Building an incentive-compatible safety net

林庭妤 R94723006

陳玉鈴 R94723050

Agenda

Introduction Objectives of the bank safety net Evaluating reforms proposals Constructing credible and effective

discipline Conclusion and caveats

Introduction

Safety net-lending to banks、 recapitalizations of distress banks and insurance of some or all banks deposits

To prevent or reverse losses in bank capital, widespread disintermediation from banks and banks failures.

In many countries, the financial system is protected by government insurance and other assistance.

The costs of safety net policy can be very large.Ex: the S&L debacle during the Great Depression

Introduction

A trade-off between constructing a safety net and the costs of the safety net.

An incentive-compatible safety net mechanism. The author discusses the following questions:(1)Whart are the objectives of the bank safety net?(2)What are the most serious shortcomings of current

approaches to designing an effective safety net in a developing economy.

(3)Which specific set of policies is liable to maximize the net benefits from the safety net?

What are the objectives of the banks safety net? What if the banks suffer distress?(1)Spillover effects.(2)Credit crunches(3)Contagion effect and systemic bank runs To insulate banks from losses due to exogenous

adverse shocks then avoid disruptions in bank credit supply and in the smooth functioning of the payments system.

To limit depositors ‘ tendency to overreact to information then avoid costly systemic runs.

Evaluating reform proposals

Six fundamental principles:(1) Government safety net to lead to excessive risk taking is undesirable. (2) Bribe and fraud by banks and monitoring forbearance are undesirable byproducts of the government safety net.(3) Safety net policies are necessarily politically credible.(4) Clear protection is superior to vague protection.

Evaluating reform proposals

(5) The social costs of gathering information and enforcing contracts should be minimized.(6) It is possible and desirable to establish an overall bank safety net policy within a single deposit insurance system.

Possible approaches to minimizing the costs of deposit insurance Proposals divide into two Groups:(1)Proposals intend to limit bank risk taking.(2)Proposals charge banks varying fees depending on

the risks they undertake. The latter proposals are impractical due to:(1)Government agents lack the ability and the incentive

to precisely measure bank risk taking and charge banks for it.

(2)Implementing it involves reliance on complicated and controversial formulas, which invites manipulation.

Risk-limiting proposals

Risk-limiting proposals divide into three categories:

(1)Early intervention/closure(2)Narrow banking (3)Market discipline Market discipline is more promising than others.

Early intervention/closure approach

Maintain minimal capital requirements (capital buffer)

Banks stockholders bear the consequences of their risk choices.

Early intervention by regulators Recapitalization or closure Main idea of Basle Accord and FDICIA law in US To limit the exposure of the deposit insurance

system ( the moral hazard problem).

Early intervention/closure approach

Problem(1)Monitoring forbearance(2)Banks may arbitrage risk categories.(3)Capital crunches

Narrow banking Narrow insured component of the banking system Include only transaction accounts Banks are required to hold marketable, low-risk assets

in separate institutions. The government’s risk of loss is limited. Problems:(1)Bank runs are still possible(2)Safety net is eliminated.(3)The government may still intervene to prop up banks during a crisis.

Market Discipline

Combine government insurance of bank deposits with market-assisted enforcement of bank regulations.

The mechanism is subordinated debt, which is the bank debt that is junior to insured deposits and not insured by the government.

Market Discipline

How does subordinated debt work?(1)Require banks to maintain minimum ratios of subordinated debt relative to insured debt (or relative to risky assets).

(2)Banks that take on excessive risk will find it difficult to sell their subordinated debts and will be forced to shrink their risky assets or to issue new capital.

Market Discipline

Possible problems :(1) How will banks find enough potential buyers of

subordinated debt?(2) Might politically influential firms and individuals

purchase the subordinated debt of their banks at above market prices?

(3) Will not the government be tempted to relax subordinated debt requirements and to bail out during recessions?

A subordinated debt plan Small domestic banks: Maintain a minimum fraction of their risky assets

in the form of uninsured time deposits held by large domestic banks or foreign banks. These time deposits are of 2-year maturity, and 1/24 of them mature each month.

To allow short-run flexibility, it may be desired to measure subordinated debt and risky assets on an average, distributed-lag basis.

A subordinated debt plan

The interest rate on these time deposits must be no greater than that of the one-year Treasury bill plus a maximum spread.

Banks pay an insurance premium that varies month-to-month with the actual interest spread they pay above the Treasury bill rate on subordinated time deposits.

A subordinated debt plan Large domestic banks: Place their subordinated debt in the form of non-

tradable certificates of deposit with foreign banks.

It ensures that subordinated debt will be held at arms length.

It makes the economic and political costs of losses on subordinated debt lower.

The government reduces the need to be concerned about the transmission of risk among large banks.

Advantages of the plan Advantages:(1) Banks are forced to finance themselves with a

minimum ratio of low-risk uninsured debt.(2) Banks are liable to be better able to judge each

other’s creditworthiness than other creditors.(3) Banks that are better able to manage risk are

rewarded by lower costs of deposit insurance.(4) It avoids potential runs on uninsured debt and

fire sales of bank assets, thus precludes bailouts.

Summary of the plan Because discipline is gradual and credible, the

system is self-stabilizing and more credible politically.

The system is easy to enforce. Regulators need only to enforce the requirement that a minimum ratio of subordinated debt relative to risky assets must be maintained.

Banks are forced to meet market discipline, not a set of rules of thumb that invite creative maneuvering .

The conflicting objectives of policy:Discipline vs. Credit smoothing

Market discipline is harmful to the desire to insulate bank credit from the effects of capital losses.

The desire to encourage banks to maintain the supply of credit is at odds with, and can undermine, the government’s commitment to market discipline.

The conflicting objectives of policy:Discipline vs. Credit smoothing

In an developing country, the long-run gains of an efficient financial system are “first-order”, while the benefits of the cyclical stabilization of bank credit are “second-order”.

Time inconsistency problem: Governments that accept the long-run argument may be tempted by the short-term gains from preserving the supply of bank credit.

The conflicting objectives of policy:Discipline vs. Credit smoothing

Recognizing the political economy as a policy constraint, the best available option is to incorporate credit smoothing into safety net policy from the beginning.

What kind of the rule would achieve this end?(1) Relax the discipline on subordinated debt.(2) Recapitalize banks during recessions and

leave the rules of market-discipline unaltered.

The conflicting objectives of policy:Discipline vs. Credit smoothing Rule one:It would make the system more fragile, and thus could undermine the long-run credibility of the commitment to market discipline. Rule two: (better option)It would increase average bank risk, but it would not amplify bank risk taking in the wake of adverse shocks by encouraging banks to increase risk when their capital falls.

The conflicting objectives of policy:Discipline vs. Credit smoothing

To be effective, capital assistance must be junior to subordinated debt, but it should be senior to common stock. Thus preferred stock purchases by the government are a reasonableway to implement this policy.

Conclusion

Safety net policy should reflect both economic goals and political constraints.

A version of the market-discipline approach is superior to other policy options.

The bank-credit motive can be at odds with the long-run stability of the banking system.

It is better to establish a “second-best” safety net that sets clear rules for bailouts.

Caveat

It is desirable to explore ways to reduce political incentives for government to pursue small short-term gains with large long-term costs.

It is important to note the limitations of this analysis. Deposit insurance system insulates depositors from default risk, not exchange risk.