Financial System Diversity and Macroprudential PolicyPreliminary. Not to be circulated without permission of the authors and the Bank of Canada

Kartik Anand, Etienne Bordeleau, Mark Carney & Prasanna Gai

Roadmap

Motivation Model set-up Key propositions/results Comparative statics – role of macroprudential policy Some empirical connections – Canada and the US

Comments welcome!

Motivation

“…A bank may consider a course of action it wishes to take to be acceptable – as it may well be in a limited context. But the same course might, if widely copied by other banks, have unfortunate effects on the banking system as a whole. It is part of the supervisors’ job to take that wider, systemic view and sometimes to curb practices which even prudent banks might, if left to themselves, regard as safe.”Sir George Blunden, Deputy Governor, Bank of England

Motivation

What drives the choice between market versus bank-finance?

Under what circumstances do financial firms pursue the same business strategy (increasing collective exposure to systemic risk as they individually diversify idiosyncratic risk)?

How to characterise notions of “risk illusion” (e.g. Boivin/Carney/Tucker)?

How might “macroprudential” policies shape the diversity of business practices and temper risk illusion?

Different policymaker perspectives...

“with exposures largely staying on balance sheet, Canadian bankers remained bankers rather than warehousers...”, Mark Carney

“Australian banks displayed...more conservative lending practices and...better lending decisions.”, Glenn Stevens

“Banks’ balance sheets, like Tolstoy’s happy families, grew all alike...At the height of the boom, financial imitation turned into near-cloning.”, Andy Haldane

– Our framework seeks to nest these views.

Points of contact with the policy debate

UK-style “ring-fencing”

Capital requirements for trading books

Credibility, transparency, and standards for securitization

Design of shadow banking regulation

Role of central bank facilities, backstops

Main ideas Nothing wrong in securitization per se. Choice of market or bank

finance arises as banks balance gains from trade versus costs of monitoring

• decision depends on a bank’s perceptions of macroeconomic risks which, in turn, colour its views on the quality of collateral

But pooling equilibria are possible. These mean that “optimists” and “pessimists” can mimic each other for certain parameter values. System-wide fragility can result.

Different macroprudential tools can have quite different consequences for the nature of financial intermediation

Points of contact with the literature Builds on Plantin (2011), Park and Sabourian (2011), Rabin and

Schrag (1999) Shadow banking and lack of system diversity (Haldane-May, 2011;

Gennaioli-Shleifer-Vishny, 2011a, Beale et.al, 2011) Financial innovation, “local think” (Gennaioli-Shleifer-Vishny, 2011b)

Relatedly... Information sensitivity of securities (DeMarzo-Duffie, 1999; Dang-

Holmstrom-Gorton, 2009) Credit booms and busts as coordination failure (Rajan,1994; Aikman-

Haldane-Nelson, 2010) Incentives, tranche retention, transparency (Chiesa, 2008; Fender-

Mitchell, 2009, Pagano-Volpin, 2010)

Model Set-up Three dates: t = 0, 1, 2. One risk-neutral bank and

passive end-investors

Bank receives an initial endowment at t=0, which it invests in illiquid assets (loans) that pay out at t=2

Bank is impatient, so there are gains from trade to exploit

Three states of the world, θ, corresponding to boom (H), normal (M), recession (L)

Loans are either good or poor in quality – good loans repay with probability 1, poor loans always default

Let α be the fraction of good quality loans– a random variable that is (high, low)

Information structure Bank receives a signal, S, about the state of the

macroeconomy. And an independent signal, Q, about loan quality.

Signals on macroeconomic risk are “U-shaped” in the spirit of Park and Sabourian (2011)

Signal on the macroeconomy “colours” the view on underlying collateral of the loan :

Confirmatory bias in the spirit of Rabin and Schrag (1999)

Interim monitoring

Bank can invest in lending relationships further via interim monitoring between dates 1 and 2.

Cost of interim monitoring, M > 0, (= benefits lost from not shirking).

Effects of monitoring– Loan repayment rates improve in slowdowns by amount p.– Prevents repayment rates deteriorating in recessions

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Fraction of loan book that pays off for the bank

Result (1) At t=1, bank decides if it wants to securitize its entire loan

portfolio and abstain from monitoring, or retain a stake and monitor (partial securitization).

