Analyzing Government Guarantees for Financial Stability

1. Discussion of Allen, Carletti, Goldstein & Leonello„Government Guarantees and Financial Stability“ Gerhard Illing LMU Munich University/CESifo Norges Bank Workshop on Understanding Macroprudential Regulation 29 November, 2012

2. Central issues • How to cope with Moral Hazard effects of public interventions (deposit guarantee schemes)? • Optimal design of Financial Safety Nets? • Challenge: Distinguish between fundamental and panic driven runs (runs due to coordination failure) • Insolvency vs. illiquidity • Panic driven runs: Multiple equilibria ~ how to handle indeterminacy? • Elegant model. Tractable Structure But only first step – some key issues not yet solved

3. Summary – Model setup • Modeling Strategy: Analyze Public Guarantuee Schemes in Goldstein /Pauzner version of Diamond/Dybvig model • Model allows for both fundamental and panic driven bank runs • Model determines strategies of depositors and banks endogenously • Indeterminacy of multiple equilibria solved by Global Game approach (Goldstein /Pauzner) • Depositors receive noisy signals about fundamentals • Inefficiency if runs are panic driven; Public support improves outcome, but may increase region with fundamental runs beyond “efficient” level

4. Summary – Model setup • Diamond Dybvig type Deposit contract High return R>1 with p(θ) at date 2θ: state of the economyDepositors get noisy signal: xi= θ+εi • θ high: Good fundamentals - no run (upper dominance); θ≤θ low: bad fundamentals - always run (lower dominance)intermediate range: multiple equilibria; panic runs • Goldstein/Pauzner Global games solution: • Critical θ*: no run above some threshold θ*!Both θ and θ* are increasing in c1In the range θ≤θ≤θ* panic driven runs Interventions can prevent panic runsencourage insurance (higher c1)Moral Hazard: Support may induce „excessive risk“ - shifting θ(c1) upward beyond some optimal level.

5. Comments • Laissez Faire solution: Banks determine θ*(c1) such that • Marginal gain from better risk sharing (higher c1 for early consumers) equals Marginal loss from increased probability of runs (higher θ*(c1) )c1D • (Constrained) efficient solution: prevent panic runs only fundamental runs;  threshold θ(c1)  c1SP>c1D • Problem: How to avoid panic runs? Costless insurance against panic runs? Implementation mechanism left unclear in the paper: Insure depositors only for θ<θ(c1). Resources needed? • Announcement to repay depositors only if θ <θ(c1) won’t help if private agents cannot observe θ • General Critique: Clear-cut regions of fundamental and panic runs implausible ~~ Too simplified view: In reality, signals provide noisy information about true state of the world  alpha error vs. beta error

6. Comments • Social planner allows transfer of resources from some public good • Idea: Real deposit insurance in period 1: Guaranteec1SPI>1 in the case of fundamental runs (θ<θ(c1)) • Paid out from funds g available for public goods • Ad hoc modeling strategySince risk averse agents prefer some insurance,why not insure depositors with c1SPI>1 in all states θ? • Why not also insure against bad realization in period 2? • Crucial issue:Resources g modeled as exogenously given; corner solutions g not properly modeled (deus ex machina): Partial equilibrium! Determine investment in g endogenously ex ante (distortionary taxes)Strong incentives to provide insurance pool against systemic risks Why no private insurance (investment in safe assets; equity funds)?

7. Comments Inefficiencies from public guaranteeschemes • Guarantuees induce moral hazard (excessive risk taking): c1GG >c1SPθ(c1GG)>θ(c1SP). • Externality: • Government provides insurance funds without adequate „pricing,“ taking private deposit contracts c1GG as given;  overinsurance • In line with intuition, but not worked out properly: Characterise efficient pricing strategy as benchmark case~ not done convincingly in the paper (only a first step) Key argument:Cannot prevent banks to offer contractsc1GG >c1SPI • Simple mechanism: Provide deposit insurance only for banks offering contracts with payout c1 ≤c1SPI • Other available options : capital adequacy; liquidity requirements No role in your set-up ~ strong limitation

8. Comments • Comparison of different public deposit insuranceschemesAll transfer resources from some given public good g to depositors1) Pay out c1D to depositors only at t=1 • 2) Pay out c1D to depositors both at t=1 and t=2 • 3) Insure all deposit claims fully at t=1 and t=2 • Key insight: Optimal scheme depends on size of gIf g is large, full insurance more efficient than moderate intervention • With tight budget (small g), limited intervention allowing panic runs is preferred • Limited insight - Puzzle: How to determine optimal size g? • Very preliminary work

9. Suggestions • Key problem:Dynamic inconsistency of conditional guaranteeschemes:Incentives to renege on commitment not to intervene • Cao/Illing (2011), JICB Endogenous exposure to systemic risk Banks have incentives to invest excessively in activities prone to systemic risk • Allows to model different regulatory designs Liquidity (and capital adequacy) requirements can address these incentivesDiamond/Dybvig framework less suitable – Sequential Service constraint: Optimality of deposit contracts?

10. Minor comments: Analysis incomplete: Compare c1SPIrelative to c1SP ? Upper dominance region: Same return R at date 1 and 2 ~ contradicts initial claims