Building an incentive-compatible safety net

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Building an incentive-compatible safety net

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Agenda

• Introduction
• Objectives of the bank safety net
• Evaluating reforms proposals
• Constructing credible and effective discipline
• Conclusion and caveats

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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 SL debacle during the Great Depression

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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?

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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.

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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.

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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.

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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.

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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.

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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).

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Early intervention/closure approach

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

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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 governments 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.

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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.

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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.

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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?

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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.

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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.

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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.

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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 others 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.

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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 .

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The conflicting objectives of policyDiscipline
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 governments commitment to market
  discipline.

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The conflicting objectives of policyDiscipline
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.

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The conflicting objectives of policyDiscipline
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.

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The conflicting objectives of policyDiscipline
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.

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The conflicting objectives of policyDiscipline
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 reasonable
• way to implement this policy.

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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.

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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.