– Updates its beliefs on the quality of borrowers and state of the economy based on private signals

– Compares expected value of portfolios under the two alternatives.

Trade off between gains from trade from securitization versus incentive to monitor.

Comment– outcome is constrained efficient.– As discount rate (r) increases, bank pursues market-based

finance

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Result (2) – “Frontiers” of intermediation

We seek bounds to the parameters in Result 1 that describe when both “types” of bank will either opt for

• Holding a stake and monitoring• selling the loan portfolio in its entireity

Extent of this depends on expected fraction of good loans perceived by the (biased) bank.

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“Frontiers” for market/bank-based finance and financial system diversity

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Comparative Statics (1): Lowering monitoring costs for the optimist

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Comparative Statics (2): Lowering monitoring costs for the pessimist

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Comparative Statics (3): The dark-side of credibility

Comparative statics (4): Black box to open source

Risk illusion versus local think

Local think: agent neglects certain low probability states of the world. I do my Bayesian updates over selected sub-set of states (those which occurred often in the past)

Risk illusion: U-shaped beliefs mean that I discount some information content in my private signal on macro risk. The consequences amplify as information on loan quality and central bank communications get misinterpreted

Stylised facts: US and Canada

1980 1981 1983 1984 1986 1987 1989 1990 1992 1993 1995 1996 1998 1999 2001 2002 2004 2005 2007 2008 20100%

10%

20%

30%

40%

50%

60%

Canada U.S.

%

Securitization as a share of total household credit

Last observation: 2010Q3Source: Bank of Canada, Federal Reserve Board, Federal Reserve Bank of Australia

Bank-based and market-based intermediation

1980 1981 1983 1984 1986 1987 1989 1990 1992 1993 1995 1996 1998 1999 2001 2002 2004 2005 2007 2008 20100

1000

2000

3000

4000

5000

6000

7000

8000

0

100

200

300

400

500

600

700

800

U.S. - Bank Based (left) U.S. - Market Based (left) Canada - Bank Based (right) Canada - Market Based (right)

$bn $bn

Mortgage Markets

Last observation: 2010Q3Source: Bank of Canada and Federal Reserve Board

Screening and origination standards

2005

2005

2005

2005

2006

2006

2006

2006

2007

2007

2007

2007

2008

2008

2008

2008

2009

2009

2009

2009

2010

2010

2010

2010

0

5

10

15

20

25

30

Commercial Banks RMBS

%

Delinquency Rates on Residential MortgagesU.S.

Last observation: 2010Q4Bloomberg and Federal Reserve Board

Securitization of insured mortgagesCanada - NHA-MBS U.S. - GSE and agency MBS

LTV range 80%-95% 80%-96.5%

Translates into a leverage of: 5-20 5-28.6

Insurance coverage Full amount of the loan Losses exceeding the 80% LTV ceiling

Minimum credit score 620 620

Debt to income ratio requirements: Housing costs Total debt

32%40%

28% 36%

Share of securitization market as of 2005Q4 84% 66%

Risk illusion and securitization – 1

2001

2001

2001

2001

2002

2002

2002

2002

2003

2003

2003

2003

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2005

2005

2005

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2006

2007

2007

2007

2007

100

200

300

400

500

600

700

800

900

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

High Yield - Investment Grade Bond Spread (left) Net Securitization income as a % of non-interest income (right)

basis points %

Search for yield and risk illusion

Last observation: 2007Q4Source: Federal Reserve FRY-9C Report & Merrill Lynch Bond Indices

Risk illusion and securitization – 2

U.S. Canada

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20-0.004

-0.002

0.000

0.002

0.004

0.006

0.008

0.010

<Chart #>:Shock to Risk IllusionResponse of Securitization/bank credit outstanding

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20-0.004

-0.002

0.000

0.002

0.004

0.006

0.008

0.010

<Chart #>:Shock to Risk IllusionResponse of Securitization/bank credit outstanding

Points of contact with policy -- revisited

Universal banks or UK-style “ring-fencing”?

Differential capital requirements on the trading book and the SIFI debate.

Communication, transparency, and financial stability.

Drawing perimeters for shadow banking

Thank you!