Economic Ideas from Ed Dolan’s Econ Blog Do Banks Take Excessive Risks? EI 131114 November 12, 2013 Terms of Use: These slides are provided under Creative Commons License Attribution—Share Alike 3.0 . You are free to use these slides as a resource for your economics classes together with whatever textbook you are using. If you like the slides, you may also want to take a look at my textbook, Introduction to Economics , from BVT Publishing.
Transcript
Economic Ideas fromEd Dolan’s Econ Blog
Do Banks Take Excessive Risks?
EI 131114November 12, 2013
Terms of Use: These slides are provided under Creative Commons License Attribution—Share Alike 3.0 . You are free to use these slides as a resource for your economics classes together with whatever textbook you are using. If you like the slides, you may also want to take a look at my textbook, Introduction to Economics, from BVT Publishing.
Banks provide essential services Accepting deposits Making loans Facilitating payments
But banking is a risky business Risk from changes in interest rates,
exchange rates, or other market prices
Risk that loans will not be repaid Risk that liquidity will dry up in a
crisis
Economic Ideas 111314 from Ed Dolan’s Econ Blog
Dime Savings Bank of Brooklyn, NY
How much risk should banks accept?
Banks should not try to avoid risk They face a trade-off: By accepting
more risk, they can earn a higher return
But how much risk should they accept?
Economic Ideas 111314 from Ed Dolan’s Econ Blog
Do banks take excessive risks?
Bank regulators fear that banks, left to their own devices, will take risks that are excessive from the point of view of the economy as a whole
Let’s look at some reasons why banks might take excessive risks: Contagion effects Moral hazard Agency problems
Economic Ideas 111314 from Ed Dolan’s Econ Blog
Contagion effects
Contagion effects arise when the failure of a bank causes harm to other parties
Failure of one bank can cause bank runs as depositors take their money from other banks
Fear of more failures causes banks to stop doing business with one another, causing failures to spread
When banks fail consumers and nonfinancial businesses can’t get the credit they need to operate normally
Economic Ideas 111314 from Ed Dolan’s Econ Blog
Moral Hazard
Moral hazard arises when someone who is protected from loss fails to take measures to avoid excessive risk
The term originated in the insurance business, where people who are insured against loss fail to take measures to minimize risk
For example, people who have flood insurance may build in areas that are known to be at risk of flooding
Economic Ideas 111314 from Ed Dolan’s Econ Blog
Moral Hazard and Deposit Insurance
The purpose of deposit insurance During a bank run every depositor tries to
be first in line to withdraw funds Deposit insurance protects against bank
runs by promising to pay depositors even if not first in line.
Deposit insurance and moral hazard Without deposit insurance, depositors
would be careful to put their money only in banks that were operated safely
With deposit insurance, this source of discipline disappears—even the riskiest banks can attract deposits
Economic Ideas 111314 from Ed Dolan’s Econ Blog
Deposit insurance can help prevent bank runs like this one at Northern Rock bank in England
How to avoid the moral hazard of deposit insurance
Grant insurance only to small depositors—use big depositors to provide market discipline
Rely on bondholders and other uninsured creditors of banks to restrain risk taking
Apply risk based premiums – banks with weak balance sheets must pay more to join the deposit insurance system.
Make sure the deposit system is adequately funded
Economic Ideas 111314 from Ed Dolan’s Econ Blog
Moral Hazard: Too Big to Fail
If a bank is so large that its services are essential to the rest of the economy, the government may be forced to rescue it when it is threatened with failure
If banks know they will be rescued, they may take excessive risks—another example of moral hazard
The implicit guarantee gives the largest banks a competitive advantage over smaller banks
Result: They grow even bigger
Economic Ideas 111314 from Ed Dolan’s Econ Blog
Ideas for limiting the TBTF problem
Establish “living wills” to guide the liquidation of even the largest banks
Make sure managers and shareholders bear their fair share of losses when the bank fails
Expose bondholders and other unsecured creditors to “haircuts” in case of failure, that is, make sure they also bear a share of losses
Executive compensation plans are often poorly aligned with fiduciary duties toward shareholdersBonuses for short-term performanceLack of “clawback” provisions to
recapture past bonuses in case of delayed losses
“Golden parachutes” that give large severance payments to executives even when their bad decisions cause large losses
Such bonus-based compensation plans cause managers to seek strategies with negatively skewed risks
“Golden parachutes” may tempt executives to take risks that are not
in the interests of shareholders
Economic Ideas 111314 from Ed Dolan’s Econ Blog
Hypothetical Example of misaligned incentives
Strategy A 5 quarters of $100 million profit 5 quarters of $10 million loss 10-quarter net for shareholders: profit of $449.5 million 10-quarter result for executive: total bonuses of $500,000
Strategy B 9 quarters of $200 million profit 1 quarter of $2,000 million loss 10-quarter net for shareholders: loss of $201.8 million 10-quarter result for executive: total bonuses of $1.8 million
Negatively skewed strategy B has higher payoff for the executive but lower payoff for shareholders
Assume a bonus plan that pays 0.1% of net profit each quarter, with zero bonus in case of loss and no clawback
Economic Ideas 111314 from Ed Dolan’s Econ Blog
Not just top managers
It is not only top managers who have opportunities to gamble with other people’s money
Individual traders within banks Creditors of bankrupt firms, when
they expect bailouts to shift their losses to taxpayers
Bank depositors, when deposit insurance shifts losses to taxpayers
UBS blamed trader Kweku Adoboli for $2.3 billion in losses . His defense was that supervisors encouraged him to ignore trading limits as long as he was winning.
Economic Ideas 111314 from Ed Dolan’s Econ Blog
Why did Shareholders Let it Happen?
Why do shareholders condone compensation policies that are not aligned with their interests?
Some hypotheses: There is no misalignment—shareholders are
also biased toward excessive risks Technical error: Risk models do not reveal the
negative skew of strategic risks Bidding for management talent is subject to a
“winner’s curse” that leads to overly generous compensation plans
Moral hazard (expectation of bailout) Corporate governance—shareholders don’t
like compensation plans, but can’t do anything about them
Economic Ideas 111314 from Ed Dolan’s Econ Blog
“Shocked Disbelief” .
“Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity are in a state of shocked disbelief”
Alan GreenspanFormer Federal Reserve Chairman
Testimony before the House Committee onOversight and Governmental Reform
