • - Also, relax the assumption of ex ante symmetric information would be interesting

8. What I find less convincing • In the model, the positive link between securitisation and leverage depends on the volume of retained tranches. • But, if retention is low (“O2D model”), that link weakens  in the limit, originators create and sell assets with no impact on the size of their balance-sheets. • On the other hand, investors in ABS may well end up raising their leverage. Bank Leverage Distribution of the outstanding stock of ABS • (Net) originators seems less leveraged than (net) investors¡

9. What I find less convincing • Is the paper’s liquidity contagion channel the most relevant?? • An alternative based on asymmetric information would help us understand the collapse of the secondary market of European securitisations, whose performance has been remarkably good (i.e. a massive “lemons problem”) Rating migrations: Spain, Europe and U.S • Asset complexity, lack of transparency and a minimum degree of standardization have exacerbated the asymmetric information, killing the EU secondary market

10. Conclusions • Great paper, it helps understand some key links in the financial system that are crucial in the origin, the propagation and the depth of the crisis. • Some assumptions and modelling choices are not fully convincing but the overall story is a credible one.